There are only two ways to create long-term competitive advantage. Efficiency isn’t one.
The goal of strategy in business is creating long-term competitive advantage. A pair of classic articles from 1996 describe two paths to that goal. In traditional industries like manufacturing, retail, and most services long-term competitive advantage can be achieved by skillfully differentiating business activities. In tech, stable advantage requires rapid growth, lock in, and market dominance.
Michael E. Porter, in What Is Strategy?, describes “activities” as the basic unit of competitive advantage. And strategy as “the creation of a unique and valuable position, involving a different set of activities.” Activities, in Porter’s sense, exist at the level of tactics or below. So strategy is essentially a deliberately chosen array of tactics.
This flips the usual conception of tactics as emanating from strategy. Top down. Instead, strategy is emergent — a pointillist image derived from actual, individual activities.
Once a strategy is identified from a company’s motley assortment of activities, that strategy will determine which new activities are pursued and which existing activities are dropped. Strategy is a low-resolution map of company activities. Shorthand for all of the tactics. And a tool for filtering options.
Being better is not a strategic advantage. Being different is.
Porter opens his article with a critical observation: operational effectiveness is not strategy. This was a particularly poignant statement in 1996. It was a time of Total Quality Management, Jack Welch, Six Sigma, outsourcing, and lean manufacturing. Efficiency was paramount. (I was in high school, but even so I had a pretty clear picture of the situation — mostly from on Newsweek and Office Space.)
“Management tools have taken the place of strategy,” Porter says. Everyone at the time, particularly in traditional industries, was focused on how to do things more efficiently. How to cut costs. How to mimic the Japanese ideas of lean manufacturing. (Which ideas were later imported to software development as popularized by Eric Ries and many others.) Globalization, Pax Americana, and trade deals made it easier than ever to find efficiencies and short-term profit by shifting production overseas. It was a time of layoffs and “just in time” production. It was also a time of limited imagination. Porter calls that out.
Unlike industry-standard, best-practices management, strategy consists in deliberately “performing different activities from rivals’ or performing similar activities in different ways.” Efficiently if possible. But efficiency gains quickly become best-practices disbursed across industry and adopted by the competition. “A company can outperform rivals only if it can establish a difference that it can preserve.”
Efficiency gains cannot be preserved so they do not provide a long-term advantage. Strategic positioning can be and does.
What are you (not) going to do?
To create a sustainable competitive advantage is to deliberately undertake an array of interlocked activities and say no to activities that don’t fit. This is true for all companies, but absolutely critical for entrepreneurial ones.
A position becomes sustainable despite market competition when it rejects certain activities that competitors will have a hard time abandoning. Entrepreneurs worry that a big company will step into their space and crush them. But big companies are themselves locked into performing a specific set of activities that make it hard to fully replicate the startup’s position. And without full replication the interlocking, mutually reinforcing benefits of activities won’t be realized.
When a startup’s position depends primarily on technological advantage, though, it probably won’t be sustainable. Patents help. First mover helps. Superior starting tech helps. But tech is fundamentally an efficiency play. Eventually the big companies with deep pockets will catch up.That’s why differentiation of activities — strategic positioning — is so critical.
Broadly speaking, “Focused competitors thrive on groups of customers who are over served (and hence overpriced) by more broadly targeted competitors, or underserved (and hence underpriced).” More specifically, Porter identified three ways to approach strategic positioning. These overlap and are not mutually exclusive.
- Variety-Based Positioning. Produce a subset of an industry’s products or services. This approach works if you do great work. It’s a niche approach, but niche doesn’t mean small. Think Jiffy Lube or Vanguard.
- Needs-Based Positioning. Serve all or most of the needs of a particular group of customers. Activities tailored to a specific customer segment. But be careful: “differences in needs will not translate into meaningful positions unless the best set of activities to satisfy them also differ.” In other words, if servicing a group of customers doesn’t require activity tradeoffs — if standard industry offerings meet all needs — there is no opportunity to take a strategic position because competitors already satisfy that segment’s needs. Think Ikea and high-touch, high-net-worth financial advisors who could not operate profitably servicing small accounts.
