“Chance only favors the prepared mind.” Strategy serves best not as an analytical redoubt, but rather in developing the “prepared mind” of those on the ground.
Power: the set of conditions creating the potential for persistent differential returns
strategy: a route to continuing Power in significant markets
The product of M 0 and g reflect market scale over time; hence they capture the “significant markets” component of this definition. The impact of competitive arbitrage is expressed in margins and market share simultaneously, so the maintenance or increase of s market share, 8 while maintaining a positive and material long-term differential margin, provides the numerical expression of Power. In other words, put another way: Potential Value = [Market Scale] * [Power]
Power is a configuration that creates the potential for persistent significant differential returns, even in the face of fully committed and competent competition. To fulfill this, two components must be simultaneously present:
- A Benefit : some condition which yields material improvement in the cash flow of the Power wielder via reduced cost, enhanced pricing and/or decreased investment requirements.
- A Barrier : some obstacle which engenders in competitors an inability and/or unwillingness to engage in behaviors that might, over time, arbitrage out this benefit.
Scale Economies - A business in which per unit cost declines as production volume increases. This happens in many tech companies: a single fixed cost which declines per unit as it is prorated over higher and higher volumes.
Benefit: lowered costs or better product for same cost.
Barrier: Prohibitive Costs of Share Gains.
competitor fails to arbitrage out the Benefit because (1) they are unable to, or (2) they can, but refrain from so doing because they expect the outcome to be economically unattractive.
If a competitor trys to undercut the incumbent to gain market share, the incumbent can lower their price to stop the competitior. Once the compeeetitor has been stopped, the prices can be raised.
Helmer, Hamilton. 7 Powers: The Foundations of Business Strategy (Kindle Locations 416-417). Deep Strategy LLC. Kindle Edition.
The Barrier, however, is subtler. What prevents other firms from competing this away? The answer lies in the likely interplay of well-managed competitors. Suppose a company has a significant scale advantage in a Scale Economies business. Smaller firms would spot this advantage, and their first impulse might be to pick up market share, thus improving their relative cost position and erasing some of this disadvantage while improving their bottom line. To get there, however, they would have to offer up better value to customers, such as lower prices.
Scale Economies emerge from other sources as well. To name a few:
- Volume/area relationships. These occur when production costs are closely tied to area, while their utility is tied to volume, resulting in lower per-volume costs with increasing scale. Bulk milk tanks and warehouses would serve as examples.
- Distribution network density. As the density of a distribution network increases to accommodate more customers per area, delivery costs decline as more economical route structures can be accommodated. A new entrant competitor to UPS would face this difficulty.
- Learning economies. If learning leads to a benefit (reduced cost or improved deliverables) and is positively correlated with production levels, then a scale advantage accrues to the leader.
- Purchasing economies. A larger scale buyer can often elicit better pricing for inputs. For example, this has helped Wal-Mart.
What must you do to get there?
With this first Power type, you must simultaneously pursue a business model that promises Scale Economies (industry economics), while at the same time offering up a product differentially attractive enough to pull in customers and gain relative share (competitive position).
Network Economies - the value of the service to each customer is enhanced as new customers join the “network.” when the value of a product to a customer is increased by the use of the product by others.
A business in which the value realized by a customer increases as the installed base increases.
Benefit: A company in a leadership position with Network Economies can charge higher prices than its competitors, because of the higher value as a result of more users. For example, the value of LinkedIn’s HR Solutions Suite comes from the numbers of LinkedIn users, so LinkedIn can charge more than a competiting product with fewer participants.
Barrier . The barrier for Network Economies is the unattractive cost/benefit of gaining share, and this can be extremely high. In particular the value deficit of a follower can be so large that the price discount needed to offset this is unthinkable. For example, “What would BranchOut have had to offer users for them to use BranchOut rather than LinkedIn?” I think most observers would agree that every user would have required a non-trivial payment, so the total spend for BranchOut would have been colossal.
What must you do to get there?
Network Economies. Here the needs are similar to Scale Economies, except that installed base, rather than sales share, is the goal.
Helmer, Hamilton. 7 Powers: The Foundations of Business Strategy (Kindle Locations 1703-1704). Deep Strategy LLC. Kindle Edition.
