Strategy formulation

1 An overview

Sustainable competitive advantage means doing better than your competitors in the long term. Profits must be sufficiently high, and sufficiently safe, to reward investors properly and to fund the research, development and marketing that defend the organisation’s position – and ideally strengthen its lead.

There are two stages in formulating a strategy for sustainable competitive advantage:

• Choose a generic strategy. This is the fundamental way the organisation will compete, and there are three: cost leadership, differentiation, and focus. Generic strategies are associated with Michael Porter and are described below.

• Choose a strategic direction. Having decided how to compete, the organisation turns to where growth will come from: market penetration (with efficiency gains, consolidation or withdrawal), market development, product development, or diversification. These directions are set out on Ansoff’s matrix.

Both choices are now made inside an ecosystem (Chapters 4 and 7): a modern option list also includes how to participate in networks and platforms, which this chapter adds after Ansoff. The chapter closes with how options are evaluated (suitability, acceptability, feasibility) and how the chosen options are integrated into one coherent strategy.

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2 Porter’s generic strategies

Porter sets out three generic strategies:

• Cost leadership

• Differentiation

• Focus

The first two are usually mutually exclusive; focus is applied on top of either. A generic strategy is required if a company is to gain competitive advantage – the capability to earn good profits in the long term: profits that adequately recompense investors for risk while funding the R&D, training and machinery needed to stay ahead. The logic of the three positions is easiest to see side by side:

2.1 Cost leadership

A cost leader supplies a basic product into a competitive market. It cannot raise prices – the product is ordinary and competitors supply equivalents – so the only way to improve margin is to lower costs. The cost leader aims to have the lowest costs of all, leaving rivals ‘stuck in the middle’, squeezed between low prices and high costs. Financial strength follows: spare cash for marketing, product development and new machinery – and the option of dropping prices temporarily to force weaker competitors out altogether.

Cost leaders need ferocious cost control: keeping costs low is their only trick, and the whole culture focuses on it. Ryanair is an excellent example: non-reclining seats (cheaper, lighter, nothing to break), no seat-back pockets (nothing to clean out), cheap airports, a modern fuel-efficient fleet and web-based customer service make it enormously profitable. Note that cost leadership normally demands scale – large companies with buying power and international production can drive costs down in ways small companies cannot. And even cost leaders are not safe forever: a technological breakthrough can let a competitor become cheaper still.

2.2 Differentiation

Differentiators compete by supplying better products and services for which they can charge more – ‘better’ meaning whatever suits the customer well enough that paying more feels worthwhile: quality, design, features, reliability, brand. The differentiator’s margin is opened by raising price, not by minimising cost – indeed its costs are usually higher, because quality and innovation are expensive. Apple illustrates the strategy: superb design values and constant innovation let it charge far more than Windows-based machines of similar performance.

2.3 Focus

A focus company concentrates on a small segment (niche) of the market rather than addressing all of it – perhaps because it lacks the resources to serve the whole market, or because certain segments are especially profitable or especially suited to its expertise. Having decided to focus, it must still choose cost leadership or differentiation within the niche. In practice focus-differentiation is the natural combination: serve one or two segments you know intimately, develop products that suit them exactly, and charge for the fit. This is how small companies survive profitably: their niche is often too small to interest the mass-market giants, while their higher costs rule out competing on price. Advising a small company to compete on cost is usually bad advice.

3 Ansoff’s matrix and gap analysis

After the generic strategy is decided, more detailed growth strategies follow. Ansoff’s product-market matrix is an immensely useful way of presenting the options – it helps to remember that it sets out every way a company can try to increase its profits:

• Existing products, existing markets. The company stays on home territory and improves profit by efficiency gains (a euphemism for cost savings), withdrawal from unprofitable markets or customers (recall the customer portfolio analysis of Chapter 9), consolidation (merging with a competitor, streamlining back-office operations), or market penetration – nudging market share from, say, 20% to 22%. Relatively low risk, and relatively modest returns: competitors retaliate against share grabs, and no one halves their costs through efficiency alone.

• Market development. Selling existing products in new markets – exporting, or a European retailer opening in the US. Potentially transformative, but riskier: retail formulas that work at home have repeatedly failed to travel, after heavy up-front investment.

• Product development. New products for existing markets – the vacuum-cleaner maker launching washing machines. Again, higher return and higher risk: success with one product line does not guarantee success with the next, and the development spend is committed before anyone knows.

