In the world of business strategy, Michael Porter’s work on the Five Forces looms large. It’s a framework that helps determine the competitiveness of a given business. The idea is that a business becomes less and less attractive as competition rises in these five arenas.
Competition, in other words, is terrible for business! It lowers profitability to the minimum level and creates threats at every turn. So a key element of strategy, by Porter’s estimation, is to operate in realms where these forces are at their lowest possible level with systemic barriers (the oft-used term “moat”) in place. The five forces include the following:
- Bargaining power of suppliers (consider airlines beholden to a few jet engine makers)
- Threat of substitutes (store-branded food items versus “name-brand”)
- Bargaining power of buyers (vehicle purchases)
- Threat of new entrants (app store developers with new, similar products)
- Industry rivalry (major retailers competing for black friday customers)
As a business and an industry matures, the competition in each of these five forces naturally increases. Business profits decrease as a result and a point of equilibrium emerges where even the biggest players can’t really grow any more and certainly can’t enjoy the old profit margins of the past. A prime example of this arc is found with Sears Roebuck.
Life and Death In The Business Ecosystem
Once upon a time, Sears was a unique business working in a realm of relatively low competitiveness on all five forces. Until Wal-Mart emerged with technology and models (regional store/distribution networks) to win large swaths of the market on cost and convenience. Around the same time, consolidation in hardware stores led to viable low-cost alternatives like Lowes and Home Depot that could steal away a major part of the Sears business (RIP craftsman tools). Finally, the realm of online shopping was a death blow as Sears mishandled its advantage against the likes of Amazon.
A fun bit of trivia: Sears offered an online retail marketplace before Amazon did.
Oh how the mighty have fallen. And will fall again. Because the business realm is an ecosystem and the limits of growth exist for these entities just as surely as it does for any participant in any other ecosystem. Bezos himself said it best recently when he acknowledged that Amazon will fail someday. You can’t avoid these fates. You can only delay them.
The best way to delay this decline in performance is to limit the rise of competition. This requires inherent systemic limits like those found with railroad and utility companies. No one is going to launch a “railroad startup” tomorrow given the upfront costs and the regulatory barriers. The same barriers can come from patents (Google’s search engine technology) or massive economies of scale (Amazon’s distribution network).
In this way, the Five Forces show how a business must fight to keep competition away.
On the flip side, the five forces show how a business can be that competition. The model is a fascinating way of understanding competitive dynamics but it’s even better as a playbook for anyone looking to compete.
So how does one win amidst these five forces? If you’re a new entrant in a good industry with existing players, you can build a strategy in all five forces on the basis of two methods: low-cost leadership or differentiation.
There are nuances to these ideas but this is the essence of all business strategy tactics. Either you’re an Apple, deeply differentiated in your brand and user experience, or you’re an Android, with modular approaches that offer a panoply of options from flagship to very low cost.
Differentiation as a Strategy
In Tuesday’s story about Oil of Olay, we saw Proctor and Gamble revive a brand with differentiation. They developed strong empathy for a specific consumer group (women age 35+) and built a different product for their need. When operating in a space of differentiation, you must satisfy the need and reap the benefit with high margins. Hence the $18.99 price for their product. Same goes for Apple Computer. There was a recent argument that Apples high prices and profit margins are the stuff of greed.
One could channel Gordon Gecko and say “greed is good” but that’s a bit ham-fisted. The truth is that the high margins are part of a broader story that Apple sells and its buyers share. Just as surely as the margins for a luxury scarf are part of a story. It isn’t greed so much as it is the result of a very human tendency to cultivate identity, tribe, and status. Seth Godin’s new book handles this quite well. To tell Apple to lower their margins would be like telling Mercedes to start making Hyundais. They operate on fundamentally different levels with equally-viable strategies. They are playing to their very identity as a business.
Low Cost Leadership as a Strategy
Low cost leadership is the other route and this is how Dell Computer became a billion-dollar company through its fantastic operational approach. Using better assembly, distribution, and leverage over suppliers, Dell Computer was able to build cheaper machines and sell them in a new method via the internet and phone. Perhaps the first major tech company to forgo brick-and-mortar retailing, they dominated the industry for quite some time.
Amazon is doing the same. Just as Wal-mart did a few short decades ago. In fact, they’ve articulated their low-cost strategy with a great motto that crystallizes the competitive strength of the approach: “Here at Amazon, their profit margins are our opportunity.”
The Battles Continue
Throughout the business world, especially in the consumer spaces, this battle wages every day. Low cost providers try to undermine differentiated providers in every arena of the five forces. There’s a lot of nuance once you get into the details of each situation but the simplicity afforded in these basic frameworks really helps.
This gets to our book: Playing to Win. Their framework does a great job of simplifying the core idea even further. They characterize everything that I just wrote under the elegant phrases of “where to play” (based on the five forces) and “how to win” (based on low cost versus differentiation).
On the surface, thinking about where to play and how to win feels simple. And in some ways, it is. Our authors certainly stay at a high level with the ideas. But any coverage of these ideas would be incomplete at-best if we didn’t dive into their conceptual foundations.
Define the Course and Stay With It
A takeaway from the idea here is that great strategy, in business and elsewhere, has the logical consistency of a science project. You treat your idea as a hypothesis and you test it fully, completely, within the full rationale you’ve developed. No scientist would ever begin a cancer drug trial and decide, mid-stream, to test it for depression instead. That would be an entirely different trial, a completely different experiment.
Similarly, the fascinating thing that happens in business is the “straddle”. A low-cost strategy suddenly tries to shift itself to a differentiation strategy. Or vice-versa. Or even worse, the business begins from the very start with something that is really nothing—neither low-cost nor differentiated. This is what happened to GM’s Saturn brand. Once a clear alternative to other car brands that competed in low-cost with some mild elements of differentiation, it eventually lost its identity and became, well, the most indistinguishable brand this side of Pontiac. Both were discontinued by GM in 2010.
To have a strategy build on these frameworks is one thing. To stick with it is another. Doing both doesn’t guarantee success. But the frameworks help you formulate the strategy in a coherent way so that, if it works, you know to stick to it as long as possible.
Image from Siyavula Education