Porter's Theory of Competitive Advantage

This article is an excerpt from the Shortform summary of "Understanding Michael Porter" by Joan Magretta. Shortform has the world's best summaries of books you should be reading.

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What is Porter’s theory of competitive advantage? What does it mean and how does it work?

Porter’s theory of competitive advantage explains that if you have a real competitive advantage, compared with rivals, you operate at a lower cost, command a premium price, or both. What actually goes into building the advantage is trickier. Study this to figure out whether your business has an enduring competitive advantage.

Porter’s Theory of Competitive Advantage

The Five Forces analysis suggests the profitability of an industry, but it does not automatically suggest how you should operate in the industry to maximize profits.

First, we’ll unpack why some companies are more profitable than average. Then we’ll see how a unique value chain is the mechanism by which superior profits are achieved. This is explored in Porter’s competitive advantage model.

Competitive Advantage

Porter’s theory of competitive advantage explains that if you have a real competitive advantage, compared with rivals, you operate at a lower cost, command a premium price, or both.

The goal of every organization is to produce goods or services whose value exceeds the sum of the costs of all inputs. Thus, Porter proposes the best metric is Return on Invested Capital (ROIC). ROIC tells you how well a company is using all its resources.

If you have a real competitive advantage, your ROIC will be sustainably higher than the industry average.

Instead of ROIC, many companies focus on inferior metrics. With competitive advantage, Porter shows:

Return on sales: ignores the capital invested in the business
Growth or market share: the game is not to be the biggest in the industry. Too many companies pursue unprofitable growth that never leads to good ROIC.
- “Market share says we just want to be big; we don’t care if we make money doing it.” – Herb Kelleher
- If you think growing large will be a winning strategy, remember that returns to scale may be illusory and cap out sooner than you think.
Stock price: these reflect value only in the long run. In the short-term, focusing on stock prices causes earnings management and encourages mimicking other companies.

Because Profits = Prices – Costs, you can achieve superior profits through increasing your relative price, or decreasing your relative cost, or both. As we’ll discuss later, these advantages should be achieved through a unique mix of activities that are difficult to replicate. Porter’s theory of competitive advantage makes this clear.

Quantify your org’s long-term profitability against the overall economy, then against the average return in your industry. Keep digging to understand why it’s performing better or worse than average – relative price and relative cost.

If you have a 5% higher return, is that because your price is 8% higher and cost 3% higher, or price is 5% lower and costs 10% lower?

Relative Price

Create more buyer value and you raise willingness to pay. The ability to command a higher price is differentiation, in the Porter competitive advantage model.

With corporate buyers, decisions are often rational and relative value can be quantified (eg a superior machine offsetting labor costs).
With consumers, buying decisions are more likely to have an emotional or intangible dimension. Rarely do they figure out what they are paying for convenience.
- The author notes that consumers pay $100/hour for grating cheese.

Examples of the Porter competitive advantage model:

People are more willing to pay for Apple products than Android products of similar specifications, because of Apple’s software ecosystem, habit, and emotion.
Organic foods sell at higher prices than conventional foods because of health, taste, and environmental concerns.

Relative Cost

Porter’s theory of competitive advantage also addresses cost. You can also produce at lower cost than your rivals. This might come from lower operating costs or using capital more efficiently.

Sustainable cost advantages usually involve many parts of the company, not just one function. The culture of low cost permeates the entire company.
Distinguish this from being “low-cost producers,” which implies that cost advantages come only from production.

Examples of the Porter competitive advantage model:

Unlike vertically integrated rivals like HP, Dell built custom computers using outsourced components. It carried little inventory and didn’t make its own components. As the prices of components rapidly fell, Dell’s balance sheet was kept healthier.
Vanguard, IKEA, Southwest all have business models and cultures that reinforce low-cost value. Their network of low-cost activities go far beyond merely being low-cost producers.

Porter’s theory of competitive advantage can help you understand why businesses succeed. Using Porter’s theory of competitive advantage, you can apply these strategies to your business plan.

Porter’s Theory of Competitive Advantage