How to assess the attractiveness of your industry and your company's position in it

I have often heard it said that big companies, the corporate giants, are the ones that need to think about their business strategically. Smaller, more entrepreneurial companies, by contrast, do not need strategy -- they can pursue other routes to business success. In my view, that is exactly backward.

Unlike the giants, small businesses cannot rely on the inertia of the marketplace for their survival. Nor can they succeed on brute force, throwing resources at problems. On the contrary, they have to see their competitive environment with particular clarity, and they have to stake out and protect a position they can defend. That is what strategy is all about -- making choices about how you position your company in its competitive environment.

At its root, strategic thinking involves asking two critical questions. First, what is the structure of your industry, and how is it likely to evolve over time? If the business you are in is not very attractive -- and we will see in a moment how to measure its attractiveness -- then you may want to get out of it or find a way of redefining it.

Second, what is your own company's relative position in the industry? No matter how attractive the game is, you will not do well if you do not hold a good position in it. Conversely, you can be in a lackluster industry with low average profitability -- yet if you occupy exactly the right niche, you can perform very well. Strategic thinking shows you how to establish and defend such a position.

Analyzing Your Industry
In every industry, no matter what product or service it provides, there are five basic forces of competition. Taken together they determine the industry's attractiveness and its long-term profitability.

First, and maybe most obvious, is the character of the rivalry among the competitors. Competition can be gentlemanly and subdued, or it can be vicious and warlike. If competition in your industry is like a guerrilla war, if someone is always attacking your position, that makes the industry less attractive and less profitable. If the competition is more focused on image and service than on price cutting, the whole industry will be more profitable.

Then there is the threat of new entrants. If it is easy for someone else to get into the business, to add new capacity and erode prices, that too will cut into profits. But if there are effective barriers to entry, all the companies in the business will do better.

Another factor: the threat of substitute products or services. Whatever your business does, customers nearly always have other ways of satisfying their needs. If you make aluminum windows, you have to worry about makers of vinyl windows. If you are a traditional full-service stockbroker, you have to worry about discount brokers. If customers have plenty of alternatives to choose from, that too will eat into your profitability.

Then too, your profits may be constrained by suppliers, on the one hand, or by customers, on the other.

The bargaining power of suppliers determines how much they can force up the price of what you have to buy. If you are buying mostly commodities and can switch suppliers easily, they will not have much leverage. But if you are dependent on specialty suppliers or on one or two dominant vendors, you will have to pay whatever they ask.

The bargaining power of buyers similarly determines how much leeway you have in your own pricing. If your customers are a lot more powerful than you, they may beat you down on price, force you to provide many free services, or make you hold inventory and thus bear cost and risk. That can drive the return right out of your business.

The fundamental profit potential in any industry is determined by the balance of those five forces. At one end of the spectrum is an enormously attractive industry such as pharmaceuticals. It is hard for new companies to get into this business. The product -- effective therapeutic drugs -- has no real substitute. Most of the raw materials are commodities, so the suppliers are unimportant. Customers historically have not exercised much bargaining power -- indeed, they have been willing to pay top dollar for anything that made patients feel better. Finally, the rivalry has been extremely gentlemanly. Nobody competes on price, because every company knows it does not have to. That is why major pharmaceutical companies make a 20% return on investment every year.

At the other end of the spectrum is a business such as aluminum-window manufacturing. It is an industry that new competitors can easily enter. There are plenty of substitute products, such as wood and plastic windows. The suppliers are giant aluminum companies with a great deal of clout; the buyers are likely to be big retail or wholesale chains that beat up companies on price. And the rivalry is cutthroat because everyone is always trying to shave a little on price to cover overhead. If the pharmaceutical business gets five stars as an industry, aluminum windows gets zero. If you make a 10% return in any year, you're a hero.

To be sure, those are extreme cases. But your industry fits somewhere; it has a structure, and you can analyze it in terms of the five forces.

Reshaping Your Industry
If this were the end of the story, it would be a bit depressing: your success would depend on how well you had chosen your industry. But the story does not end here. In fact, the real insight for strategy is that industry structure can be changed. You, by the way you choose to compete, can influence every one of the five forces.