An upstart who developed a superior, heterodox business model. That business model’s ability to successfully challenge well-entrenched and formidable incumbents. The steady accumulation of customers, all while the incumbent remains seemingly paralyzed and unable to respond.
A newcomer adopts a new, superior business model which the incumbent does not mimic due to anticipated damage to their existing business.
Think of Dell vs. Compaq, Nokia vs. Apple, Amazon vs. Borders, In-N-Out vs. McDonalds, Charles Schwab vs. Merrill Lynch, Netflix vs. Blockbuster, etc.
Benefit. The new business model is superior to the incumbent’s model due to lower costs and/or the ability to charge higher prices. In Vanguard’s case, their business model resulted in substantially lower costs (the elimination of expensive portfolio managers, as well as the reduction of channel costs and unnecessary trading costs) which then translated into superior product deliverables (higher average net returns). Due to their business structure of returning profits to their fund-holders, they realized value from market share gains ( s in the fundamental equation of strategy), rather than ramping up differential profit margins ( m ).
Barrier. The barrier for Counter-Positioning seems a bit mysterious: how could a powerhouse (such as Fidelity Investments in this case) allow itself to be persistently humbled by an upstart over such an extended period? Couldn’t they foresee the potential success of Vanguard’s model? Frequently in such situations, naïve onlookers castigate the incumbent for lack of vision, or even just poor management. Often, too, they level this accusation at companies with prior plaudits for business acumen. In many cases, this view is unjust and misleading. The incumbent’s failure to respond, more often than not, results from thoughtful calculation. They observe the upstart’s new model, and ask, “Am I better off staying the course, or adopting the new model?” Counter-Positioning applies to the subset of cases in which the expected damage to the existing business elicits a “no” answer from the incumbent. The Barrier, simply put, is collateral damage. In the Vanguard case, Fidelity looked at their highly attractive active management franchise and concluded that the new passive funds’ more modest returns would likely fail to offset the damage done by a migration from their flagship products.
Counter-Positioning is not an exclusive source of Power. The two prior chapters covered Power types that were exclusive: there could be only one company with Power. This is a reflection of the “Competitor Position” portion of the leverage calculation I have detailed. For these earlier types, there can be only one firm with a favorable competitive position. In contrast, there could be—and often are, in fact—many challengers Counter-Positioned respective to the incumbent.
What must you do to get there?
You pioneer a new, superior business model that promises collateral damage for incumbents if mimicked
The value loss expected by a customer that would be incurred from switching to an alternate supplier for additional purchases.
Benefit. A company that has embedded Switching Costs for its current customers can charge higher prices than competitors for equivalent products or services. 40 This benefit only accrues to the Power holder in selling follow-on products to their current customers; they hold no Benefit with potential customers and there is no Benefit if there are no follow-on products.
Barrier. To offer an equivalent product, competitors must compensate customers for Switching Costs. The firm that has previously roped in the customer, then, can set or adjust prices in a way that puts their potential rival at a cost disadvantage, rendering such a challenge distinctly unattractive. Thus, as with Scale Economies and Network Economies, the Barrier arises from the unattractive cost/benefit of share gains for the challenger.
Switching Costs are a non-exclusive Power type: all players can enjoy their benefits.
As a market matures, the Benefit of Switching Costs becomes transparent to all players and they are able to calculate the value of an acquired customer. More often than not this leads to enhanced competition to grab new customers, which arbitrages out the Benefit for new customer acquisitions. 44 So the major value contribution comes from capturing customers before such value-destroying pricing arbitrage transpires.
Switching Costs offer no Benefit if no additional related sales are made to the customer. To assure that such additional sales take place, one tactic might be to develop more and more add-on products.
The building of such product portfolios can serve to boost all three categories of Switching Costs. Not only does it extend the revenue coverage of the Switching Costs (Financial), but it often increases their intensity by making the prospect of disentanglement more and more forbidding (Procedural). A high level of integration into customer operations, and the extensive training that demands, can also further disincentivize such disentanglement.
Helmer, Hamilton. 7 Powers: The Foundations of Business Strategy (Kindle Locations 1026-1029). Deep Strategy LLC. Kindle Edition.
Helmer, Hamilton. 7 Powers: The Foundations of Business Strategy (Kindle Locations 1017-1018). Deep Strategy LLC. Kindle Edition.
