STRATEGY:

THE QUEST TO KEEP

PROFIT FROM
ERODING
What has been the key to the company’s
success?

According to Schultz:
“Starbucks is the quintessential experience brand
and the experiencecomes to life of the people. The
only competitive avnantage. The onlu competitive
advantage we have built with our customers.”
 WARREN BUFFETT said that
“sustainable competitive advantage” is
the most important thing to look when
evaluating a company.

While valuation matters, it is the future growth and prosperity of

the company underlying a stock, not its current price that is
most important. A company’s prosperity, in turn, is driven by
how powerful and enduring its competitive advantages are.
Powerful competitive advantages
(obvious examples are Coke’s brand
and Microsoft’s
control of the personal computer
operating system) create a moat
around a business such
that it can keep competitors at bay
and reap extraordinary growth and
profit.
Numerous studies confirm that
there is a very powerful trend
of regression toward the mean
for high-return-on-capital companies.
In short, the fierce competitiveness of our
Capitalist system is generally wonderful for
consumers and the country as a whole, but bad
news for companies that seek to make
extraordinary profit over long periods of time
 A SIMPLE VIEW
OF STRATEGY
To keep one step ahead of competitors or imitators and keep
profit from eroding, firms develop strategies to gain
sustainable competitive advantage. Firms have a competitive
advantage when they can
a) deliver the same product or service benefits as their
competitors but at a lower cost or
b) deliver superior product or service benefits at a similar cost.
Firms with a competitive advantage are able to
earn positive economic profits.
The height represent the total value of the product
where value is the maximum amount a buyer is willing
and able to pay for the product.
 Cost represents how much value is captured by suppliers

• Price – Cost = Profit

• Value – Price = Consumer surplus
 Say a representative consumer values the product
at $400, it’s priced at $300, and it costs $200 per unit to
produce. The box between $300 and $200 (price minus
cost) represents $100 of profit to the firm. Consumer
surplus is also $100 ( $400 less $300)

Strategy is all about how to increase the size of the profit

box. The box gets bigger if the firm can lower its costs or raise
its price. At a very high level, it’s really that simple. Strategy is
about raising price or reducing cost. Really successful firms
manage to do both.
 SOURCES OF
ECONOMIC
PROFIT
The Industry (External) View
The Resource (Internal) View
 The Industry (External) View

In the IO perspective, the fundamental unit of analysis is the

industry. According to Michael Porter, “The essence of this
paradigm is that firm’s performance in the marketplace depends
critically on the characteristics of the industry environment in
which it competes.” Certain industries, due to their structural
characteristics, are inherently
more attractive than other industries, and companies within
Those industries possess market power to generate economic
profit.
 The IO perspective assumes that the industry structure is the most
Important determinant of long-run profitability. The key to
Generating economic profit for a business is its selection of industry.
According to Michael Porter’s Five Forcesmodel, the best industries
are characterized by

1. low buyer power,

2. low supplier power,
3. Low threat of entry (high barriers to entry)
4. low threat from substitutes, and
5. low levels of rivalry between existing firms.
A key first step in applying the Five Forces model is
determining the industry. An industry is comprised of a
group of firms producing products that are close
substitutes to each other to serve a particular market.

Suppliers want to charge as much as

possible and buyers want to pay as
little as possible. The Five Forces
model helps you think about how much of
the industry value your firm is likely to
capture given the characteristics of the
industry.
 Suppliers can charge higher
prices (and capture more of the
industry value) when they have greater
power. They are the providers of any
input to the product or service.

Examples include labor, capital, and providers of raw/

partially finished materials.
Supplier power tends to be higher when the inputs
they provide are critical inputs or highly differentiated.
Concentration among suppliers also contributes to
supplier power because a firm will have fewer bargaining options.
Even if many suppliers exist, power may still be high if
there are significant costs to switching between suppliers.
If buyers are concentrated or if it is
easy to switch from firm to firm,
buyer power will tend to be higher.
More power means these buyers
will find it easier to capture value,
taking value away from your firm
 Threats from potential entrants are another
important force to consider. These entrants will
quickly erode the profit of an industry unless barriers
prevent or slow their entry.

Examples of entry barriers include

government protection (patents or licensing
requirements), proprietary products, strong
brands and high capital requirements for
entry, and lower costs driven by economies
of scale.
Substitute products can still erode a firm’s ability to capture value
even if barriers to entry are high. If close substitutes to a product
are available and buyers find it inexpensive to switch to them, it
will be hard for a firm to build and maintain high profits.

