Chapter 1

Strategy as Process and Product, or, How to Build a Business Strategy Without Too Much Pain

Introduction

Every firm needs a strategy for competing and surviving (if not succeeding) in its market, and this is no less true for small shops than it is for large, diversified firms. Firms lacking strategy wander without direction, spending resources on initiatives and projects that often conflict with other firm efforts. Often spasmodically reacting to the latest crisis, they introduce products and services that imitate those of more successful firms—but weakly so, without the cachet or the cost efficiency of the leaders. Employees don’t know the “right” thing to do, and neither do managers. In short, firms without a strategy fail. Yet, strategic planning often gets a bad reputation because it doesn’t seem to work. Actual business outcomes are often less than satisfactory, so strategic planning must be useless, right?

I argue that there are two major potential causes of these results: poor formulation or poor execution. In the latter case of poor execution, the strategy simply is not implemented properly. The best-crafted strategy, if not well executed, is a hollow product. Therefore, understanding gaps in implementation is a very useful and highly recommended exercise. However, in this book I focus on the primary and more fundamental cause: The strategy is not crafted, or developed, properly.

This can happen for a number of reasons. First, developing a strategic plan is often perceived to be difficult, time consuming, and sometimes just a self-congratulatory exercise. The tools strategists use are unfamiliar to many managers, and as they are infrequently—if ever—used, it is hardly surprising that participants are unhappy! Just as playing one round each year is a poor way to keep up golfing skills, inexperience and unfamiliarity leads to outcomes that are incomplete, biased, and far too subjective. One purpose of this book is to overcome the perceived problem of difficulty by developing a systematic approach to strategic analysis that makes the tools more familiar and accessible. I introduce and explain well-known models, from assessing the general industry environment and analyzing industry forces and firm resources. These models culminate in selecting a strategy that is consistent with industry and firm specific conditions.

Another problem is that the strategy process is treated as an episodic or, as described earlier, spasmodic task. Once crises emerge, the firm needs a new or improved strategy, but all that strategy work has to be done while the business still needs running—and that’s hard! The second purpose of this book, then, is to help you see how to avoid the novelty trap through the perspective that strategy is not just a product or outcome but a process, if not a way of thinking. Strategy may ultimately be the responsibility of the CEO, but it needs (and benefits) from the engagement of others.¹ Done right, that engagement and development aligns the organization more effectively. In addition, the models we’ll explore connect to and reinforce each other, and using them well requires reflection and revision. In short, strategy crafting is not ever completely done. This is a virtue because analysis becomes a lens you constantly bring to bear on your firm and its environment.

The outline of this book is as follows: In the remainder of this chapter, I will discuss some of the definitional problems regarding strategy and what we are trying to accomplish with it as well as cover some economic principles that are the logical basis for the models or frameworks we’ll subsequently develop. Chapter 2 focuses on building a good beginning by developing a detailed and inclusive definition of the industry. Being thorough here prevents problems of too broad or too narrow an analytic scope, and it also gets you to ask and answer important questions about customers, products, and processes that will be used repeatedly. Chapter 3 introduces a process called PEST or PESTLE for systematically assessing what is happening in the general—that is, outside the industry—environment (see Figure 1.1).

Chapters 4 and 5 introduce and elaborate Michael Porter’s well-known Five Forces model of industry analysis as a way to understand the factors affecting the internal environment of a focal industry. Chapter 6 turns to understanding why, given the general environmental and industry characteristics you’ve uncovered, some firms perform better than others. The fundamental idea here is that resource differences are the of performance differences, and you’ll learn how Barney’s VRIN model (which identifies resources that are Valuable, Rare, Inimitable and Non-substitutable) can help you identify important resources. Since the purpose of all this is to craft a strategy, chapter 7 pulls this material together in an exploration of various conceptions of strategic approach. Different as they may appear to be from each other, there are some very important and clear similarities that should drive your approach. Chapter 8 addresses some criticisms and concerns about strategy in dynamic or rapidly changing environments and chapter 9 concludes this book with reflections on and recommendations for making strategy a powerful tool for you and your firm.

What Is Strategy?

Probably, most people would answer the question of the definition of strategy with some statement about strategy as a plan, and this is, in fact, a pretty good start. However, it leaves a lot in the air as to content or structure or even objective. I think it is useful to begin by probing the roots of the word to get a better starting point.

