You have to take deliberate action to generate the information necessary to find the route to Power.
The way to achieve long-term differential margins are through a million small operational tweaks; the road to sustainable advantage is with unsustainable advantage and there are only seven forms that advantage can take, and each of them emerge at a particular point in the business’s life.
The one sentence story of Intel is a single design win, then a decade and a half of very high Switching Costs, then Scale Economies.
The one sentence story of Netflix is Counter-Positioning against Blockbuster, modest spatial-distribution Scale Economies against other DVD-by-mail look-alikes; a switch to streaming; then Counter-Positioning against the cable companies, then Scale Economies.
The seven Powers tend to emerge at a particular stage in a business’s life:
- When the company is searching for product-market fit, and has yet to scale, there are two Powers that apply: Cornered Resource and Counter-Positioning.
- When the company is scaling rapidly there are three Powers available: Scale Economies, Network Economies, and Switching Costs.
- When the company begins to slow down (when growth slows to 30-40% per-year unit growth) there are two Powers available: Branding and Process Power.
The Power Progression informs you that at any given growth stage the maximum number of new Powers that you might explore is 3.
Strategy (big ‘S’) is the study of the fundamental determinants of potential business value.
Power is the set of conditions creating the potential for persistent differential returns.
strategy (small ‘s’) is a route to continuing Power in significant markets.
Power is whatever allows you to maintain or grow your market share, and maintain differential profit margins in the face of competition, in a growing market that is either already large, or will become large.
Real world businesses are able to create value even if they lose market share to the competition (i.e. iPhone vs Android phones). Pick a path that allows you to keep differential margins compared to the rest of the players in your market.
The goal of business strategy is to deliver durable, differentiated returns, therefor we can reduce business strategy to “how do I get to a point where I can resist margin compression?”
Certain businesses can have Power, while others cannot.
Power One: Scale Economies
Benefit: reduced cost
More customers than competitors = lower unit cost per customer than competitors. Fixed costs are amortized across an entire customer base.
Scale advantages come in a few other flavors:
- Purchasing economies: purchase in bulk and demand lower prices, lowering your costs.
- Volume/area relationships: As area increases so does production costs; milk production needs space for milk tanks, so the more milk you want to produce, the higher the total area costs. At higher volumes, your per-volume costs go down.
- Distribution network density: As the density of a distribution network increases to accommodate more customers per area, delivery costs decline as routes become more economical to service. E.g. a UPS competitor should expect to burn a lot of money in the process of building their distribution network density.
- Learning economies: The more you produce, the more you are able to discover new ways to reduce production costs. Experience curve effects.
Power Two: Network Economies
Benefit: A company with Network Economies may charge higher prices than its competitors, due to the higher value as a result of more users.
Barrier: if the value is in the network, then building that network is expensive, given that a winning network already exists elsewhere.
The value realized by a customer increases as the installed base increases.
Industries with strong Network Economies tend to have the following properties:
- Winner takes all
- Boundedness: LinkedIn can co-exist with Facebook because its Network Economics are bounded to professional networks; Facebook is in turn bounded to personal networks.
- Decisive early product: With strong tipping point dynamics, the network that grows the fastest usually wins a decisive victory.
Power Three: Counter-Positioning
Benefit: The new business model is superior to the incumbent’s model by lower costs and/or the ability to charge higher prices.
Barrier: The barrier for Counter-Positioning is that the incumbent would be harmed if they go after the challenger.
- An upstart develops a superior, dissenting business model (or offering).
- That business model (or offering) successfully challenges well-entrenched and formidable incumbents.
- The upstart steadily accumulates customers while the incumbent remains seemingly paralyzed and unable to respond.
Counter positioning is when a newcomer adopts a new, superior business model which the incumbent does not mimic due to anticipated damage to their existing business.
“Am I better off staying the course, or should I adopt the new model?”
- “Is this new business model an attractive stand-alone business?” If no, then there’s no counter-position to be had. If yes, then:
- “If we adopt this new business model, would the joint NPV (that is, value) of our overall company be positive or negative?” If it is negative, then the incumbent would not be willing to enter the new business model. If positive, then:
- “Can we accept the consequences of accepting this new business model?” Management teams can fail in one of two ways: first, they may be a slave to history, second, incentives are set up for the old world.
Power Four: Switching Costs
Benefit: A company with high Switching Costs embedded in its customers can charge higher prices than competitors. This Benefit only accrues if you sell follow-on products to your current customers; no Benefit accrues with potential customers, or if there are no follow-on products.
Barrier: A competitor must compensate customers for their Switching Costs. The Power-holder may also reduce their prices temporarily until you stop going after their customers.
