Linking strategy to operating models
In 1996, Michael Porter, the father of modern business strategy, wrote a long
article in the Harvard Business Review titled “What is Strategy”. He felt the need
to remind readers the core principles of good business strategy because the
1990s had become dominated by “business process reengineering” and “total
quality management”.
“Operational effectiveness is not strategy”, he argued. “Competitive strategy is
about being different. It means deliberately choosing a different set of activities
to deliver a unique mix of value.” This summary article explains and updates
Porter’s ideas and interprets them for those concerned with operating model
design.
At the heart of Porter’s point is that competitive strategy is little more than
marketing if it does not result in a different operating model: “a different set of
activities”. While Porter uses the term “activities”, he includes people,
organisation structure, locations, buildings, IT systems, intellectual property,
supplier relationships and business partners. In other words, all the elements of
an operating model.
He uses the contrast of low cost airlines and full service airlines. Low cost is
about point-to-point short haul flights. Full service (or maybe it should be called
connected service) is about a hub and spoke system, a mix of long haul and short
haul, connecting flights, connecting baggage, in flight meals, etc. Low cost
airlines have a different operating model based on a different set of activities
that deliver a different value proposition to customers.
The best strategies are those that are hard for the incumbent competitors to
copy, as full service airlines discovered. Despite seeing the writing on the wall,
despite case studies being written for most major business schools, despite some
attempts to copy the low cost strategy, such as BA’s launch of GO, full service
airlines were impotent in stopping the rise of low cost airlines. There were
things the full service airlines could do, cut costs, cut prices, reduce service
levels, but they had only limited impact on the low cost competitors.
Developing Winning Strategies
If winning strategies come from designing different operating models, how do
companies find winning strategies? Porter suggests that there are three sources
of ideas for winning strategies – product focus, segment focus or channel focus.
Here I am going a little beyond his 1996 article. But the key appears to be to
observe what current competitors are doing, then think of ways of doing it
differently.
Along the product dimension, a new competitor can offer a broader range of
products or a narrower range of products. Alternatively, a new competitor can
offer products that are based on a different technology or delivery process.
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Supermarkets offered a broader range of products than either butchers or
bakers or candlestick makers. The Tie Rack offered a narrower range of
products than menswear stores. In terms of technology, refrigerator companies
offered cooling using a different technology from those who were cutting ice and
hauling it to ice houses. In terms of delivery process, Internet banks offered
financial services on-line rather than through branches.
To emphasise the importance of activities, it is easy to see how hard it was for ice
cutters to compete with refrigerator companies. But what about metal framed
tennis racquets versus wooden tennis racquets or carbon fibre racquets versus
metal. As it turned out, most of the incumbent tennis racquet companies were
able to compete successfully with those who focused only on the new
technologies. Although the new technology offered “unique value”, it did not
require much change to the operating model of old companies, just some new
machines and skills in the factory, for the old companies to compete. So, a
winning strategy must have the unique value, the unique value must need a new
operating model and the new operating model must be hard for incumbents to
copy or incorporate.
Internet banks have not succeeded as standalone banks for the same reason.
The incumbents were able to graft Internet services onto their existing customer
relationships, preventing focused Internet banks from offering unique value.
Along the customer dimension, a new competitor can focus on a narrower
range of customers or a broader range of customers. Private Banks focus on a
narrower range: people with plenty of money, who want tailored services and
have little spare time. Commercial Banks offer services to a broad range of
people, rich and poor. Services are standardised to keep costs down, to make
them easy to sell and easy to consume. The two operating models require
different systems, different buildings, different locations and different people
working in them.
When thinking about whether a segmentation strategy will work, it is necessary
to understand whether different groups of customers have different needs. But
it is also important to think about whether those needs require differences in the
operating model and whether those differences are likely to be hard for existing
competitors to copy. While many Commercial Banks have tried to compete with
Private Banks, they have only successfully done so by setting up their Private
Bank as a separate and pretty autonomous division within the larger
organisation. Even then, they have not been as successful as the focused Private
Banks. It has not proved possible for Commercial Banks to graft private banking
services onto their other services in the same way that they were able to add
Internet services.
The third way of finding a winning strategy is channel focus: approaching
customers through either a broader or narrower range of channels. Direct Line,
a successful British insurance company in the 1990s, focused on selling
insurance only by telephone and then later also on-line. Avon sells cosmetics
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only through agents and in-home “parties”. Net-a-Porter sells luxury products
only on-line.
In contrast many companies have a multi-channel strategy, selling their services
on-line, through a direct sales force and through third party distributors or
retailers. Most luxury brands, have their own stores, sell on line, sell to luxury
retailers like Sephora, sell to on-line retailers like Net-a-Porter and take
concessions in departments stores. Multi-channel strategies are likely to eclipse
single channel strategies unless there are reasons why the multiple channels are
less effective.