Strategy derives from the Greek words strategoi and strategos, or “generals” and the “work of generals.” That is, strategy was originally about what leaders did to win battles and wars. It is not hard to see how that idea gets extended to games or sports, like chess or football, or even to business because the objective is often perceived as the same—beating the competition. What is it that generals think about? What factors enter into their calculations and plans? What do they consider as they craft an approach to battle? At a basic level, generals must ask and answer questions about what resources they have, what resources the other side has, where the battle is to be fought, and the importance of the conflict at all (e.g., is it essential to fight here and now? Is it essential to win or only to delay?).

When generals consider resources, they might well begin by focusing on the soldiers available to them both in quantity and quality. Other considerations would include material assets (such as artillery, shot, shells, horses, and wagons) and supplies (such as food, water, and shelter). In short, the resource assessment tells a general something about what he can (but not should) do. Getting from “can” to “should” means that the same sort of analysis has to be conducted for the enemy forces. What resources do they have? What skills or assets are important to them? What is their supply situation? Finally, generals would consider the context of battle, the geography and climate or weather, as they decide when and where to fight.

For example, consider the Peninsular War or the conflict between France and England in Spain and Portugal in the early 1800s. Napoleon’s French armies had swept through Europe with battle tactics that seemed unstoppable. At that time, opposing armies usually faced each other in lines, but Napoleon configured his forces to fight as narrow but long columns of soldiers. These could pierce the relatively shallow lines of opponents, and when this happened, the enemy force was not only divided and contained but the French troops could also bring fire against their enemies from the front and the rear. Still, the English went to battle against Napoleon’s armies in line formation—and won. How?

In part, the answer lies in technology and training. Infantry was armed with smoothbore muskets. Smoothbores are not very accurate because of the round ball, lack of rifling, and the fact that soldiers often turned their heads or shut their eyes when they pulled the trigger to avoid powder burns. Beyond 50 yards, hitting anything was a matter of luck. What all generals realized was that a mass of infantry with muskets was still a formidable force—at least, until Napoleon arrived—because the simultaneous firing by thousands of soldiers put enough bullets in the air to make probability work in their favor. In other words, enough bullets would hit to damage the enemy. A drawback to the musket, though, was that it took a long time to reload because the gun needed powder, wadding, ball or bullet, more wadding, and priming before it could be fired again. In general, soldiers might be able to fire as a group (essential to this sort of battle) twice a minute. This was Napoleon’s insight: Given a two per minute firing rate, if the French columns could move fast enough, then the losses from enemy fire would not be sufficiently high enough to prevent breakthrough and victory.

The English army was different, though. More than any other, it had institutionalized, or standardized, training for soldiers, particularly in musketry. English soldiers drilled and drilled until a company could generate a fire rate of three, four, or perhaps even five shots per minute. Imagine what sort of difference this makes to an approaching column; the first volley from a broad line directed at both sides of the column would be expected, but because reloading was so rapid, the subsequent volley fire by the platoon would mean a continuous ripple of shot. The French would have no respite from the fire and losses would be much higher than expected, high enough to slow the column down. And, once slowed (then stopped), the column was virtually defenseless as few soldiers could return fire. Thus, a consideration for English generals was to offset enemy strengths (columns) by deploying key resources (trained musketry) appropriately (where lines could be deployed—i.e., broad battlefronts).

Two confrontations with the French during the 1810 Portugal campaign illustrate the English strategic approach. Napoleon’s armies had swept Spain, deposed the king, and only Portugal remained as a holdout on the peninsula. The British army under Sir Arthur Wellesley (later Lord Wellington) was just hanging on; in fact, if Napoleon’s General Masséna had been successful in pushing the English out of Portugal, then it would have become virtually impossible to confront Napoleon in Europe. In September of 1810, Masséna was marching toward Lisbon for a final battle. He was anxious to end the campaign as winter was coming and Napoleon’s armies did not depend on provisioning from headquarters but on local supply. Capturing Lisbon was critical.

Wellington adopted two plans. The first was to intercept and to battle the French on the way to Lisbon at a place called Bussaco. The second, and far more ambitious plan, was called the Lines of Torres Vedras. At Bussaco, on September 27, 1810, Wellington and elements of the British and Portuguese armies had occupied the top of a long ridge while the French had camped in the valley below. Masséna believed that the French had to get over the ridge to proceed to Lisbon but by ceding the high ground to the British and Portuguese, he faced an almost impossible task. Indeed, marching columns up a steep slope would slow them (eliminating the power of speed) and leave them exposed to the murderous infantry fire described earlier. Nonetheless, Masséna attacked. The French suffered 4,600 casualties that day to the British-Portuguese’s 1,252² and did not take the ridge. On the next day, the French cavalry discovered a road that would avoid the ridge altogether so Masséna moved on toward Lisbon, and the British abandoned the ridge and moved to intercept at Torres Vedras.