Types of Switching Costs
- Financial . Financial Switching Costs include those which are transparently monetary from the outset. For ERP, these would include the purchase of both a new database and the sum total of its complementary applications.
- Procedural . Procedural Switching Costs are somewhat murkier but no less persuasive. They stem from the loss of familiarity with the product or from the the risk and uncertainty associated with the adoption of a new product. When employees have invested time and effort to learn the particulars of how to use a certain product, there can be a significant cost to retraining them in a different system. In the case of SAP, applications exist for a wide array of enterprise functions. This means that there are employees in human resources, sales and marketing, procurement, accounting, not to mention managers across these many divisions, who have all learned how to create reports based on the SAP system and its complementary software. Such a system-switch breeds organizational discontent by forcing many within the ranks of the organization to change their daily routines. Furthermore, procedural changes open the door for errors. With databases, these are particularly costly, since they involve the totality of the customer’s information. Even when a competitor provides services and programs to help mitigate such difficulties of transition, these often prove costly and imperfect.
- Relational. Relational Switching Costs are those tolls which would result from the breaking of emotional bonds built up through use of the product and through interactions with other users and service providers. Often a customer establishes close, beneficial relationships with the provider’s sales and service teams. Such familiarity, ease of communication and mutual positive feelings can create resistance to the prospect of severing those ties and switching to another vendor. Additionally, if the customer has developed affection for the product and their identity as a user, or if they enjoy the camaraderie which exists amongst a community of like users, they may shrink from the prospect of switching identities and abandoning that community.
What must you do to get there?
With Switching Costs, you must first attain a customer base, meaning the same new-product requirements demanded of Scale and Network Economies factor in here as well.
Branding is an asset that communicates information and evokes positive emotions in the customer, leading to an increased willingness to pay for the product.
The durable attribution of higher value to an objectively identical offering that arises from historical information about the seller.
Benefit. A business with Branding is able to charge a higher price for its offering due to one or both of these two reasons:
- Affective valence. The built-up associations with the brand elicit good feelings about the offering, distinct from the objective value of the good. For example, Safeway’s cola may be indistinguishable from Coke’s in a blind taste test, but even after revealing the result, the taste tester remains willing to pay more for Coke.
- Uncertainty reduction. A customer attains “peace of mind” knowing that the branded product will be as just as expected. Consider another example: Bayer aspirin. Search for aspirin on Amazon.com and you will see a 200 count of Bayer 325 mg. aspirin for $9.47 side-by-side with a 500 count of Kirkland 325 mg. aspirin for $10.93. So Bayer has a price per tablet premium of 117%. Some customers still would prefer the Bayer because of diminished uncertainty: Bayer’s long history of consistency makes customers more confident that they are getting exactly what they want. Note that the Benefit from Branding does not depend on prior ownership, as with Switching Costs.
Barrier. A strong brand can only be created over a lengthy period of reinforcing actions ( hysteresis ), which itself serves as the key Barrier. Again, Tiffany has cultivated its brand name for more than a century. What’s more, copycats face daunting uncertainty in initiating Branding: a long investment runway with no assurance of an eventual path to significant affective valence. Efforts to mimic another brand run the risk of trademark infringement actions as well with their attendant costs and unclear outcomes.
Branding—Challenges and Characteristics
Brand Dilution . Firms require focus and diligence to guide Branding over time and ensure that the reputation created remains consistent in the valences it generates. Hence, the biggest pitfall lies in diminishing the brand by releasing products which deviate from, or damage, the brand image. Seeking higher “down market” volumes can reduce affective valence by damaging the aura of exclusivity, weakening positive associations with the product. For example, Halston rose to fame in the 1970s as a high-end design standard for women’s clothing. However, when Halston accepted $1 billion from lower-end retailer J.C. Penney to expand into affordable fashion lines for the mass consumer, Bergdorf Goodman dropped the label in order to protect their brand. The J.C. Penney line was a failure, and the Halston name never recaptured its previously enviable Branding. I stated earlier that Branding’s Barrier is hysteresis and uncertainty. Dilution threatens Branding Power because it can “reset the hysteresis clock,” forcing a company to restart the slow and uncertain process of building affective valence. The Halston experience serves as a persuasive case in point.