One reason is that some channels, say distributors, will refuse to distribute the
products of companies that are also selling through other channels. In this case
channel focus is necessary, at least for that channel.
Another reason is that the skills, product types and operational systems are so
different between channels that they do not fit naturally together. Why don’t all
cosmetic companies graft an Avon-style direct sales force onto their retailfocused sales approaches? This may be because retailers would be unlikely to
stock the products if they were also sold through in-home parties. But, more
likely, the operating model of an Avon approach is so different from that of a
typical brand marketing strategy that one management team would not be
competent at leading both approaches. It is like tennis and squash. On the
surface these are similar sports. But, being good at one makes you less good at
the other.
Often a strategy to differentiate by channel is also combined with a strategy that
also differentiates by product and by customer segment. Avon’s strategy uses a
different channel, but also offers some different services, such as delivery to your
home, in-home advice from the agent and from friends, and an excuse to meet up
with friends. The strategy is also only attractive to a segment of consumers.
Many prefer to shop in the glitzy environment of department stores or branded
shops.
Resisting the Reactions of Incumbents
Good strategy involves “unique value”, “a different set of activities” and “an
operating model that is hard for incumbents to copy ”. So what makes activities
hard to copy.
The most important ingredient is trade-offs: more of one thing means less of
another. Take retail channels versus direct sales channels. The more a
company uses direct sales, the less enthusiastic retailers will be to stock the
company’s products. There is a trade-off, unless the company owns its retail
outlets.
Another trade-off was explained to me by a manager from Duracell. Duracell
don’t sell short life batteries as well as long life batteries, as most of its
competitors do. So why has Duracell been successful with a product focused
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strategy? Because, if you give a sales person both products to sell, the sales
person will mainly sell short life batteries: they are cheaper, look the same and
hence are easier to sell. However, if you give sales people only long-life batteries
to sell, they will successfully sell long-life batteries. There is a trade-off. The
wider the product range the sales team has the fewer of the high margin long-life
batteries will be sold.
Trade-offs can come from activity conflict like the Duracell example. They can
come from channel conflict like the tension between retail sales and on line sales.
They can also come from customer conflict. A customer buying a luxury product
does not normally want to buy that product from a company that also sells
products to the mass market. The customer wants the product to be seen to be
different, wants a different buying experience and probably does not want to rub
shoulders with mass market customers during the process. This is true for
customers buying luxury handbags, luxury cars, private banking services or first
class air travel.
As a result, in air travel, a number of companies have tried offering business
class only air travel – a customer segmentation strategy. Unfortunately, although
there are conflicts between luxury travel and economy travel, airlines have found
ways to reduce the conflict. Hence the advantages of a business class only flight
have not proved to be large enough to overcome the cost disadvantages and
route choice limitations of a focused supplier. Product, customer or channelfocused strategies are only likely to be successful if they involve some significant
trade-off that incumbents are unable to get round.
One area to look for trade-offs is between cost and quality. Some forms of
quality are free: money spent on reducing substandard product, for example,
normally saves more in rework or complaints handling. But, additional features
or higher levels of service add cost: there is a trade-off. At some points along
this cost/quality continuum there are incompatibilities. For example, strategy
consulting work typically requires a more expensive consultant: someone who is
able to dialogue with top managers, who has enough experience to challenge and
probe, who is able to prioritise issues and so on. Process redesign work can
often be done by less expensive consultants following a standard set of analyses
and steps. While the more expensive consultant could do the process redesign
work, the cost of doing the work would be uncompetitive. One solution might be
to use the junior consultants for process work and the more experienced
consultants for strategy work. But, there is a trade-off. Process consulting is not
the best preparation for strategy consulting. Also, consultants ambitious to work
in the boardroom are not enthusiastic about spending five years doing process
work. As a result of these trade-offs, consulting firms typically focus either on
strategy consulting or on process redesign. It is hard for one firm to be
competitive in both.
Building competitive advantage
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A good strategy will be hard for incumbents to copy, but, as with low cost airlines
or private banks, other newcomers can make the same choices and follow the
same strategy. Once one company develops a refrigerator, others can set up in
direct competition. So how does a company gain competitive advantage over
companies that have a similar focus and a similar set of activities?
Michael Porter’s answer is that competitive advantage comes from having an
“activity system” that fits together better than similar competitors. At one level
this sounds a bit like “operational effectiveness”, but at another level it is about
having a better designed operating model.
Porter’s tool for helping managers think about “fit” is the “activity system map”
(see below the activity system that Roger Martin and AG Laffley generated for
Procter & Gamble, as recorded in their book “Playing to Win”)
Fit is defined by the lines between the different elements. “Innovation” fits well
with “Go-to-market capabilities” because retailers like to work with companies
who innovate. “Go-to-market capabilities” are reinforced by an organisation
structure (the “GBU/MDO structure”) that gives power to regions and countries.
