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Articles
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Originally published in Financial Times 
"Fanciful Dreams that Confuse the Vital Issues"
by Bruce C. Greenwald
Published August 11, 2005
Everyone agrees that a company needs to have the right strategy to be successful. Nonetheless, there is still some confusion about what kinds of decisions should be considered strategic, and what kind of guidance they should provide.
Since the 1960s, the idea that a modern business enterprise should be guided by a broad strategic vision has been widely accepted. Media companies are supposed to be global businesses distributing a full range of owned content. Car companies are supposed to think of themselves as integrated transportation systems providers. Telecommunications companies should offer universal, electronic, multimedia connectivity. Drug companies should be biotechnology enterprises that develop and distribute the entire range of products made possible by the modern revolutions in biochemistry and genetics.
Yet all too often, these broad strategic visions have proved dysfunctional in practice. They have led to fruitless mergers, diffuse investments, low returns and, perhaps most important, a lack of attention to the mundane but essential task of running an efficient business. For corporate decision makers, "strategy" has increasingly become the enemy of effective management.
I suggest that we think of strategic decisions as those concerned with the behaviour of competitors, rather than the nitty gritty of operational management. Management can then concentrate on analysing and, wherever possible, manipulating the actions and responses of a restricted set of identifiable competitors. All the internal, day-to-day business decisions can then be made without regard to the often distracting considerations of broad strategy.
This recasting of the meaning of strategy generates a number of insights. First, in markets where no company has an incumbent competitive advantage - where there is nothing that an established company can do that its current and potential competitors cannot match - there is really no role for strategy in business policy formation. If there are no incumbent competitive advantages, then there is nothing to keep out an endless cast of potential competitors.
In such a market, success is entirely a matter of operational efficiency, not strategy. Dell, which has always competed on a level playing field against many PC manufacturers, is a good example of the extent to which a highly efficient operation can contribute to a company’s success.
A second insight from this view of strategy is that there are only a few types of competitive advantages. An established company can have either (1) a lower cost structure than its potential rivals, (2) better access to customers, or, (3) a scale of operations in the relevant market that cannot be achieved by potential competitors. Economies of scale exist in an environment where fixed costs are a substantial portion of total costs. Competitive advantages based on economies of scale, which affect both costs and revenues, are the most sustainable. The most successful long-term strategies generally rest on economies of scale advantages.
Companies with lower cost structures are mostly those with proprietary technologies, whether patent protected or not. Executives may believe they have an advantage from special access to low cost resources such as labour, capital or talent, but they seldom do. The competitive players will all have access to cheap labour, of which there is no shortage in today’s global economy. The same holds true for capital and talent.
Even advantages based on proprietary technology tend to be relatively rare and fleeting. In rapidly evolving industries, such technologies quickly become outdated. In stable industries, other companies have time to adopt and master the latest technologies. And patent protection, valuable in the short term, eventually expires, leaving companies subject to competitive pressures. Companies that have benefited from technological advantages over the long term, like Intel, have repeatedly pioneered new technologies ahead of their competitors. And they are able to do so because their economies of scale advantages permit them to spend more on research and development.
Superior access to customers is often associated with a strong brand image and high-quality products. This is a misconception. Mercedes-Benz, for example, is one of the most widely recognised symbols of quality in the world. By any standard, it is a powerful brand. Yet there is no measurable payoff. Its corporate parent, Daimler, did not earn superior returns on invested capital, even before its acquisition of Chrysler.
By contrast, brands such as Coca-Cola and Marlboro have generated outstanding returns over a long period of time. A key difference is that Coca-Cola and Marlboro consumers are captive to their brands: they make repeated purchases reflexively. Potential competitors have a difficult, expensive and perhaps impossible task in luring those customers away. Mercedes-Benz customers, on the other hand, are more than willing to test-drive a BMW, Lexis or other luxury vehicle.
Customer captivity, like proprietary technology, has a limited shelf life as a competitive advantage. Whether based on habit (as with Coke and Marlboro), the cost of switching to other providers (as with Microsoft), or the costs of finding an effective alternative (as with drugs, legal service providers or insurance carriers), customer captivity fades with time. Customers eventually die, move or otherwise slip the bonds of attachment to a product or provider.
In the long term, a competitive advantage is only sustainable if it attracts unattached customers and helps the company acquire new technologies. It is in these situations that advantages based on economies of scale dominate. Microsoft and Coca-Cola are truly unassailable not just because they have captive customers, but also because they enjoy the advantage of scale in their markets. Microsoft can spread the fixed costs of product development over an enormous user base. Coca-Cola’s fixed costs in local bottling, distribution and advertising are supported by many customers.
The advantage that stems from economies of scale has two important features. First, to be sustainable, it needs to be accompanied by some degree of customer captivity. If new competitors have equal access to customers, they can reach the necessary scale without great difficulty.
Second, new entrants need to win significant market share to be competitive. Suppose the incumbent’s scale advantages are eliminated once the new competitor produces and sells 1m units. If total demand in the entire market is only 3m units, the newcomer will need one third of the market to pose a challenge. But if demand is 20m units, it has to capture only five per cent. The larger the market, then, the more difficult it is for the incumbent to defend its dominant position.
The boundary of a market is defined by the the level of fixed costs necessary to supply it. When new fixed cost investments, such as a new manufacturing plant, are required to supply customers outside these original boundaries, the original economies of scale advantages have reached the limits of their effectiveness, and the competitive game starts afresh. The boundaries can be geographic, as in the reach of a distribution network or a media buy, or they can be defined by product space, as in the scope of a research and development program to create new products. In both types, scale advantages work only in “local”, that is, tightly bounded, markets
When formulating strategy, therefore, managers should start by assessing the company’s market position in local markets, defined both geographically and by product space. There will be some such markets where no companies enjoy a competitive advantage. The only option here is to focus relentlessly on operational effectiveness and ignore fanciful strategic dreams. In other markets, managing the dynamics of competition lies at the heart of strategy.
The companies that have created the greatest shareholder value in the past twenty years have recognised these imperatives, intentionally or not. Wal-Mart, for instance, began by dominating its local market in the southern central US. It then expanded at the edges of this region, where it could extend its core competitive advantages of scale in distribution and advertising. When it attempted to leap into distant markets, such as Germany, or different markets such as warehouse stores, even Wal-Mart failed to produce superior returns compared to powerful local competitors.
Similarly, Microsoft began in the local product space of PC operating systems and expanded by adding adjacent products such as the office suite. Intel’s striking success dates from its decision in the mid-1980s to concentrate solely on microprocessors, leaving memory and other chips to its competitors.
The key to formulating an effective strategy, especially in an increasingly global world, is to "think local".
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