Counterfeiting . Since it is the label, not the product, that bestows Branding Power, counterfeiters may try to free-ride by falsely associating a powerful brand with their product. Because Branding relies upon repeated positive interactions with consumers, counterfeiters who flood the market with inconsistent offerings can gradually undermine it. For instance, in 2013 Tiffany sued Costco for intimating to shoppers that they sold Tiffany jewelery; the company had previously sued eBay for facilitating the sale of counterfeits. A press release to investors after the filing of the 2013 suit explicitly noted that, “Tiffany has never sold nor would it ever sell its fine jewelry through an off-price warehouse retailer like Costco.”
Geographic boundaries . The affective valence may apply in one region but not another. For example, for many years, Sony enjoyed a Branding advantage with its televisions in the United States. In Japan, however, it enjoyed no such advantage, thus preventing it from enjoying premium pricing over rivals such as Panasonic.
Non-exclusivity. Note that Branding is a non-exclusive type of Power. Indeed, a direct competitor might have an equally impactful brand that targets the same customers (e.g., Prada and Luis Vuitton and Hermès). All competitors with brand Power, however, still will earn returns superior to those of the competitor with no Branding.
Type of Good . Only certain types of goods have Branding potential (more on this in the Appendix on Surplus Leader Margin) as they must clear two conditions:
- Magnitude: the promise of eventually justifying a significant price premium.
- Business-to-business goods typically fail to exhibit meaningful affective valence price premia, since most purchasers are only concerned with objective deliverables. Consumer goods, in particular those associated with a sense of identity, tend to have the purchasing decision more driven by affective valence. Here’s the reason: in order to associate with an identity, there must be some way to signal the exclusion of alternative identities.
- For Branding Power derived from uncertainty reduction, the customer’s higher willingness to pay is driven by high perceived costs of uncertainty relative to the cost of the good. Such products tend to be those associated with bad tail events: safety, medicine, food, transport, etc. Branded medicine formulations, for example, are identical to those of generics, yet garner a significantly higher price.
- Duration: a long enough amount of time to achieve such magnitude. If the requisite duration is not present, the Benefit attained will fall prey to normal arbitraging behavior.
What must you do to get there?
Over an extensive period of time, you make the consistent creative choices which foster in the customer’s mind an affinity that goes beyond the product’s objective attributes.
Cornered Resource - Preferential access at attractive terms to a coveted asset that can independently enhance value.
Benefit. In the Pixar case, this resource produced an uncommonly appealing product—“superior deliverables”—driving demand with very attractive price/volume combinations in the form of huge box office returns. No doubt—this was material (a large m in the Fundamental Equation of Strategy). In other instances, however, the Cornered Resource can emerge in varied forms, offering uniquely different benefits. It might, for example, be preferential access to a valuable patent, such as that for a blockbuster drug; a required input, such as a cement producer’s ownership of a nearby limestone source, or a cost-saving production manufacturing approach, such as Bausch and Lomb’s spin casting technology for soft contact lenses.
Barrier. The Barrier in Cornered Resource is unlike anything we have encountered before. You might wonder: “Why does Pixar retain the Brain Trust?” Any one of this group would be highly sought after by other animated film companies, and yet over this period, and no doubt into the future, they have stayed with Pixar. Even during the company’s rocky beginning, there was a loyalty that went beyond simple financial calculation. To illustrate: in 1988, long before Disney began its association with Pixar, Lasseter won an Academy Award for his Pixar short Tin Toy, prompting Disney CEO Michael Eisner and Disney Chairman Jeffrey Katzenberg to try to recruit their former employee back into the Disney fold. Lasseter demurred: “I can go to Disney and be a director, or I can stay here and make history.” 59 So in Pixar’s case, the Barrier was personal choice. In the case of spin casting technology, it is patent law, and in the case of cement inputs, it is property rights. Our general term for this sort of barrier is “fiat”; it is not based on ongoing interaction but rather comes by decree, either general or personal. In a case of the cart driving the donkey, it was Lasseter’s commitment to Pixar that helped convince Katzenberg to do the three-picture deal with Pixar in 1991. Likewise, Disney’s later CEO, Bob Iger, would decide to acquire Pixar only after realizing such an acquisition would be the sole means of bringing Pixar’s talent to Disney’s flagging animation group. The subsequent revival of Disney Animation affirmed his wisdom.
five screening tests for a Cornered Resource:
Idiosyncratic. If a firm repeatedly acquires coveted assets at attractive terms, then the proper strategy question is, “Why are they able to do this?” For example, if one discovered that Exxon was able to persistently gain the rights to desirable hydrocarbon properties, then understanding their path to access would be the more crux issue. Perhaps their relative scale allows them to develop better discovery processes? If so, their discovery processes are the Cornered Resource, the true source of Power, and it would be misleading to simply cite only the acquired leases.
