What is strategy?

"Strategy" is a term frequently used in business. However, it is often widely misused and misunderstood. So, what is strategy, particularly within the context of a business?

The two components of business strategy

The objective of a business strategy is to maximize a firm's return on invested capital (ROIC). From a strategic standpoint, a firm's return on invested capital (ROIC) is a function of two components:

The structure of the industry it competes in (industry structure)
How it chooses to position itself within the industry (competitive positioning)

Thus, strategy is about two things. First, it's about understanding industry structure and identifying where within the industry to compete. Second, it's about making choices and tradeoffs to achieve the desired competitive position.

Let's explore each of these two components.

Component 1: Industry structure

Industry structure is best understood through "Porter's Five Forces," which are five dimensions conceptualized by Michael Porter for understanding the profit dynamics of any industry. According to Porter, the interplay of the five forces determines the average ROIC (and therefore the attractiveness) of an industry. A brief summary of each of the five forces is below:

Customers: In any industry, you can segment the customers in different ways. For instance, you can segment customers by geography, income, size, or a multitude of other dimensions. However, no matter how you segment an industry, each segment will always have slightly bespoke needs and a different willingness to pay. For instance, customers in one geography might have slightly different needs than customers in another geography. High-income customers are likely willing to pay for certain features that low-income customers are not. Large customers are likely to exert more buying power than smaller customers due to their scale.
Suppliers: These are the companies that supply input materials to a firm. If there are few suppliers in an industry, this will raise the industry's input costs and reduce the industry's overall ROIC. Interestingly, firms will sometimes "backward integrate" to overcome strong supplier power. For instance, Amazon previously relied heavily on FedEx and UPS to ship the majority of its packages. However, in recent years, it has developed its own logistics network, comprised of its own planes, pilots, delivery trucks, delivery workers, and distribution centers. In doing so, Amazon is now likely capturing a share of the industry profits that were once flowing to FedEx and UPS.
Threat of new entrants: Over an extended period of time, new firms will almost always attempt to enter an industry. This threat of new entrants places a cap on industry profitability. If an industry has a low average ROIC, then few firms will attempt to enter it. On the contrary, if an industry has a high average ROIC, more firms will be induced to enter.
1. Firms can reduce the threat of new entrants by building high fixed-cost barriers. For instance, to continue the Amazon example above, it is very capital-intensive for new firms to enter the logistics industry to compete with FedEx, UPS, or Amazon Logistics. Any new firm would have to acquire its own planes, trucks, labor force, and distribution hubs.
2. Firms can also reduce the threat of entry through scale economies. For instance, in capital-intensive industries like mining, the larger a firm grows, the lower its unit costs tend to fall. This makes it hard for a new entrant, who would presumably have little scale initially, to be price-competitive with larger, more established firms in the industry.
Threat of substitutes: The threat of substitutes also places a cap on industry profitability. A straightforward example is transportation. If I want to travel from New York City to Boston, I can fly, rent a car, take a train, take a bus, or even take a rideshare (e.g., Uber). The fact that there are multiple substitutes limits the profitability that any one industry (airlines, rental cars, trains, buses, rideshare) can earn on the NYC to Boston route.
Competitive rivalry: This is the rivalry among firms within the same industry. For instance, within the airline industry in the United States, this would be Delta, American, United, etc. Generally, the higher the fixed costs in an industry, the more intense the competition is.

Component 2: Competitive positioning

Once a firm understands the structure of its industry, it can then work to find an attractive position within it.

According to Michael Porter, there are three generic strategies for competing in any industry.

Cost leadership: the firm competes to offer the lowest prices to customers in the industry by having the lowest cost structure. Typically, there is only room for one low-cost leader in an industry.
Differentiation: the firm intentionally has a higher cost structure in order to provide a differentiated experience to its customers. There is room for multiple firms to choose a differentiated strategy in an industry.
Focus: sometimes, a firm might choose to only serve one or a handful of segments in an industry. By maintaining intense focus, it is not uncommon for firms with a focus strategy to achieve both cost leadership and differentiation in their target segments.

A firm achieves its chosen strategy through its "value chain," which is the set of choices or trade-offs a firm makes.

Common strategy mistakes

Mistake 1: Competing to be "the best" rather than competing to be unique.

Remember, strategy is the set of choices a firm makes to maximize return on invested capital (ROIC). The key term here is "choices." All too often, I've seen business leaders attempt to be all things to all customers. For instance, at one company I worked with, their "strategy" was to be the "best company in the industry." They wanted to be:

The best company for price-conscious AND premium customers
The best company for small businesses AND large businesses
The best company in the United States AND internationally

The company wanted to be "the best" provider to all customers. However, the reality is different customers have different needs. By attempting to meet the needs of all customers, no set of customers was served particularly well.

The key lesson here is that strategy is about making trade-offs - about finding ways to be unique from the competition. A firm must decide which customer segments to serve, which distribution channels to use, which products to develop, which geographies to compete in, and, most importantly, which ones NOT to.

By competing to be unique, there can be several successful firms in an industry, not just one. In other words, in business, strategy is not a zero-sum game. There can be many winners.

Mistake 2: Confusing a goal for a strategy. A goal is not a strategy; a strategy is how you achieve a goal.

A lot of times, business leaders will say things like, "Our strategy is to grow...", or "Our strategy is to outsource...", or "Our strategy is to internationalize...".

However, statements like these are goals, not strategies. These goals might be achieved as part of a strategy, but none of these goals on their own is a strategy.

For instance, a company might choose to become the cost leader in its industry. To do so, it might need to outsource to reduce service delivery costs. It might also need to take several actions to grow its market share in the price-sensitive segments of the industry, which might involve internationalizing. So, all of the goals above ("outsource", "grow", "internationalize") might be components of a strategy, but none of them on their own is a strategy.

Conclusion

Strategy can be a confusing and misunderstood topic, but I hope the above brings some clarity to the concept. Stay tuned for my next post, where we'll take a look at how a company took the concepts above and applied them to become a leader in its industry.

Sources:

"Competitive Strategy" by Michael Porter
"Competitive Advantage" by Michael Porter
Michael Porter strategy lecture (https://www.youtube.com/watch?v=KvYwKM5bY0s)
Individual analysis