Strategy: the Quest to Keep

Profit from Eroding

Chapter 10
 In 1971, three partners opened a coffee shop in Seattle's Pike Place Market. Two of the partners wanted to name the
store after the ship Pequod from Moby Dick, but the third disagreed. Eventually they agreed to name the store after the
Pequod's first mate. The company enjoyed mild growth until 1988 when the partners agreed to sell the company to their
former director of retail operations and marketing. Over the following 20-plus years, that director has overseen the
expansion of the company to over 23,000 worldwide stores as of 2015 and revenues of over $19 billion. And in case you
haven't put it all together, yet Starbuck was the first mate on the Pequod and that former di- rector of retail operations is
Howard Schultz, who recently stepped down as CEO of the world's largest coffee retailer, Starbucks.

What has been the key to the company's success? According to Schultz:¹ * Starbucks is the quintessential experience
brand, and the experience comes to life by our people. The only competitive advantage we have is the relation- ship we
have with our people and the relationship they have built with our customers. The ability to create this unique experience
draws on distinctive capabilities the company has developed in both producing high-quality coffee and establishing a
relationship-oriented culture among its employees and customers. In a 2012 study of U.S. consumer sentiments expressed
through social media outlets, Starbucks was ranked as the most loved restaurant- related brand, and the company
generated over $3.6 billion in 2015 operating income despite operating in a very competitive industry.
 Succeeding in the face of competition requires that you first find a way to create an advantage and then
figure out how to protect that advantage. How important is creating and sustaining advantage? Here's how one
financial columnist summarized the view of one of the most respected investors of our time:
Warren Buffett was once asked what is the most important thing he looks for when evaluating a
company. Without hesitation, he replied, "Sustainable competitive advantage.“
 I agree. 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. Like Buffett, I seek to identify and then hopefully purchase at an attractive price the rare
companies with wide, deep moats that are getting wider and deeper over time. When a company is able to achieve this, its
shareholders can be well rewarded for decades. Take a look at some of the big pharmaceutical companies for great examples
of this.
It Is extremely difficult for a company to be able to sustain, much less expand, its moat over time. Moats are rarely
enduring for many reasons: high profit[s] can lead to complacency and are almost certain to attract competitors, and new
technologies, customer preferences, and ways of doing business emerge. 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.³

In Chapter 9, we discussed how the forces of competition tend to erode high profit; in this chapter, we show you what to do
about it. This material will help you formulate long-run strategies to slow your firm’s competitive erosion of profit; it will help you
figure out how to build a moat around your company so that you can sustain profitability. We’ll also evaluate Buffett’s in- vestment
strategy.
A Simple View of Strategy
From Chapter 9, you should know that firms would rather be monopolists than competitors. In fact, if you hire management
consultants, they should advise you to figure out how to become a monopolist (assuming they’re worth the money you are paying them).
To keep one step ahead of the forces that erode profit, firms develop strategies. And although there are lots of different definitions of
strategy, they all generally tend to emphasize the importance of gaining sustainable competitive advantage. For example, in the 2013
book Playing to Win, co-author A.G. Lafley, the former CEO of Procter & Gamble, defined strategy as an integrated set of choices that
uniquely positions the firm in its industry so as to create sustainable 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. In some respects, strategy is very simple.
Figure 10.1 shows the allocation of economic value for a particular product. The height of the column represents the total value of the
product where value is the maximum amount a buyer is willing and able to pay for the product. That total value gets divided among the
different players. Cost represents how much value is captured by suppliers. The difference between the price you charge, and your cost
is profit, and the difference between value and price is surplus captured by the consumer. Here’s a simple example. 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).
This simple diagram communicates several important ideas in strategy. First, it highlights that both value creation and value
capture are critical. The starting point to strategy is producing a product that a consumer is willing and able to pay for. But you also have
to be able to capture some of that value for yourself as profit. Strategy is ultimately 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. Extremely successful firms like Starbucks do it over a long period of time,
reflecting a sustainable competitive advantage.
Sources of Economic Profit
So, what are the keys to competitive advantage and generating sustainable eco nomic profit? Two schools
of thought offer differing points of view. The first the industrial organization (IO) economics perspective locates
the source of advantage at the industry level. The second the resource-based view (RBV)Đ locates it at the
individual firm level.
The Industry (External) View
The 10 perspective focuses on the industry. According to Michael Porter, "The essence of this paradigm is
that a firm's performance in the marketplace de- pends critically on the characteristics of the industry
environment in which it competes. Certain industries are more attractive than other industries because of their
structural characteristics. Companies in those industries possess market power, which allows them to keep
prices above the competitive level and to earn economic profit. Industry structure includes factors such as
barriers to entry, product differentiation among firms, and the number and size distribution of firms. For
example, industries with high barriers to entry are more attractive because competitors find it more difficult to
enter the industry and drive profit down to competitive levels; firms in industries with differentiated products
have less elastic demand and therefore higher profit; and indus- tries with a small number of firms of different
sizes are less likely to compete vigorously.
Sources of Economic Profit
If industry structure is the most important determinant of long-run prof- itability, then the key to generating economic
profit is to operate in the right industry. According to Michael Porter's Five Forces model, the best industries are characterized
by:
• low buyer power,
• low supplier power,
• low threat of entry (high barriers to entry),
• low threat from substitutes, and
• low levels of rivalry between existing firms.