Observe how important terrain is to enhancing or degrading assets. The slope of the hills nullified the rapid striking power of the French columns. Terrain plays an even more critical role in the next meeting two weeks after Bussaco. In 1809, Wellington had commanded the development of the most ambitious earthworks ever created as the ultimate defense of Lisbon. The Lines of Torres Vedras were a series of interlocking forts and cannons along 30 miles of two parallel ridges that stretched from the Atlantic Ocean to the Tagus River. Moreover, the engineers of the British Army had enhanced the natural geography by blasting hillsides into small cliffs all along the ridges, flooding the interior valley, eliminating any natural cover, and developing support roads behind the lines to move troops. Masséna and the French staff quickly recognized—after one attack—that any attempt to force Torres Vedras was hopeless, and they were forced to retreat. This was of great significance in the war: Winter was coming; there were no supplies to be had; and because Lisbon was unreachable, the French Army would be severely degraded by disease and hunger. Moreover, the British had secured a foothold on the Peninsula and from that could support campaigns in the coming years. It was the turning point of the war.³

The defenses of Torres Vedras are excellent examples of strategic thinking, even though there was no real battle fought here. Wellington struck very effectively at Napoleon’s logistic weakness, crippling an army required to live off the land. This illustrates that the objective of military strategy is to win the war, not a battle. Thus, Bussaco was a win but not terribly important other than it stung and delayed the French. Torres Vedras was the great win, even though no real battle was fought.

So how do these examples relate to managers and business? In one sense, the process maps completely. As managers, you should also analyze environment, opposition, and resources, and from that analysis, construct strategies that exploit opportunities or negate threats (see Figure 1.2). Probably every CEO believes that he or she has a strategy for the firm, even if others crafted it. Still, most firms are not very successful (if success is defined as outperforming others in the industry). One of the key issues is the value of that strategy—that is, what went into developing it? Generals don’t get to be generals without a substantial amount of disciplined training in military history and strategy, but the same may not be true for managers. The benefit of training in strategic thinking is that developing a good plan is much more likely to happen if your thinking is disciplined, formal, and based on good theories or models. Yet, managers often fail at this, and their plans don’t work out.

Clayton Christensen and Michael Raynor⁴ argue that a large part of the problem is the willingness of managers to adopt recommendations from the seemingly endless flow of consultants or gurus (just look at the business shelves at any bookstore) without careful critical thought about the merits of the advice. There is no doubt that some of these books work—sometimes—but where is a manager to begin? In this book, we focus on understanding some particularly well-known and widely applied models or theories of competition; we learn how to apply them; and we draw conclusions in a very structured way.

Strategy as Process

Wellington was good, no doubt, but even he suffered setbacks. The old saying that no battle plan survives contact with the enemy (that’s why they are called the enemy!) is illustrative and shows the limitation of plans. In other words, if success depends on everything going exactly as planned, failure is almost certain. Earlier, I noted that most firms don’t succeed. The problem gets worse: Even successful firms have profound difficulty maintaining industry leading performance over time. For example, the shifts in the membership of the top 20 firms in the United States from 1958 to 2008 (according to Fortune) are illustrative. The 1958 version is dominated by manufacturing firms, such as the big three automakers, Bethlehem Steel, Boeing, General Dynamics, and, of course, seven oil companies.⁵ By 2008, the list had changed quite dramatically⁶. Wal-Mart was number one, but the list also included six financial institutions and five companies in communications and computers. Only six firms repeated from the list fifty years earlier. This happened to the largest, most robust firms; imagine the difficulties smaller firms face in contending with seismic shifts in technology, social structure, regulation, or political economies and trade policy.

Often, part of the problem lies in how managers regard their planning. When crafting strategy is regarded as just a formality, the work gets put on the shelf somewhere and managers work on instinct, hunches, and whatever fire burns brightest on the desk. They are, as we’ll see later, strategic reactors. A better position, although still problematic, is one that regards the strategy making process as only an analytic tool. As Montgomery⁷ points out, though, really effective strategies are dynamic and adaptive (meaning they change to fit new circumstances and conditions). This is, as Figure 1.3 illustrates, the role of assessment, or measuring how well the strategy is working. Good assessment leads to feedback and reconsideration of the analysis and assumptions made earlier (as these are virtually always not quite right). This cycle should lead to a refined view and a better plan.

