Sustainable competitive advantage

Sustainable competitive advantage, we hear, is the goal of every strategy. But what exactly is such an advantage, and how do you know when you have it? The answers are not always clear, and many carefully planned strategies have come to grief because the competitive advantages they were designed to achieve turned out to be ephemeral, irrelevant, or both. It may be worthwhile, then, to take a more rigorous look at sustainable competitive advantage and its implications for running a business.

In simple terms, producers who sell their goods or services at a profit enjoy a competitive advantage when customers choose to buy from them instead of from their competitors. But some advantages are worth more than others. In particular, for a competitive advantage to have any strategic meaning, three things must happen.

1. Customers must perceive a consistent difference between a company's product or service and those of its competition, and that difference must occur in one or more key buying criteria—that is, in one or more of the few product attributes that actually shape the purchasing decisions of consumers.
2. The difference must come from a capability gap between the favored company and its competitors.
3. The product difference and the capability gap must endure over time.

What differences do customers want?

Competitive advantages can exist only in particular market segments. It is, after all, entirely possible to have an advantage in one segment and not in another. That said, the essence of point one above is that although competitive advantage does result from differentiation among competitors in a given segment, not just any kind of differentiation will do. To have strategic value, it must persuade large numbers of customers to buy and buy again.

Only some key attributes will matter in a given market segment, and any useful differentiation must target at least one of them

That is why the differentiation must reside in key buying criteria. These key criteria have little to do with the producer's internal characteristics, such as plant location or choice of raw materials, unless these features translate into product or delivery attributes that influence buying decisions. Instead, the buying criteria are usually attributes that affect the price consumers pay for the product, the way they perceive the product, or their access to it. These attributes could include quality, appearance, functionality, and the availability of after-sales service. But in any case, they are likely to be fundamental to the concept of the product or service being sold. Only rarely do they include add-ons or features. Price itself isn't always such an attribute, as Texas Instruments learned when it lowered the price of wristwatches to the point where customers no longer valued further reductions. Only some of these critical attributes will matter in a given market segment, and any useful differentiation must target at least one of them.

A gap in capabilities

Differentiation alone is not enough. The advantage must also stem from a fundamental gap in the capabilities of the competing companies—a gap that cannot be bridged, at least not with an economically rational amount of effort. True capability gaps consist of specific, often physical, differences and are likely to be prosaic and measurable. Abstractions such as "technological leadership" rarely qualify. Capability gaps tend to fall into four categories:

1. Business-system gaps, which result from the ability to perform individual functions better than competitors do.
2. Position gaps, which result from prior decisions, actions, and circumstances. They can include reputation, consumer awareness and trust, order backlogs, and irreversible investment choices, such as better plant locations.
3. Regulatory and legal gaps, which result from government action. They can include patents, import quotas, and consumer safety laws.
4. Organizational or managerial quality gaps, which result from an organization's ability to innovate and adapt more quickly and effectively than the competition, consistently.

Only the factors in the first category—business-system gaps—are under the short-term control of producers. Frustrating as it may be to the strategist, competitive advantage or disadvantage often results from factors that cannot be altered quickly.

Differentiation must be sustainable

Finally, both the key product differences and the capability gap must be likely to last for a long time. Therefore, the differentiation must affect product attributes that the market will continue to care about, not attributes that rely on ephemeral trends or are liable to be exploded by technological improvements.

One of the greatest threats to a sustainable competitive advantage is a competitor that somehow changes the rules of the competitive game, not so much tearing down the old capability gap as rendering it irrelevant.² The introduction of the transistor in 1955, for example, did nothing to erode RCA's capability advantage in producing vacuum tubes, but it did render that advantage far less valuable. In some cases, competitors may be perfectly able, but for some reason unwilling, to close a capability gap. This, of course, does not create the most secure position for a company that relies on the gap for its viability. Such a company should look closely at the reasons for its competitors' forbearance to determine whether it is likely to last.

Sustainable competitive advantage and strategy

Our definition of competitive strategy as "an integrated set of actions designed to create a sustainable advantage over competitors" could be taken to mean that a strategic competitive advantage guarantees business success. It does not.