The final force concerns the rivalry among existing firms, the
force most directly related to our typical view of “competition.” If
a large number of firms compete in an industry with high fixed
costs and slow industry growth, rivalry is likely to be quite high.
Rivalry also tends to be higher when products are not very well
differentiated and buyers find it easy to switch back and forth.
 The most profitable industry,
pharmaceuticals, exhibits relatively high
barriers to entry, arising from significant
investments in personnel and technology;
moreover, successful products enjoy
extended periods of patent protection
(legal barriers to entry).

The IO view suggests that the way to earn

economic profits is to choose an attractive industry and
then develop the resources that will allow you to
successfully compete in the industry.
 What about managers who don’t have the
luxury of choosing a new industry?
The tools of industry analysis can still be helpful.

 First, move beyond a historical analysis of your industry

to think about how the five forces might change in the future.

 Second, and more importantly, think about what actions

you can take to make your current industry position more
attractive.
It’s also important to realize the limitations of tools
like the Five Forces.

 First, this view focuses on value capture. It

doesn’t really provide any insight into how value
gets created in the industry

 Second, this view portrays an industry as a zero-

sum game
 Cooperative efforts with rivals,
buyers and suppliers feature prominently in a
book by Adam Brandendurger and Barry
Nalebuff called Coopetition (cooperative
competition

Annabelle Gawer and Michael A. Cusumano offer a similar

idea for thinking about strategy in industries like telecommunications
where success requires creating an “ecosystem” of complementary
products. A company must first decide whether to pursue a “product”
or a “platform” strategy; a “product” is proprietary and controlled by
one company whereas a “platform” needs a set of complementary
innovations to reach its full potential.
The Resource (Internal) View
The RBV explains that individual firms may exhibit
sustained performance advantages due to their
superior resources, where resources are defined as “the
tangible and intangible assets firms use to conceive of
and implement their strategies.”
Two primary assumptions underlie the RBV:
The first is the assumption of resource heterogeneity
(firms possess different bundles of re- sources); the
second is the assumption of resource immobility (since
resources can be immobile, these resource differences
may persist).
If a resource is both valuable and rare, it can
generate at least a temporary competitive advantage over
rivals. A valuable resource must allow a business to
conceive of and implement strategies that improve its
efficiency or effectiveness. For a resource to be rare, it
must not be simultaneously available to a large number of
competitors.
Resources that generate temporary
competitive advantage do not
necessarily lead to a sustainable
competitive advantage.
We can list several conditions that make resources hard to imitate
(inimitability):

1. Resources that flow from a firm’s unique historical conditions will

be difficult for competitors to match.
2. If the link between resources and advantage is ambiguous, then
competitors will have a hard time trying to re-create the particular
resources that deliver the advantage.
3. If a resource is socially complex (e.g., organizational culture), rivals
will find it difficult to duplicate the resource.
 The Three Basic Strategies
Firm looking to generate superior economic
performance, given its industry and resource base,
has three basic strategies it can follow to keep one
Step ahead of the forces of competition:

1. cost reduction,
2. product differentiation, or
3. reduction in competitive intensity.
 The first strategy, cost reduction, is pretty self-
explanatory. Low-cost strategies are usually found in
industries where products are not particularly differentiated
and price competition tends to be fierce. Note, however, that
cost reductions generate increases in long-run profitability
only if the cost reduction is difficult to imitate. If others can
easily duplicate your actions, cost reduction will not
give you sustainable competitive advantage.
The third strategy, reducing competitive intensity, is also
self-evident. If you can reduce the level of competition within
an industry and keep new competitors from entering, you
may be able to slow the erosion of profitability.
We can interpret the second strategy,
product differentiation, as a reduction in
the elasticity of demand for the product. Less
elastic demand leads to an increase in price because the optimal
markup of price over marginal cost is related to the elasticity of
demand; that is, (P –MC)/P=1/|e|.

The more unique your product is relative to other products, the

less elastic is your demand and the higher is the markup of price
over marginal cost.
 This strategy leads to sustained, above-average
profitability for the company, but remember that the
stock price also determines the return from
investing. If the stock price is high relative to its
discounted future earnings, the investment is a bad
one, regardless of whether the company has a
sustainable competitive advantage.