The value loss expected by a customer that would be incurred from switching to an alternate supplier for additional purchases.
There are three basic flavors of switching costs:
- Financial: Switching from one ERP system to another might result in huge financial losses.
- Procedural: There can be a significant cost to retraining people in a different system. This cost includes both organizational discontent and the cost of potential errors.
- Relational: Switching from one product to another could mean severing ties with with other product users, service providers, and sales or customer service staff members. This is basically the ‘community moat’; it is also the case whenever a customer develops affection for a product (or builds their identity as a user around it).
Whenever you have a high Switching Costs environment, you’ll get:
- A land-grab for new customers as the market is growing,
- A switch to a build or buy strategy for integrated add-on products, to sell to your captive install base. This is why SAP and Oracle buy so many adjacent enterprise software products to sell to their customers.
Power Five: Branding
Benefit: A business with Branding is able to charge higher prices for its products due to one or both of the following two reasons:
- Affective valence: the built-up associations with the brand elicit good feelings about the product, distinct from the objective value of the good. You’re willing to pay more for Coca Cola compared to an unbranded coke, even if they taste the same.
- Uncertainty reduction: a customer has peace of mind knowing that the branded product will be just as expected. Some buyers are more willing to pay for Bayer aspirin compared to a generic, locally made alternative, purely as a function of their trust in the Bayer brand.
Barrier: The barrier here is time. A challenger would need to spend a huge amount of resources over a long period of time in order to cultivate a new brand name. Why? Simple: a strong brand can only be created over a lengthy period of reinforcing actions (which Helmer terms ‘hysteresis’).
The amount of money a consumer would pay for a brand above and beyond functional equivalents.
- Brand dilution: Firms require focus and diligence to guide Branding over time, so that the reputation created remains consistent with the valences that its products generate. Companies that have strong brands usually evolve unique cultures that reinforce the protection of that brand. (Disney’s managers, for instance, are famous for the fierceness with which they protect the company’s reputation).
- Counterfeiting: Since the label is what confers pricing power, counterfeiters may free-ride by falsely associating a powerful brand with their product, undermining the repeated, positive interactions that consumers need to have to sustain the brand.
- Changing consumer preferences: Marlboro Man was a thing. Now it is not.
- Geographic boundaries: Brands that confer Power in one region may not translate to another. Levis is not considered a premium jeans brand in the United States. In Asia, the brand commands premium prices.
- Brand recognition is not Branding Branding is only a moat when it confers pricing power to the business. You may have a well-known brand, but no ability to charge higher prices than functionally-equivalent alternatives.
Only certain products are able to use Branding as a Power. A product that may eventually command a price premium means:
- Your product can benefit from affective valence. Business-to-business goods don’t usually have this quality, because most purchasers are only concerned with objective deliverables.
- If the source of your pricing power hinges on uncertainty reduction, then your product must operate in some category where there are high perceived costs of uncertainty relative to the good. (For instance: medicine, food, transport, or safety).
- Finally, you must have time
Power Six: Cornered Resource
Benefit: Variable, and dependent on the resource in question. In Pixar’s case, the benefit from the Brain Trust was the differentiated margins it received from its consistent ability to produce hits; in other companies, it may result from a number of uniquely different benefits.
Five screening tests for a Cornered Resource, since spotting one might be really difficult:
- Idiosyncratic: If a firm repeatedly acquires coveted assets at attractive terms, then the proper question to ask is ‘Why are they able to do this?’ For instance, if a company is able to consistently close customers in a difficult market above and beyond what its competitors are able to do, then maybe it is the sales team that is a Cornered Resource.
- Non-arbitraged: If the business gains preferential access to a coveted resource, but then pays a price that fully captures the benefits of the resource, it doesn’t count as a Power.
- Transferable: If a suspected Cornered Resource fails to recreate value at a different company, then you’re likely missing some other complement that is required to make that Cornered Resource work.
- Ongoing: If you remove the Cornered Resource from the business, the business should fail to generate the same differentiated margins.
- Sufficient: To qualify as Power, it has to be sufficient as an explanation for continued differential returns.
Preferential access at attractive terms to a coveted asset that can independently enhance value.
Power Seven: Process Power
Benefit: Ability to improve products and/or lower costs as a result of process improvements embedded within the organization. This goes beyond the typical improvements that may be had from plain ‘operational excellence’ improvements.
Competing Against Time goes into greater detail on what Process Power actually looks like.
Process Power is rare. It is not readily available to companies that do not manufacture their own products.
Embedded company organization and activity sets which enable lower costs and/or superior product, and which can be matched only by an extended commitment.