The Sources of Competitive Advantage

It was Michael Porter who first viewed competitive strategy from the perspective of economics.With his famous Five Forces framework, Porter provided a paradigm which allowed firms to understand the structure of their industry and the nature of the forces which shape industry profitability.

A criticism of Porter’s thinking was that he failed to carry his ideas through to practical implementation. In response to that criticism, Porter advanced the idea of the value chain – the extended set of activities a firm uses to create value for its customers. Most importantly, Porter developed the idea that, because it is the firm’s value creation system, the activities which comprise a firm’s value chain are the source of its competitive advantage.

Activities are synonymous to some degree with processes. A process is a set of activities, or operations, that are carried out to transform inputs into outputs. It is processes, and their member activities, which create the value which a firm carries to the marketplace.

As noted in my last blog, most firms believe that to gain a competitive advantage, they must become the best in their industry. Accordingly, firms tend to emphasize excellence of execution in their business processes and activities. Such firms believe that to win in business, they must pursue a strategy of operational effectiveness, or what Porter calls OE. The emphasis on OE is evident in the plethora of management programs and fads that have come and gone over the years, including Total Quality Management (TQM), Six Sigma, and Lean Manufacturing or Service.

As Porter notes, OE is not a strategy. A competitive strategy is not about being the best, it is about being unique and different from the competition. If your value chain is the same as the competition’s, then you are no different from them. In such cases,the ability to price lowest, often at reduced margin, becomes the main competitive differentiator.

A good competitive strategy emphasizes creating a competitive advantage through building a relative price or cost differential from competitors. The source of this price or cost differential is the activities (or processes) that a firm chooses for its value chain. Of course, these activities need to be well-executed, but the primary source of the competitive advantage is in the choice of the activities, not in how well they are performed. Knowing which activities to perform, as well as not to perform, is the key insight which is often overlooked.

Value chain configuration is therefore a key component of competitive strategy. Remember, a price or cost advantage finds in source in the value chain and nowhere else.

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Strategy is Not About Being the Best

The essence of business strategy is competing to offer unique value to customers. This is different from competing to be the best.

The mindset of many firms is that they view competition as a contest where all competitors are vying to serve the same customers with the same products and services, and that the firm who does this best will win. This mindset reveals a lack of understanding about the true nature of competition.

When firms compete to be the best, they automatically enter a zero-sum game where there can only be one winner. If all competitors in an industry compete for the same customers with the same products and services, they will all converge at more or less the same point. This point is what economists call perfect competition – where there is little or no difference in the products or services being offered and customers have no incentive, other than price, to choose one provider over another. In such a situation, industry profitability approaches zero.

Rather than competing to be the best, competing effectively requires firms to differentiate themselves from the competition. This means identifying customer groups whose needs can be met with a value proposition that is distinct and different from the competition.When firms do this, they can generate returns that are above the average of the firms that are competing to be the best.

The starting point for strategy is not mission statements and goals, but rather with developing a deep understanding of the forces that are shaping industry competition and profitability. This understanding allows a firm to begin to see what forces are driving prices and costs and where there is opportunity to position within the industry to achieve differences in prices and cost relative to competitors. It is industry structure that determines industry economics and firms must understand their industry and competitors from this perspective.

Understanding industry structure and the nature of competition allows a firm to begin to determine the actions that can be taken to improve economic profit. These actions comprise the firm’s competitive strategy. Forsaking this analysis leads a firm into the dangerous trap of competing to be the best: the firm assumes that higher returns can be had by simply doing better what it is already doing. Avoid this trap at all costs.

Contribution, Improvement and Culture

How vital is the contributive energy in your firm? Are all of your employees bringing ideas for improvement forward on a regular basis, without prompting or having “improvement events” orchestrated? Are your employees engaged in making improvements happen and do they have responsibility for implementing good ideas? Do your employees think about your customers, their work, and how to make the work go better to satisfy the customer?

If not, you probably have a low contributive energy within your firm. Eliciting contribution from all who work in a firm is an executive leadership and management function. Leaders and managers have a responsibility, and an obligation, to provide a sense of purpose and context that is sufficiently compelling so that those who work in an organization will be disposed to contribute towards its fulfillment. What else is improvement but changes made in pursuit of a purpose or goal?

Many firms work hard at improvement. but are much less good at gaining contribution from members. If you have to orchestrate improvement events to make improvement happen, you are missing the real point of continuous improvement.

All improvement is done with, through, and by people. If people have to be coerced into participating in improvement events, this is antithetical to the spirit of real improvement. The miracle of the best Japanese firms is not the improvement tools and techniques they use, it is the frequent and regular contribution they get for improvement from employees in all areas of their organizations.

Building a culture where all employees are induced to contribute their ideas for improvement is not easy. The organization’s purpose must be clear and compelling. Leadership and management behaviours must be congruent with that which encourages employees to bring ideas forward. Reward and feedback systems must be such that many small ideas are valued over few, breakthrough ideas. And the organization must be prepared to delegate some responsibility and accountability to employees for implementing their ideas.

The quickest way for a firm to improve its economic performance is for it to start eliciting, and using, ideas for improvement which come from workers. Those closest to the work are the ones who know best how it can be made to go better. This is the quickest way to drive down costs and add value to customers. And, no improvement events are needed!

Creating Learning Economies in Firms

There has been a lot of press in recent years about the importance of the “learning organization.” While the idea of a learning organization from the perspective of how learning can be enabled and shared is well-explored, the economic impact of learning, and its resulting effect on competitive advantage, have been less fully examined. This blog post looks at the notion of organizational learning from this perspective.