Non-arbitraged. What if a firm gains preferential access to a coveted resource, but then pays a price that fully arbitrages out the rents attributable to this resource? In this case, it fails the differential return test of Power. Consider movie stars. A turn by Brad Pitt would probably advance box office prospects, therefore proving “coveted,” but his compensation captures much or all of this additional value and so fails the Power test. Likewise, although the Pixar Brain Trust is highly compensated, the amounts do not come close to matching their value. I was an investor in Pixar when it was public, and I realized a very nice return over the life of my investment, until the Disney acquisition.
Transferable. If a resource creates value at a single company but would fail to do so at other companies, then isolating that resource as the source of Power would entail overlooking some other essential complement beyond operational excellence. The word “coveted” in the definition conveys the expectation by many that the asset will create value. In the lead-up to his acquisition of Pixar, Bob Iger had an epiphany: the legacy of Disney’s animated characters formed the core of the corporation, and only the Pixar team could revive that legacy. This motivated his purchase of Pixar, as well as his decision to place Catmull and Lasseter at the helm of Disney Animation, which resulted in the meteoric revival of that storied division. Such a comeback would never have been possible without Catmull and Lasseter in key decision-making roles, and the Brain Trust on call, and it ultimately vindicated the steep price paid by Disney. This resource was transferable.
Ongoing. In searching for Power, a strategist tries to isolate a causal factor that explains continued differential returns. There’s a contrapositive to this, too: one would then expect differential returns to suffer should the identified factor be taken away. Clearly this perspective has bearing on the identification of a Cornered Resource. There may be many factors that proved formative in developing Power but whose contributions then became embedded in the business.
Sufficient. The final Cornered Resource test concerns completeness: for a resource to qualify as Power, it must be sufficient for continued differential returns, assuming operational excellence.
What must you do to get there?
You must secure the rights to a valuable resource on attractive terms. This often comes from having developed that resource in the first place and then gaining ownership of it, the most common avenue being a patent award for research developments.
Process Power -
Embedded company organization and activity sets which enable lower costs and/or superior product, and which can be matched only by an extended commitment.
Benefit. A company with Process Power is able to improve product attributes and/or lower costs as a result of process improvements embedded within the organization. For example, Toyota has maintained the quality increases and cost reductions of the TPS over a span of decades; these assets do not disappear as new workers are brought in and older workers retire.
Barrier. The Barrier in Process Power is hysteresis: these process advances are difficult to replicate, and can only be achieved over a long time period of sustained evolutionary advance. This inherent speed limit in achieving the Benefit results from two factors:
- Complexity . Returning to our example: automobile production, combined with all the logistic chains which support it, entails enormous complexity. If process improvements touch many parts of these chains, as they did with Toyota, then achieving them quickly will prove challenging, if not impossible.
- Opacity . The development of TPS should tip us off to the long time constant inevitably faced by would-be imitators. The system was fashioned from the bottom up, over decades of trial and error. The fundamental tenets were never formally codified, and much of the organizational knowledge remained tacit, rather than explicit. It would not be an exaggeration to say that even Toyota did not have a full, top-down understanding of what they had created—it took fully fifteen years, for instance, before they were able to transfer TPS to their suppliers. GM’s experience with NUMMI also implies the tacit character of this knowledge: even when Toyota wanted to illuminate their work processes, they could not entirely do so.
What must you do to get there?
You evolve a new complex process which renders itself inimitable within a reasonable period and yet offers significant advantages over a longer period of time.
Power comes on the heels of invention, be it in products, processes, brands or business models. However, most invention is merely a manifestation of operational excellence and thus not immune to the arbitraging actions of competition. So in this formative period, as your invention takes shape, you must attune yourself to the exigencies of Power and stay constantly vigilant. This is why I developed the 7 Powers—to give you a ready guide for this.