It is also helped by “customer teams”, who bring the full resources of P&G
together to serve a Tesco or a Wallmart. “Go-to-market” is also helped by scale:
retailers like to work with category leaders, and scale gives P&G bargaining
power.
One of Porter’s points is that a winning activity system is not about two or three
core capabilities. It is about the connections and reinforcing benefits of a system
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of 20 to 40 activities: the system (the operating model) is greater than the sum of
the parts.
Porter identifies three levels of fit. Companies with all three levels of fit have an
advantage over others. They have a better designed model, and their model is
harder for others to understand and copy.
The first level of fit is consistency fit. Consistency fit means an activity does not
erode the benefit coming from other activities. For example, if Procter & Gamble
was structured only into Global Business Units, the structure would impede the
development of good relationships with the world’s largest retailers: P&G’s “goto-market capability” would be diminished.
The second level of fit is reinforcement fit. Here an activity is a positive
reinforcement that multiplies the benefits coming from other activities. For
example, P&G’s customer teams for major retailers, like Tesco and Wal-Mart,
reinforce the company’s “go-to-market capability”.
Porter’s third level of fit is optimisation fit. Optimisation fit occurs when
activities, and particularly activity combinations, have been designed for
minimal cost and maximum customer value. For example, global purchasing at
P&G is a reinforcing activity for P&G’s scale advantage. But P&G has also taken
care to understand where global scale gives lower costs and better supplier
performance and where it does not. Not all purchasing is centralised. Global
Business Units and Market Development Organisations do some of their own
purchasing where economies of scale are limited or where the item is particular
to their needs.
“Optimization fit” feels very like operational effectiveness, hence Porter’s
concern about too much attention on operational issues seems a little misplaced.
Nevertheless he does a useful job of explaining the link between strategy and
operations. Strategy starts with decisions about where to compete - which
customers, which geographies, which products and which channels. But strategy
work is not done until an activity system (an operating model) has been
designed and optimised to give an advantage not only over incumbents but also
over other companies that might try to copy the new model.
Operating model design is, therefore, an important element of strategy
development. Moreover, since it is the operating model that provides the
organisation with a sustainable advantage, thoughts about operating elements
can be a big influence on the product, market and channel choices that make up
the strategy: insights about how to use new technologies or how to transform
operations can lead to different choices about product, customer or channel
focus.
The importance of choice
Throughout his article Porter underlines the importance of choice: of deciding to
do one thing and not something else; of deciding to do more of X and less of Y; or
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of focusing on one type of customer or channel and not another. It is the myriad
of choices that one company makes in selecting where to compete and in
designing its operating model that is hard for others to copy. Not only is it often
difficult to understand from the outside what choices have been made, but it is
also hard to make the choices in the right order and at the right point in time. A
well functioning operating model will have evolved over time as different choices
were made. To arrive at the same level of performance another company often
needs to follow a similar development path, which can be hard if it is starting
from a different position.
Of course, choices can be bad as well as good. P&G’s initial choices about how to
handle global retailers were not very successful. A group of managers serving
the retailer would meet as a project team, devise a strategy for the retailer and
then explain this strategy to the retailer. Retailers felt told: they thought P&Gers
were arrogant and self-serving. It was only after a few mistakes that P&G
designed joint teams with retailers where the team members were drawn from
both the retailer and from P&G. These combined teams then developed
strategies aimed at optimizing the ambitions of both parties.
Why leaders often fail to develop good strategies
Porter closes his article by providing some reasons why leaders often fail to
develop good strategies.
First is the unwillingness to make choices. Leaders he argues have been
encouraged to believe that they do not need to make choices, that they can do
“both and”, that everything is possible with hard work and ambition. Yet
strategy is all about making choices.
Second is the focus on best practices and world class. Instead of looking to be
different, managers are looking to be in the top quartile. Apart from the
impossibility of all companies being in the top quartile, the quest for best
practice can be misguided. Leaders should be focused on “different practice”,
particularly practice that leads to “unique value” and particularly practice that is
hard for competitors to copy.
The third factor, and Porter believes that this is the most powerful, is the growth
imperative. A product or customer or channel focus puts limits on growth. This
feels uncomfortable for leaders who have put growth on a pedestal. Even in
organisations that do have a clear focus, the pressure for growth causes
managers to experiment at the edges, often undermining the focus, complicating
the operating model and confusing the development of capabilities. McKinsey &
Co tried to get into IT consulting. Unilever entered the luxury perfumes
business. Mercedes launched Smart. Intel entered the data warehouse business.
All were strategic moves that demonstrated a lack of understanding of the
unique operating model at the foundation of these organisations’ ability to
deliver unique value to selected customers in ways that were hard for others to
match.
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Strategy is hard work, involving hard choices. It is best done by managers who
understand both the market and the operating trade-offs. Unfortunately
managers that understand both markets and operations, and who are willing to
take the difficult decisions are rare.
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