Over time, such an advantage can help a producer achieve higher returns than its competitors, but there are pitfalls. The market segment in which the advantage exists may not be able to sustain any profitable producers in the long term. Competitors may inflict tactical damage using measures, such as purchasing market share by aggressive price cuts, that are not related to the competitive advantage. Conversely, even if only one firm in an industry has an advantage, others can still succeed—for instance, when the market is growing so quickly that the company with the advantage cannot expand production fast enough.

Finally, remember that although the attainment of sustainable competitive advantage is the goal of competitive strategy, such an advantage is not an end in itself but rather a means to an end. The corporation is not in business just to beat its competitors. It is in business to create wealth for its shareholders. Thus, actions that contribute to sustainable competitive advantage but detract from shareholder wealth may be good strategy in the competitive sense but bad strategy for the corporation.

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New-game strategies

Traditionally, companies compete in their markets either by enhancing the value of a product or by lowering its price. But there is another, often overlooked, mode of competition: prevailing over your rivals. Here, instead of accepting the market-defined rules of the game and competing obediently within them, the strategic competitor seeks to influence the rules themselves, creating a new game in which its own particular strengths become prerequisites for success. I call such approaches "new-game strategies."

An example helps make the point. Between 1975 and 1977, Savin Business Machines Corporation increased sales to over $200 million, from $63 million, in the $2.6-billion-a-year US office-copier market, which until then was dominated by Xerox. Savin's strategy: attack the low- and medium-speed submarket by using a new liquid-toner technology and novel approaches to manufacturing, distribution, and service.

Savin appealed to companies in the more time- and cost-sensitive market segment by offering them the opportunity to buy several cheaper machines for key office locations rather than leasing a costly, higher-quality Xerox machine and installing it in a central office—the existing paradigm. In the chosen market segment, Savin changed just about every step of the competitive game. Where Xerox machines used custom-made components, the Savin product took low-cost standardized ones. And because Savin's machines were priced for sale rather than leasing, the company sidestepped the need to finance a large leasing operation. Then, rather than building up a direct-sales force to rival Xerox's, Savin recruited independent office products dealers, enabling the company to take competitors by surprise.

To visualize strategy in a way that allows for such radical realignments of the competitive landscape, you can use the "strategic gameboard"—a matrix that shows "where to compete" on one axis and "how to compete" on the other (Exhibit 1). "Where" ranges from a single market niche, at one end of the spectrum, to the entire market, at the other. "How" ranges from playing by the traditional rules to rewriting them completely. It is this latter variable that determines whether the strategy involves a same-game or a new-game approach.

Same-game approaches

The most common strategies fall in the relatively safe upper-left-hand corner: same-game/across-the-board competition. A company that follows such a strategy must accept the leader's definition of the market, copy the leader's functional approach to the business, and emulate the leader's strengths. Rarely does such an emulator take the lead itself.

A second class of company is shrewder. In this category come the same-game/ selective players. They accept the conventional definitions of products and markets but seek to gain an advantage by choosing market niches that play to their strengths. The more innovative among these companies "resegment" the market, tailoring their product designs or marketing approaches to a segment never before viewed as a coherent group. Take a particular consumer durables market that has traditionally been segmented by price. A producer might resegment it on the basis of consumer attitudes and lifestyles, perhaps targeting consumers who are more interested in saving energy or time than money.

For a challenger, the same-game/selective approach is often less daunting than confronting the market leader head-on. However, because the challenger has made no basic changes in technology, manufacturing, or distribution, others can go after the newly discovered segment as well. In a sense, then, the same-game/selective player relies on the forbearance of its competitors—and this often lasts only as long as they regard the new market segment as too small to be worthwhile.

American Motors Corporation (AMC) learned this lesson in 1959. In just two years, AMC had increased its sales to 6 percent of the American automobile market, from 2 percent, by focusing on the small-car segment and persuading US car buyers to "think small." As soon as the company's success caught the notice of General Motors, Ford, and Chrysler, the Big Three introduced compacts of their own, and by 1965 AMC was back down to 3 percent of US sales and operating at a loss.