Some companies, for example, get around customers' bargaining power by giving them computer terminals and letting them order directly on-line. Suddenly, it's harder for the customer to order from another supplier. Similarly, companies can raise barriers to entry. A manufacturer might forge exclusive relationships with its retailers, preventing them from taking on competing lines. A company could offer speedier delivery to its customers, requiring more inventory and overhead, which would-be competitors would be hard-pressed to match. The point here is simple: if you think strategically, you can influence the structure of your industry in a positive way.

Once in a great while companies can effectively reshape an entire industry. American Airlines has done it, for example, in air transportation. After deregulation, air travel was a pretty unattractive business. It was easy to get into -- all you needed was a couple of planes, which could be heavily financed. Buyers had a lot of bargaining power because they viewed airline seats as commodities. And the rivalry was cutthroat. Airlines had high fixed costs and would do anything to fill their empty seats. So there were massive price wars, and the industry as a whole lost money.

American effectively changed the industry's structure. The company introduced a computer reservations system that cost more than $1 billion. Pretty soon anyone who wanted to be a serious competitor needed such a system -- and suddenly an upstart airline with a few planes could not play the game the same way anymore. American also aggressively pursued the hub-and-spoke concept, meaning that it had dozens of flights going in and out of one city. Now would-be competitors needed 10 or 20 flights going to a city, not just 2 or 3. And American set up the first frequent-flyer program. Even though it was quickly imitated, the program created brand loyalty, giving customers a big incentive to stick with the airline they flew on most. Taken together, those moves fundamentally changed the airline business. Except during the Gulf crisis and its aftermath, the industry's profitability has soared, and American has done better than most.

Positioning Strategically

Most small companies, of course, cannot change an industry's structure. What they can do, however, is establish a good position in the industry -- a position based on sustainable competitive advantage.

What constitutes a competitive advantage? Well, advantage comes in only two basic varieties. You can have consistently lower costs than your rivals. As long as your product maintains an acceptable quality level, that will lead to higher margins. Alternatively, you can differentiate your product or service from your competitors', in effect making yourself unique at delivering something your customers think is important. That allows you to command a premium price. And provided you keep your costs under control, the premium price will translate into a superior return.

There is one other crucial variable in strategic positioning: what I call competitive scope. Some companies seek advantage in what might be called a broad scope: they serve more or less all types of customers in an industry, offering a wide product line and operating in many geographic areas. Companies with a narrow scope, alternatively, focus on a narrow range of customers or product varieties, or in one geographic region, and dedicate all their efforts to that one small niche or market segment.

These crucial choices in strategy lead to some different combinations, depending on the breadth of the target and the type of advantage sought. In cars, for example, Toyota is the broad, low-cost competitor, BMW and Mercedes-Benz the differentiators in the premium segment, and Hyundai the low-cost player in the price-sensitive segment.

There is room for several successful strategies, as long as each company makes a different choice from its rivals'. The worst error, however, is not to choose, to try a little bit of everything and therefore not have any advantage at all. That is what I call "stuck in the middle." It does not work, because all good strategies involve trade-offs. You cannot be both low cost and differentiated at the same time, because being unique at quality or service usually involves higher costs. A sustainable competitive advantage comes from choosing an appropriate strategy and appropriate scope. For small companies, the operable choice is normally what is known as focus: narrowing the strategic target and dedicating every action to serving that target. Take the hotel business as an example. Nationally, it is dominated by big, full-service chains -- Marriott, Hilton, and so on. Each of them seems to offer everything a traveler could want: Comfortable accommodations. Bars, restaurants, room service. Meeting rooms, suites, health clubs, game rooms for the kids. You might think an upstart company would have no chance of finding, let alone defending, a profitable niche in the industry.

How, then, to explain the success of La Quinta Motor Inns, a company that grew from $61.8 million in 1980 revenues to $226.5 million in 1990?

La Quinta's success lies in strategy: in narrowing its target to the regular, middle-level business customer, the kind of traveler who visits a city over and over, and who does not have an unlimited expense account at his or her disposal.

What do those particular customers want? Mostly, a nice, comfortable room to sleep in. They do not want suites -- they cannot afford them. They do not want a lounge -- if they are going to drink, they know the city and have a car; they will go out. They do not even need a restaurant. La Quintas are always built next door to a Denny's or a Howard Johnson's, something open 24 hours a day, so guests can go get breakfast anytime.

The list goes on. Meeting rooms? No need. Room service? Too expensive. Recreation facilities? No time. Transportation? Already have it.