• Diversification. New products and new markets – by far the riskiest quadrant, entered either through related diversification (a sister industry, where synergies such as shared supply, distribution or cross-marketing are plausible) or unrelated (conglomerate) diversification, for which there is very little justification: genuine synergy – two businesses together producing more profit than the sum of them apart – is hard to create between unrelated businesses. Diversification is covered fully in the next chapter.

3.1 Gap analysis

Ansoff’s matrix is often coupled with gap analysis, which compares what the organisation is likely to achieve if it carries on much as it is (the forecast, F0) with what its owners want it to achieve (the target, T). The forecast is then adjusted in layers: F1 adds improvements in internal efficiency; F2 adds product-market expansion. Whatever gap remains needs something more radical:

Ansoff’s matrix maps directly onto the gaps:

• Efficiency gap – closed by efficiency gains, penetration, consolidation, withdrawal (the existing/existing quadrant)

• Expansion gap – closed by market development and product development

• Diversification gap – closed only by diversification

4 Participation strategies: networks, platforms and ecosystems

Chapter 7 analysed how platforms and ecosystems create value. When formulating strategy, that analysis becomes a set of options – for most organisations today, ‘how do we participate?’ is as fundamental a question as which Ansoff quadrant to enter:

Evaluating these options uses the ideas from Chapter 7:

• Are network effects available, and could the market tip to a single winner? If it already has, building a rival platform is usually hopeless – joining or differentiating in a niche is more realistic

• What take rate and terms will a platform impose, and how easily could we multi-home or leave later? Dependence is a strategic cost, to be weighed like any other

• Do we have the capabilities an orchestrator needs (technology, matching, governance, deep pockets for the subsidy phase) – or are we better complementors?

• What happens to our customer data and relationship under each option?

Participation choices also read naturally through Ansoff: joining a marketplace is often market development at low cost; opening your pipeline to third-party sellers is a form of product/service development; building a platform in a new domain is diversification, with diversification-level risk.

5 Strategy evaluation

Towards the end of the strategy-formulation process an organisation will have identified several options, any of which might achieve its objectives – develop a new product, enter a new country, merge with a competitor, join a platform. It is unlikely that one option is obviously better on every measure: one may promise higher profits with higher risk, another modest but safe returns. So evaluation needs criteria, set in advance – the syllabus expects criteria to be developed first and options evaluated against them, not chosen on instinct and justified afterwards.

The most useful framework is Johnson and Scholes’ suitability, acceptability and feasibility (SAF) – in that order:

In practice options score unevenly – one is suitable and acceptable but not feasible; another suitable and feasible but unacceptable to key stakeholders. Unless there is an outright winner, the comparison is hard, and management must weigh the criteria (often prioritising acceptability to the most powerful stakeholders and hard feasibility limits) before recommending. SAF’s virtue is that it makes those trade-offs explicit and simple to communicate.

6 Integrating choices into a coherent strategy

Evaluation does not end with picking winners one at a time. The syllabus’s final requirement here is to produce strategy by integrating the chosen options into a coherent whole: generic strategy, growth directions, participation choices and functional plans must reinforce – not contradict – each other. Tests of coherence:

• Consistency with the generic strategy: a cost leader that adopts an expensive high-touch service option, or a differentiator that starts price-cutting, is dismantling its own advantage

• Value chain fit (Chapter 7): do the chosen options strengthen the activities and linkages the strategy depends on?

• Portfolio balance (Chapter 11): do the choices, taken together, leave a sensible spread of products and businesses across life-cycle stages and risk levels?

• Resource realism (Chapter 6): the combined resource demands of all chosen options must fit what the organisation can fund and staff – options that pass feasibility individually can fail collectively

• Trade-offs made consciously: choosing one option usually forecloses others; integration means deciding what will NOT be done

This is where integrated thinking (Chapter 12) earns its place in strategy: decisions are taken looking across all the capitals – financial, human, intellectual, social and natural – and across silos, so that a choice that flatters one measure does not quietly destroy value somewhere else. A coherent strategy, resourced realistically and accepted by the stakeholders who matter, is the output that the strategic-control machinery of Chapters 8 and 12 then implements and monitors.

7 Test your knowledge

Two short exercises close the chapter in the online notes: ten flashcards on the terms and frameworks above, and ten practice questions with worked feedback on every option. Work through the cards first, then the questions.