- Access-Based Positioning. Target market segments that, because of geography, scale, or other restriction, are best reached or served by a specific set of activities. Think of Carmike Cinemas, a theater chain that served small, rural communities.
What you don’t do is most important.
Choosing the right mix of activities is important. But differentiation and sustainable advantage is fundamentally achieved by choosing what not to do. A company’s activities should be complimentary, reinforcing, and in line with its strategic positioning. Any activities outside those bounds, that doesn’t further the strategy, should be dropped.
Competitors trying to overtake a strategic position often misstep by attempting to tack on activities that don’t fit with their core competency, aren’t complimentary to existing activities, or even undermine activities critical to their main business line.
The litmus test for deciding which activities to add, keep, skip, or drop is this: does this activity further our strategy or improve or compliment other activities that do. That is the North Star. Saying no to alluring opportunities — legitimately good opportunities — is the critical discipline to preserving an established position.
In technology differentiation is not enough.
Econ 101 teaches that diminishing returns are a central feature of all production models. As a company grows it will run out of good opportunities (like quality farm land) and after a point, it stops being productive to add resources. Beyond the individual firm, an industry will maximize resource exploitation and the market leader will soon have its advantaged position undermined as competitors bid up the price of inputs and customers bid down the price of outputs until everyone’s profit drops to zero. That sounds a lot like Porter’s observation that efficiency gains are not sustainable.
Around the time Porter published What is Strategy?, W. Brian Arthur published another HBR article, Increasing Returns and the New World of Business. Arthur’s insight was that diminishing returns do not describe the tech industry. In tech the model is reversed: increasing returns. Winners get further ahead. Locked in tech — even inferior tech, as we well know — dominates its market. This is the most true where there are high up-front costs (and low marginal costs), network effects, and high switching costs. Operating systems are paradigmatic but certainly not the only case.
For startups pursuing opportunities with these characteristics we can take Porter further: efficiency is irrelevant. The only thing that matters is building a product that dominates, and domination is achieved through rapid user acquisition, network effects, and lock in. Efficiencies can be pounded into place later. But profit margins are so large — because marginal costs are so small — that investments in efficiency are not very productive. When marginal costs are negligible, invest in high-margin growth. Before efficiencies are ever worth their cost the acquired user base can be leveraged into new, adjacent opportunities.
Super important caveat on efficiency in startups.
There is one super important caveat here. Inefficient startups do face another problem: burn. At early stages a startup’s primary objective is to find product-market fit before running out of cash. Funding minus burn — the amount of cash a company is spending on a monthly basis — determines how much runway the company has to lift off with product-market fit before it plunges off the runway. Inefficiency — generally inefficient burn in the form of foosball tables and beer on tap in the lobby — shortens runway.
A startup can look for more funding to extend its runway. But funding isn’t always available. And when it is available it will come at a high price if the company is still floundering about searching for its business model.
In any case, excess funding is its own problem. Deprivation creates clarity. “When a man knows he is to be hanged in a fortnight, it concentrates his mind wonderfully.” Lean startups, particularly before product-market fit, find clarity by necessity. (Or don’t.) Overfunded startups tend to be complacent and fail.
There is a tension, then, in the specific case of startups. Efficiency is largely irrelevant. But it matters to the extent that the company must survive long enough to find product-market fit. Then it’s back to the original point and efficiency must take a back seat to aggressive growth in pursuit of a leading position and increasing returns.
Interestingly, startups have one clear strategic advantage over larger companies. Because of constrained resources they are all but forced to choose activities that compliment their strategic objective. Large companies always run the risk of saying yes to everything because it looks like they can. Which is why established companies struggle to compete with focused startups. It’s never about resources or ability. It’s about having a tailored set of activities.
Think about strategy as creating a set of activities that produce differentiation or relentless pursuit of growth.
In traditional markets strategic positioning means assembling a self-reinforcing array of activities aimed at a specific niche or market segment. In technology this is true too. But in traditional markets, after differentiation, strategy drives more differentiation. In tech, strategy demands differentiation only to the point of product-market fit, then it’s flat out growth and leveraging locked-in audiences to unlock new opportunities.
Efficiency is not irrelevant in either world, but it will never create sustainable advantage. Sustainable advantage can only be achieved by differentiation of activities or growth to the point of increasing returns.