By not providing all those extras -- extras the La Quinta customer does not want anyway -- the hotel chain is able to lower dramatically the cost of providing a room. So even if it sells the rooms for $38 a night, as compared with $80 or $100 or even $120 at a Marriott, it can make a lot of money. That is focus.

Note one thing, however: if the typical hotel customer wandered into a La Quinta, there would be a lot of dissatisfaction. Room service? "Sorry, we don't have it." How about a playground for the kids? "Sorry." A good focused strategy inevitably makes many customers unhappy. But it is going to make a certain group of customers very, very happy, and that is the logic. You target all your efforts on those customers, and you achieve either lower costs or uniqueness in meeting their needs. Best of all, the big boys cannot easily move in on your turf. How is Marriott ever going to sell rooms for $38 a night?

Five Fatal Flaws

Any strategy, of course, is only as good as its execution. And owners of small companies frequently make critical mistakes in applying strategic thinking to their own competitive situations. In my experience, I have seen the same five errors repeated over and over.

Mistake number one: misreading industry attractiveness. Entrepreneurs always have a tendency to think the attractive industries are those that are growing fastest. Or those that involve the fanciest technology. Or those that are the most glamorous. It is not so. Attractive industries are those that have high barriers to entry, the fewest substitutes, and positive scores on the other factors mentioned previously. The more high-tech or high-glamour a business is, the more likely a lot of new competitors will enter and make it unprofitable.

Mistake number two: possessing no true competitive advantage. For many companies, "strategy" means imitating their rivals. That is easy and gives managers a sense of security. But imitating means you have no competitive advantage -- you are stuck right in the middle of the pack. To succeed you have to find different ways of competing. That is both risky and hard.

Mistake number three is most common for otherwise successful companies: pursuing a competitive advantage that is not sustainable. A lot of companies succeed initially because they discover a hot new product or service -- a new piece of software, for example. But they are so busy getting off the ground and finding people to buy their products that they forget what will happen if they succeed. In software, for example, a successful program will be imitated in a matter of months. So the advantage it alone gives you cannot be sustained. Real competitive advantage in software comes from servicing and supporting buyers: providing regular upgrades, getting a company on-line with customers so that their computer departments depend on your organization. That creates barriers to entry.

Sometimes, of course, small companies simply cannot sustain an advantage. In these cases you would be wise to regard your business as an investment rather than an ongoing institution: get in, grow, then sell out.

Mistake number four: compromising a strategy in order to grow faster. Remember People Express Airlines? Founder Donald Burr found a price-sensitive market in the Northeast Corridor and developed an artful strategy for delivering no-frills air travel at rock-bottom cost. People Express made a lot of money. But then Burr decided he wanted to run a major airline and started expanding nationwide. He began to add services, just like other airlines. (The ultimate irony was when People began offering first-class seats.) Pretty soon the major airlines started to pay attention and offered blocks of incredibly low-fare seats on each flight. Burr was unable to match them.

Eventually, Burr was blown away by this competition. If he had kept his focus, he probably would still be running a profitable airline.

Mistake number five, finally, is a twin bill: not making your strategy explicit and not communicating it to your employees. In a lot of entrepreneurial companies, the CEO thinks up a strategy in the shower and never tells it to anyone else. But without an explicit strategy, how can you test the assumptions on which it rests? How can you modify it over time? You do not need a planning staff or even a formal planning process to develop an explicit strategy. All you need to do is write it down and talk about it every so often with your key managers, directors, or close counselors.

A similar issue is communication. One of the fundamental benefits of developing a strategy is that it creates unity, or consistency of action, throughout a company. Every department in the organization works toward the same objectives. But if people do not know what the objectives are, how can they work toward them? If they do not have a clear sense that low cost, say, is your ultimate aim, then all their day-to-day actions are not going to be reinforcing that goal. In any company, employees are making critical choices every minute. An explicit strategy will help them make the right ones.

Well executed, strategy is a powerful tool -- one that is far too important to be left to the strategic planners in America's biggest corporations.

Michael E. Porter is a professor at Harvard Business School and an adviser to numerous companies and governments. He has written widely on the subject of competitive strategy and national economic policy. He is the author of The Competitive Advantage of Nations (1990), Competitive Advantage (1985), and Competitive Strategy (1980), all published by Free Press. His ideas are also presented in the video "Michael Porter on Competitive Strategy."