Hardly anyone today disputes the importance of learning in firms. Learning is essentially the acquisition of knowledge, understanding and skill through experience, instruction or study. For most firms, experience will be the main pathway to learning where people gain knowledge and skill from actually performing a job. By acquiring and leveraging the learning acquired through accumulated experience, a firm can drive significant improvements in quality, work processes and routines, and products and services.

Economists and business strategists have long appreciated the impact of learning on organizational performance. The so-called experience or learning curve shows how costs fall as a function of cumulative output – as a firm acquires learning about how to better make and provide a product or service over a greater quantity of output, it can leverage that accumulated experience and learning to gain greater efficiencies and thereby reduce unit costs.

To see how this works, consider the learning curve for a firm shown in the diagram below.

In this figure, as the firm accumulates output from quantity 1 (Q1) to quantity 2 (Q2), it also moves down the learning curve by accumulating experience and learning. At quantity Q1, the firm’s acquired learning results in an average unit cost of AC1. At quantity Q2, by moving down the learning curve and applying its accumulated experience, the firm is able to lower the average unit cost to AC2.

Proponents of the learning curve have generally held that, as accumulated experience doubles, unit costs can fall 15 to 20 percent. In some industries, the rate is higher. For example, in aircraft manufacture it is not uncommon for unit costs to fall by 25 percent or more by the fourth or fifth year following a new model introduction. However, it should be kept in mind that the learning curve is not uniform across all industries: the accumulated experience that a firm would acquire from making a simple stamped metal part would not be as deep, and therefore not as impactful on unit costs, as the learning that a complex microchip manufacturer, for example, might acquire.

Why do unit costs decrease with accumulated experience? Cost decreases generally result from employees gaining greater proficiency and experience in performing work, higher quality, and also from efficiencies gained by finding better ways to do things. Firms that are able to use learning to drive improved performance use less input factors of production – less labour, less materials, less machines, less facilities, etc. – resulting in lower costs.

An important feature of learning curves is their predictive ability. If a firm can calculate its learning curve, it can predict what its unit costs should be at a given cumulative volume. With this knowledge, and provided other market conditions are appropriate, a firm can set its pricing based on the future unit costs which will be attained once the firm drives down the learning curve and achieves the predicted cumulative volume. Driving down the curve before competitors can result in a gain of market share at competitors’ expense, while at the same time erecting a barrier to imitation which can only be removed through a competitor’s commitment to learning.

Eliminate Costs That Don’t Drive Benefits

There are basically two strategic approaches a firm can adopt for competing in the marketplace: cost advantage and benefit advantage. A firm pursuing a cost advantage strategy is strives to achieve the lowest cost structure in its industry. This can be accomplished through a unique configuration of the firm’s value chain so that total costs are minimized. A benefit strategy, on the other hand, is where a firm chooses to offer unique value to the customer that commands a price premium. A benefit strategy results in higher costs to enable the benefits being offered – higher costs that are more than offset by the price premium that can be charged.

Benefit advantage providers are not exempt from reducing costs. Just because a firm offers unique benefit which incurs higher costs, and higher prices, this does not mean that such a firm should neglect its costs structure. On the other hand, benefit advantage providers must be very focused on costs.

Benefit advantage providers can erode their margins and profitability by incurring costs that are not directly related to the benefits being offered. Often, such costs are masked by the higher price premiums benefit advantage providers can extract from customers. This results in the firm’s average cost of production curve being higher than it need be, reducing overall profitability.

Firms pursuing a benefit advantage strategy should evaluate and assess their cost structures to make sure that all costs incurred are driving or supporting the benefits offered. Such cost assessments should be done across the entire value chain, including all primary and secondary (supporting) processes. Activity-based analyses can help trace costs to activities, allowing the firm to evaluate the relationship of the activity to benefits offered. Activities that do not have a high correlation to benefits offered should be reduced or eliminated.

Benefit advantage providers can have their benefit provision eroded by competitors who offer similar benefits, but at lower cost (and therefore, price). It is therefore extremely important for firms pursuing this strategic approach to pay close attention to their cost structures.

Cost Reduction Fixation

Why are so many firms fixated on reducing costs? Obviously, the recent recession has resulted in a collapse of aggregate demand, and firms are faced with lower revenues as a result. In such an environment, reducing costs is the fastest way to maintain profit levels.

Yet, the obsession with reducing costs goes beyond the recession. Both Lean and Six Sigma are heavily promoted as methodologies which can help a firm to improve its profitability through the greater efficiencies. Both of these approaches pre-dated the recession.

My own answer to this question is that firms are often unprepared to do the heavy lifting that is required for thinking through the revenue side of their businesses. It is much easier to identify how you can reduce costs than figure out how to compete more effectively and create customers. An intellectual laziness, if you will.

As a result, firms learn to become quite adept at reducing costs, but much less good at determining how they will create and keep customers.The tacit assumption that firms make in cost reduction initiatives is that “our approach to the marketplace is fine. We just to need to improve our costs and everything will be OK.” The danger here is that if the assumption is wrong (as it often is), the firm is actually harming itself since reducing costs does little to enhance how the firm will enhance its ability to build a competitive advantage in the marketplace.

It is time to start looking less at operational cost reduction initiatives and more about how a firm can compete more effectively and create and keep customers. I’ll have more to say about this in future columns, including looking at how Lean and Six Sigma can be leveraged for revenue generation as opposed to cost reduction.