New games

Occupying the riskier, right-hand side of the matrix are the new-game strategies. They are less common than the same-game approaches but carry correspondingly greater rewards. Like same-game strategies, new games can focus on select niches or on an entire market, as reflected by the vertical axis of the matrix.

Stanley Works embarked on a selective new-game strategy when it noticed that many of its professional hand tools were being purchased by do-it-yourself homeowners. The company developed a cheaper line and a mass-marketing approach, tapping into large, unexploited market segments. Stanley's risk was limited: if the consumer line failed, the company could still fall back on its professional clientele. This is a common characteristic of new-game/selective strategies. The downside is limited precisely because the strategy is selective.

The riskiest of the four kinds of strategy—and the one that bestows the richest prizes on its winners—is the new-game/across-the-board approach. Following this path means nothing less than rewriting the rules of an entire industry to suit your own company's strengths. It often means changing the way some customers purchase, configure, or use your product or service. You may find yourself helping customers meet a need that they, or even you, had never associated with your product. Hanes Corporation's decision to sell pantyhose through grocery and discount chains is a good example of a new-game/across-the-board approach, as is Procter & Gamble's pioneering venture into disposable diapers. When the new-game/across-the-board approach works, it can leave competitors stranded, like a river port town left high and dry by a change in the watercourse.

None of the varieties of strategy on our matrix is right or wrong for every circumstance, so the timing of the choices can be as important as the decisions themselves. For instance, even if you ultimately plan to play a new-game/across-the-board strategy, you may want to start more cautiously with a new-game/selective strategy, expanding to the entire market only after successfully redefining a certain niche. That is what Texas Instruments did in the mid-1970s. First it created a new segment—simple, four-function, handheld consumer calculators. Encouraged by success there, it then attacked the higher-end scientific and educational segments of the calculator market. Similarly, a company with high market share may want to pursue a safe same-game/across-the-board strategy for a while, launching a new game only when market conditions shift. Thus, even market leaders must constantly scrutinize their industries to determine when to shift strategies.

New-game strategies are not for every occasion. They are hard to pull off, and successful examples are rare. But executives must always be alert to new-game opportunities, because when the conditions are right the rewards can be especially high.

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Attacking through innovation

Most of the managers of companies enjoying transitory success assume that tomorrow will be more or less like today. Believing that significant change is unlikely, unpredictable, and in any case slow, they strive to make their operations ever more cost-effective. While valuing innovation, and espousing the latest theories on entrepreneurship, they still regard it as a highly personalized process that cannot be managed or planned to any great extent. They believe that innovation is risky—riskier than defending their present business.

Companies such as Hewlett-Packard, Johnson & Johnson, and Corning make the opposite assumptions. They know that when change comes, it comes swiftly. So being in the right technologies at the right times, having the ability to protect your competitive position, and having the best people are more important to such companies than becoming ever more efficient in their current lines of business. They assume that the ultimate competitive advantage will go to the companies playing the role of attacker in the innovation war. They assume that, as risky as innovation is, failing to innovate is riskier.

They are right. And these insights are rare because they stem from something that too many companies lack: an understanding of the dynamics of competition, and in particular, of the relationship between the effort put into improving a product or process and the results achieved over time. When charted, this relationship appears as the familiar S-curve (Exhibit 2). At first, as funds are put into development, progress is frustratingly slow. Then, as research uncovers the key pieces of information necessary to make advances, the pace surges. Finally, progress slows down again, and each successive innovation requires a greater outlay of resources.

Ultimately, the S-curve levels off entirely, often as the technology approaches some fundamental limit—for example, the ultimate density of devices that can be squeezed onto a silicon chip. Indeed, it is important to pay attention to such limits, as they are the best clues a manager has for recognizing when a new technology must be developed within the company. It is comparatively easy to see how technological limits will affect the sales of a product that is closely related to the technology, as computers are to silicon chips. It is not so easy, however, when dealing with air travel, say, which combines thousands of technologies. Still, there are usually no more than a handful of technologies that are crucial to a certain product or process, and these are the ones managers should identify and nurture if they hope to anticipate change.