A key first step in applying the Five Forces model is defining what exactly we mean by industry. An industry is a group of
firms producing products that are close substitutes to each other to serve a market. It's important to realize that firms often
operate in multiple industries. So, the analysis may need to be done on a product-by-product basis for multiproduct companies.

Industry analysis and the Five Forces model is largely about which players capture the value in an industry. Just because
you are in an industry that creates value doesn't mean that you are going to capture it. Suppliers, industry rivals, and buyers all
want to capture value too: 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. It all depends on the strength of the forces. Let's start with supplier power.
 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. The story on buyer power is similar. If buyers are concentrated (consider if
your firm were an automotive supplier and your buyers were the major auto manufacturers) or if it is easy for
buyers 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 (e.g., by bargaining hard to pay a lower price), taking value away from your firm.
Threats from potential entrants are another important force to consider. As we discussed in Chapter 9,
economic profits tend to draw new entrants. These entrants will quickly erode the profit of an industry unless
barriers pre- vent or slow their entry. Examples of entry barriers include government protection (e.g., patents or
licensing requirements), proprietary products, strong brands, 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 bi and maintain high profits.
 The final force concerns the rivalry among existing firms, the force m directly related to our typical view of “
competition. If a large number of similarly situated 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 wide differences In profitability across industries in Figure 10.2 sup- port the 10 view. The most profitable
industry, pharmaceuticals, exhibits relatively high barriers to entry, arising from significant investments in person
and technology; moreover, successful products enjoy extended periods of patent protection (legal barriers to entry).

Overall, 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. But, what about managers who
don’t have the luxury of choosing a new industry? The tools of industry analy-sis 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.
For example, how can you reduce supplier power? One answer is to increase rivalry among your suppliers. For
example, you could do this by using an online procurement auction to purchase raw materials and semifinished
inputs. Auctions are the topic of Chapter 17. Steps that you take to decrease rivalry with your competitors, reduce
buyer power, and build entry barriers will all help improve the attractiveness of your industry position.
 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; that is, the way you get a bigger piece of the pie is to take it from one
of the other participants in the industry. Although this is one way to view competition (and one that is often
correct), companies can also work with other industry participants to try to build a larger pie. With a larger pie,
everyone’s slice grows bigger. Cooperative efforts with rivals, buyers, and suppliers feature prominently in a
book by Adam Brandenburger and Barry Nalebuff called Coopetition (cooperative competition). The authors
remind us that to look beyond the threats to firm profitability, emphasized by Porter’s Five Forces analysis, to
opportunities for cooperation that can enhance firm and industry profitability.