Moreover, assessment also highlights the purpose or vision of the firm. Montgomery quotes John Browne, former CEO of British Petroleum to this end, “Our purpose is who we are and what makes us distinctive. It’s what we as a company exists to achieve, and what we are willing and not willing to do to achieve it.” Thinking effectively about the world enables managers to recraft, clarify, strengthen, and reinforce vision and purpose.

Therefore, effective strategy making is not just a one-off analytic exercise but a way of thinking about your firm and the environment and industry in which it operates. Strategy becomes a living document and strategic thinking a disciplined way of viewing the world.

Some Economic Background for Competitive Analysis

Since strategy is about understanding firm performance and competitive advantage, it will be useful to review some fundamental microeconomic concepts about industries, firms, and performance and connect them to the work we’ll be doing later.

When a firm has a competitive advantage, we should expect it to show up in performance, and it is reasonable to expect that that performance will be better than its competitors. Firm performance has been measured in many ways. In particularly volatile industries, for example, survival can be a useful measure. More broadly, researchers have measured outcomes like growth in market share or revenue, improvements in efficiency, stock price, liquidity, and so on, but the most popular measure is some version of profitability.⁸ We’ll use this as our departure point and define competitive advantage as abnormal profitability, or profitability greater than the industry average.

To be more specific, we are interested in profitability measured a certain way. Just using profit dollars as a measure is not a good choice as it tends to make large firms better than small firms just because they are large. What we need is a measure that corrects for size differences and tells us something useful about how efficient a firm is at turning revenues into profits. What would really be a good measure is a comparison of the firm’s weighted average cost of capital (WACC) versus its return on invested capital (ROIC). This can be calculated, but it is cumbersome; we are going to rely on a proxy for this and use profit margins (either gross or net—and sometimes both). The reason this proxy is useful is based in some fundamental microeconomic ideas about industries.

Economists can analyze what happens in industry competition and how equilibrium is reached by making some simplifying assumptions about industry structure and the firms in them. For example, in the simplest models industry entry and exit are assumed to be costless (i.e., firms can freely come and go). Similarly, firms are assumed to have the same technologies (i.e., firms do not differ in the products they offer) and to be price takers (i.e., consumers are price driven). Finally, firms are assumed to be too small to greatly affect supply individually. With these assumptions in hand, economists show that the equilibrium profitability for any industry is…zero!

That bears a little explanation. Let us first understand the difference between economic and accounting profits. We are all familiar with accounting profits, or revenues less costs. If the costs we take out are just the immediate costs of production (COGS), we have gross profit. If we also take out administrative and other indirect costs, we end up with net profit—but in either event, profit equals revenues minus costs. Economic profit includes the opportunity cost of being in the industry (that is, the return an investor would expect) in the equation. Some industries are safe and stable while others are volatile and risky. The return or opportunity cost should reflect this. The economic return is calculated as accounting profit less opportunity cost. That is, from an economist’s perspective, if a firm or investor got a return exactly equal to the opportunity cost, economic profits would be zero.

Let’s see how this conclusion develops. Figure 1.4 shows the supply curve of an individual firm where AC = Average Cost and MC = Marginal Cost. The short hand description here is that firms are willing to supply product where the MC > AC because the price paid for any such quantity (the vertical axis) is greater than the average cost to produce them. Economists also show that industry supply is additive; if another firm joins the industry, we’ll see the supply curve shift to the right.

In Figure 1.5, we see an industry with a single firm where LRAC means long run average cost (which proxies, or stands in, for the opportunity cost). What can you determine about the profitability of the firm? Is profitability greater than the opportunity cost? If so, and the conditions about firm entry and exit described earlier hold, what would you expect to happen? You should expect that other firms and investors would see this as abnormal profitability and would want to enter. Assume one does enter, what happens? Figure 1.6 demonstrates the additive nature of supply as the supply curve shifts to the right. What happens to profits? Is the industry still attractive?

It turns out we can continue this process until the supply curve shifts to intersect demand and the LRAC simultaneously. When that happens, profits are equal to cost (particularly opportunity costs) so economic profits equal zero. It is essential to note that this will happen every time in every industry if the assumptions described earlier hold or are true. Yet, we know that firms don’t always perform the same and that some firms are more profitable than others. That’s why we are in business! The problem, then, is to figure out why and how these conditions don’t hold true and why some firms can take advantage of that to achieve abnormal profitability. As you’ll see, both the industry analysis and firm analysis models reject some of the economic assumptions on very good grounds—and by doing so, generate powerful ways to explain what is really happening.