The important thing, therefore, is to spot the technological opportunities. A company should watch its rivals: when one competitor is nearing the top of the S-curve, others are likely to be exploring alternative technologies that could give rise to curves of their own, leading to discontinuities that could take a slower company by surprise. Think about the switch from vacuum tubes to semiconductors, from cloth to paper diapers, and even from conventional tennis rackets to those with enlarged "sweet spots."

Every single day brings further learning about the process of innovation—how it works and how it can be made to work better

Today, technological discontinuities are arriving with increasing frequency. The scientific knowledge that underpins our products and processes is multiplying by leaps and bounds in fields as diverse as quantum physics, surface chemistry, cell biology, mathematics, and the structure of knowledge itself. Furthermore, every day brings further learning about the process of innovation—how it works and how it can be made to work better.

These two developments are not new, but they have never interacted to produce an explosion of knowledge and change comparable to the present one. Before the year 2000, major technological changes may have transformed up to 80 percent of all manufacturing industries and a large portion of all service industries. We are living in an age when the risks to industry leaders are greater than ever before. Not only will technological discontinuities continue with increasing frequency, but during these discontinuities the attackers will have the advantage.

It is perhaps more important, then, for chief executive officers to be involved in technology than in other functional areas—especially because, at least in the United States, the business culture is strongly predisposed against such involvement. When the Conference Board asked the CEOs of the 400 largest US companies to identify their most trusted advisers, they tended to mention the top financial officer, the general operating officer, or the heads of the major corporate staff functions. In only one case in five was the head of research and development considered a member of top management. In Japan, according to my partner Kenichi Ohmae, the chief technical officer would make the list of key advisers in four cases out of five, putting this role about 3rd on the list instead of 11th. How is the United States going to compete in a world full of technological possibilities if the technology-savvy executives are isolated from those who can most readily deploy funds and people?

To innovate in new technologies, CEOs must help to develop the right management practices

With the next 10 to 20 years filled with technological discontinuities, companies will have to innovate in new technologies, not once or twice a decade, but almost continuously. And that will happen only if the CEO helps to develop the right management practices and corporate culture. Being up-to-date on every technology the company uses is probably unnecessary, but a CEO must understand, in what may sometimes seem like obscure detail, the critical ones: germanium's band gap versus silicon's, the differences in molecular structure between napthalene and orthoxylene, the compositions of complex and simple sugars. These details dictate the range of options managers have at their disposal.

It isn't as complex as it sounds. To push a company toward better and more sustainable strategies, a CEO need only ask some basic questions about technology—and insist on honest answers:

• For the markets my company competes in, or intends to compete in, which alternative technologies might meet the customer's requirements? Which rivals are pursuing each approach?
• What are the two or three key parameters that influence the customer's decision to buy? How do these relate to the technical performance factors or design parameters of each alternative technology?
• How far is my company from the limits of each alternative technology? Are there ways to circumvent these limits?
• How much would the customer value the remaining technical potential? How much would it cost to realize this potential?
• What portion of a technology's value to the customer can a producer capture, given the industry's structure, the alternatives available to the customer, and expected legislation, if any? Is the portion of value large enough to provide adequate returns on investment?
• When will each alternative technology be competitive in the marketplace, and how long will it remain so? Can my company, or any other, develop each technology rapidly enough to meet the timing requirements?

Questions like these help CEOs see technology for what it is: a battlefield of ever-changing S-curves. Armed with the answers to these questions, CEOs will be in a far better position to tackle the ongoing process of technological innovation successfully and to exploit the attacker's advantage.

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Hustle as strategy

Strategy, its High Church theologians insist, is about outflanking competitors with big plays that yield long-term "rents" from a sustainable advantage. But it is questionable whether this proposition is itself sustainable. These strategy theologians overlook the records of the many successful companies that do not have such long-term strategic plans or an obsessive preoccupation with rivalry. These are the companies that concentrate on operating details and on doing things well. In a word, their strategy is hustle. And executives at these companies may be doing exactly the right thing for their industries.

The Big Play

The traditional model of strategy calls for a Big Play: a decisive move that erects barriers around key assets, such as strong distribution systems, brand names, and proprietary technologies. But the Big Play has its limitations, and nowhere are they better demonstrated than in financial services, an industry in which firms somehow manage to do without the elaborate strategies that take hold at manufacturing companies.