Annabelle Gawer and Michael A. Cusumano offer a similar idea for thinking about strategy in industries
like telecommunications where success re- quires 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. One of the biggest mistakes a company can make is to pursue a product strategy and fail to recognize
the platform value of their product. The best example of this is perhaps the Macintosh computer, which, due to
its early technological lead, could have become the dominant platform for personal computing. Instead, they
priced high, failed to encourage complementary innovation, and let Microsoft become the dominant platform.
The Resource (Internal) View
If industry structure told the whole story about strategy, we wouldn’t expect to find performance differences
across firms within industries. These differences do exist, however, and the resource-based view (RBV) gained
favor in the 1990s as an explanation for these inter-firm differences.
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. Resources can be tangible like equipment, real estate, and financial capital as well as intangible
like brand, knowledge, and organizational culture. Two primary assumptions underlie the RBV: resource
heterogeneity and resource immobility. The RBV views firms as possessing different bundles of resources that are
immobile (the resources resist transfer or copying). These immobile resources are the sources of differential
performance within an industry.
Given the differences in resources across firms, the RBV provides further guidance on when these resources
may lead to superior performance, where superior performance is defined as the firm’s ability to earn above-
average profit. 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. Examples include resources that let a firm operate at lower costs than its rivals or
charge higher prices to its customers. For a resource to be rare, it must not be simultaneously available to a large
 Resources that generate temporary competitive advantage do not necessarily lead to a sustainable
competitive advantage. For such resources to deliver a sustainable advantage, they must be difficult to substitute
for or imitate. Otherwise, any advantages that those resources deliver will be competed away. Imitation and
substitution both erode firm profit. In the first, a competitor matches the resource by exactly duplicating it; in
the second, a competitor matches the resources by deploying a different but strategically equivalent resource.
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 unclear, then competitors will have a hard time trying to
recreate 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.
 Be wary of any advice you read that claims to identify critical resources or capabilities that successful
companies have to develop in order to gain a competitive advantage. You should be skeptical of such advice
for two reasons. First, explanations such as these often mistakenly conclude a causal relation- ship when only
a correlation exists. Remember the Good to Great companies that we mentioned in Chapter 9. They all had
five management principles in common that supposedly drove their success. Their subsequent less-than-great
performance raises serious doubts about whether these “ best practices” caused their prior superior
performance.
The second reason you should question such advice has to do with the nature of competition in general.
Publicly available knowledge is not going to help you create a competitive advantage. Let’s say an author
discovers that having a chief managerial economics officer (CMEO) in your company always leads to a
competitive advantage in companies and publishes this advice in a new book. You read the book and decide to
hire a CMEO for your business and no competitive advantage follows. What happened? Well, your competitor
probably read about the CMEO secret as well and hired one, too. Now that everyone knows about it, no
advantage is possible. Competitive advantage flows from having something that competitors can’t easily
duplicate, such as an extremely valuable brand like Starbucks. You’re not likely to find these on the shelves of
your local bookstore. Nor are you likely to get it from a consultant who is selling the same advice that he or she
sells to your competitors.
 The Three Basic Strategies
A 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.

Most strategies fall into one of these three categories. 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 com- petition tends to be fierce. Walmart and Southwest are two famous examples of
companies that have been very successful in developing low-cost strategies. Note, however, that cost
reductions generate increases in long-run profitability only if the cost reduction is difficult to imitate. If others
can easily du- plicate 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. (In the chapter on strategic interaction, we’ll use game theory to develop strategies that
reduce the intensity of competition.) One easy way to reduce rivalry Is to ask the government to do it for you.
This is what the bookselling industry in Germany does. Discounting of new books by German booksellers is
illegal, essentially making price competition a crime. U.S. washing machine manufacturers have benefited
from regulation as well. A 2000 Department of Energy regulation banned the sale of low-priced washing
machines under the guise of increasing energy efficiency. Who were the biggest supporters of the ban? It was
not the consumers, who by a margin of six-to-one preferred to purchase lower-priced machines. It was the
washing machine manufacturers because now they would be able to sell expensive “front-loading” models at
an average price of $240 more than the banned machines.

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 margin of price over marginal
cost is related to the elasticity of demand; that is, (PMC)/P1/lel. When your product is effectively differentiated
from other products, demand is less elastic, leading to a higher margin of price over marginal cost. Starbucks is
an excellent example of a company that has successfully pursued a differentiation strategy for over 40 years.
Another successful example of a product differentiation strategy is Perdue Chicken. Frank Perdue took an
essentially homogeneous product chicken and turned it into a branded product, Perdue Chicken. He did this by
exercising quality control over the entire supply chain, from the feed to the final product. Consumers perceive
his branded chickens to be of higher quality. Thus, they have less-elastic demand, allowing Perdue to charge a
higher price.
Economies of scale (cost reduction) also have played a part in Perdue’s success. Prelude Lobster’s” managers
tried a product differentiation strategy simi- lar to Perdue’s. Although they advertised their superior after-catch
handling of the lobsters, customers correctly perceived that, for lobsters, unlike chicken, the supply chain is
largely uncontrollable. Prelude was eventually forced out of business by lower-cost competitors who did not
advertise.
With the benefit of hindsight, it is easy to identify successful strategies (and the reasons for their success) or
failed strategies (and the reason for their failures). It’s much more difficult to identify successful or failed
strategies be- fore they succeed or fail. But this is what you have to do in order to invest successfully, or to build
successful strategies.
To illustrate the importance of this idea, let’s return to the wisdom of investing in companies with a sustainable
competitive advantage.
 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. Warren Buffett, for instance, makes money by acquiring companies whose potential future earnings
are high relative to their current stock price. He then helps develop strategies to help them realize their high
potential earnings by creating a sustainable competitive advantage. He doesn’t make money simply by investing
in companies with a current competitive advantage. Instead, his success is due to his ability to help these
companies craft successful long-run strategies.