In financial services, strategic plans consist of targets—for revenues, costs, profits, and numbers of employees—and terse descriptions of the capabilities of competitors as "strong," "weak," or "average." Occasionally, these plans are garnished with vague comments about a company's own competitive advantages: "our abundance of capital," "our people," et cetera. But rarely do such companies attempt to win the war with a single pincer move. Why? Because such tactics are largely pointless. As Warren Buffett put it, "Major sustainable competitive advantages are almost nonexistent in the field of financial services." The reason for this lack of competitive advantage is that, in the financial-services industry, trade secrets are hard to protect and product innovations are relatively easy to copy.

The bottom line

Without barriers to competition, conventional wisdom has it, a company will earn uniformly low returns. Here again, the financial-services industry casts doubt on convention. With practically no proprietary products, captive customers, or economies of scale, some companies in the industry nevertheless enjoy huge rewards. Goldman Sachs is reputed to have earned $400 million before taxes in 1983—a 60 percent return on capital. Morgan Guaranty regularly earns twice the return on assets of other banks serving similar customers with similar products.

Huge rewards stem from superior execution and the flexibility to take advantage of opportunities, not from structural competitive barriers

These rewards stem largely from superior execution and the ability to adjust quickly to take advantage of transitory opportunities, not from structural competitive barriers. Many wholesale banks earn higher-than-normal profits simply by doing what their competitors do—but getting it right. They make fewer credit mistakes and therefore don't suffer large write-offs. They get a higher share of corporate cash balances because their account officers stay close to their clients. They provide accurate and informative statements. In short, they hustle.

The manager's role

When the key to profitability lies in superior execution and hustle, managers have a mix of responsibilities different from those they have in environments where strategic invulnerability is paramount. They don't need to—in fact, can't—analyze their competitors in great depth and formulate detailed counterstrategies. Instead, they must turn inward, promoting the vigorous pursuit and satisfaction of customers. And because success in such an environment can hinge on a company's ability to respond to subtle but important differences among customers, managers cannot lead by grand proclamation.

In financial services, it makes no sense to subject every new business proposal to elaborate management screens. Managers simply have to live with lower levels of proof. At investment banks, for example, senior executives allow 25-year-old traders to risk millions of dollars. By contrast, industrial companies subject far smaller expenditures to trial by committee.

And although the top financial-services firms do monitor the competition, they don't let it control their own plans, because they know that, in their business, the competition isn't the point. "I don't view competition as an obstacle," says the head of one of the most successful banks. "Our most significant challenge is internal—making certain we manage our resources so that we are the best in the business."

Sustaining the hustle

Paradoxically, a company can encourage individual hustle only when it adopts a fine-grained, centralized system to measure the profitability of businesses and customers. Only then will its managers feel comfortable delegating responsibility, knowing that they won't get blindsided. Good managers at financial-services firms know the importance of good profit measures and other metrics and are obsessed with establishing them. American Express, for instance, identified 180 measurable customer service indexes, such as the time it took for the company to replace a lost card or respond to billing inquiries.

At a company where hustle is the main strategy, recruiting takes on a new importance. Look again at the investment banks, where candidates are rarely offered jobs without being interviewed by at least one managing director. Also, managers at such firms must give as much status to back-office functions as to the more glamorous marketing jobs. "Class" divisions between lending officers and back-office operators can be crippling. Institutions that are serious about customer service and operational quality give back-office managers a high level of recognition and reward.

The value of vision

The best financial-services companies have more than a well-designed set of controls and are more than way stations for capable free agents. Their leaders have an institutional vision: a shared understanding of what the firm is about and where it is headed. Goldman Sachs and Morgan Guaranty deify teamwork and putting clients first. Salomon Brothers focuses on taking trading risks. Such a vision provides continuity amid the turbulence and confers advantages that transcend the fluctuating fortunes of the company's individual businesses.

Perhaps for the companies where hustle is paramount, the equivalent of the Big Play is the Big Vision. Whereas the Big Play concentrates on barriers and rivalry, the Big Vision is just that: a broad view, which gives individual hustlers more freedom and flexibility to find their own opportunities.

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