Harvard Business Review

Executive Summaries

Cover Feature

Putting Leadership Back into Strategy

Cynthia A. Montgomery Reprint: R0801C

In recent decades an infusion of economics has lent the study of strategy much needed theory and empirical evidence. Strategy consultants, armed with frameworks and techniques, have stepped forward to help managers analyze their industries and position their companies for strategic advantage. Strategy has come to be seen as an analytical problem to be solved.

But, says Montgomery, the Timken Professor of Business Administration at Harvard Business School, the benefits of this rigorous approach have attendant costs: Strategy has become a competitive game plan, separate from the company's larger sense of purpose. The CEO's unique role as arbiter and steward of strategy has been eclipsed. And an overemphasis on sustainable competitive advantage has obscured the importance of making strategy a dynamic tool for guiding the company's development over time.

For any company, intelligent guidance requires a clear sense of purpose, of what makes the organization truly distinctive. Purpose, Montgomery says, serves as both a constraint on activity and a guide to behavior. Creativity and insight are key to forging a compelling organizational purpose; analysis alone will never suffice.

As the CEO--properly a company's chief strategist--translates purpose into practice, he or she must remain open to the possibility that the purpose itself may need to change. Lou Gerstner did this in the 1990s, when he decided that IBM would evolve to focus on applying technology rather than on inventing it. So did Steve Jobs, when he rescued Apple from a poorly performing strategy and expanded the company into attractive new businesses.

Watching over strategy day in and day out is the CEO's greatest opportunity to shape the firm as well as outwit the competition. Forethought

Love and Fear and the Modern Boss

Scott A. Snook Reprint: F0801A

Should a leader be loved or feared? That age-old question still has no simple answer. It depends on who the leader is and whom she's leading. Successful executives adapt their styles when they need to; they also know their limits.

Beware of Old Technologies' Last Gasps

Daniel C. Snow Reprint: F0801B

When a new technology appears, the old one experiences a sudden leap in performance. Whether you are an old- or a new-technology company, understanding how that phenomenon works can help you win during this critical transition period.

High Margins and the Quest for Aesthetic Coherence

Robert D. Austin Reprint: F0801C

The key to selling well-designed, well-crafted products at high margins is the aesthetic coherence of the company and its goods. Embodying that ideal isn't easy, but it's possible if you avoid three temptations.

Do Well by Doing Good? Don't Count on It

Joshua D. Margolis and Hillary Anger Elfenbein Reprint: F0801D

Research over 35 years shows only a weak link between socially responsible corporate behavior and good financial performance. However, there's no evidence of risk in doing good, only in being exposed for misdeeds.

The Value of a Broader Product Portfolio

Bharat N. Anand Reprint: F0801E

The mantra "Every product must stand on its own bottom line" may no longer be the one to chant. Nowadays, broadening your portfolio can increase both your chances of a big win and the benefit your other products can get from a hit's popularity.

A Conversation with Sandra J. Sucher Reprint: F0801F

When executives meet together to grapple with moral and ethical questions in literature, they end up applying their insights in practice. This Harvard Business School professor endorses book clubs as part of leadership development.

Seek Strategy the Right Way at the Right Time

Giovanni Gavetti and Jan W. Rivkin Reprint: F0801G

Deliberate, emergent, and analogical approaches to finding the best strategy all have their advantages, depending on where an industry is in its life cycle. Be open to the best option at each juncture and wise enough to make the right call.

When (Not) to Listen to Activist Investors

Robin Greenwood and Michael Schor Reprint: F0801H

Poorly performing managers shouldn't necessarily heed the demands of hedge funds that call for change in a company's strategic direction. Giving in does not, on average, yield stock gains that outperform the market--that is, unless the firm gets acquired.

Learning the Fine Art of Global Collaboration

Alan MacCormack and Theodore Forbath Reprint: F0801J

Companies that excel in managing partnerships for innovation put a great deal of effort into improving their ability to collaborate. Their plans address four critical areas.

How to Talk to Investors--Through the Press

Gregory S. Miller Reprint: F0801K

If you're seeking attention from investors and analysts, the press can be a convenient megaphone. Cultivating relationships with the media takes patience, but the payoffs in both good times and bad are priceless. HBR Case Study

How to Change the World

Howard H. Stevenson Reprint: R0801A

Alan Wilson has a decision to make. The CEO of his company, Grepter, wants him to relocate to Zurich, where he can gain valuable experience for a rise to the top. Karl, his best friend, hopes to lure him to a hedge fund that promises big money fast. Shiori, an enticing former girlfriend, wants him to join her in delivering medical care to patients in developing countries. Alan knows for sure only that he wants to make an impact. Four experts comment on this fictional case study.

Laura Scher, the CEO of Credo Mobile, advises Alan to consider what each option will deliver in terms of money, power, quality of life, and--most important--personal values. As long as he brings his values into the workplace, any of the three could be the right choice.

Daniel Vasella, the CEO of Novartis, cautions Alan to examine what truly drives him, personally and professionally. All things considered--not least the potential hazards of working with a friend--his future looks most promising at Grepter.

Barbara H. Franklin, the CEO of an international trade consulting and investment firm, thinks Alan would do well to join Shiori's enterprise. The experience with social policy might draw him to public service, where his impact on society could be significant.

Christina C. Jones, the CEO of Extend Fertility, has also faced a variety of choices combined with an urge to do meaningful work. She believes that Alan should cultivate his skills at Grepter while developing a firmer notion of what he wants to be and do. The HBR Interview

Giving Great Advice

Bruce Wasserstein Reprint: R0801G

Interview by Thomas A. Stewart and Gardiner Morse

Few deal makers have been at it as long, and at such a high level, as Bruce Wasserstein, the chairman and CEO of the financial advisory and asset-management firm Lazard. In this edited interview, two HBR editors explore how he creates value as a manager, as a deal maker, and as a counselor to CEOs. Wasserstein, who has been a major figure in mergers and acquisitions for more than 30 years, talks about attracting and managing talent, building and sustaining a knowledge business, sizing up industries and companies, and crafting advice to help CEOs unlock value. At the heart of his approach is a singular ability to dissect a strategy's underlying premises in order to figure out whether a plan or deal "makes sense." Part of that determination involves understanding the broader context: Where is the industry going? What external factors will affect it?

Such sensemaking informs every move Wasserstein makes, and it has paid off handsomely. In his career, he has helped broker more than a thousand deals, worth hundreds of billions of dollars. His intellect, creativity, and doggedness are what allow him to pick apart the most complex problems and devise novel solutions. In an age of specialization, he recognizes the importance of connecting the dots; he draws on the knowledge and skills of creative generalists as well as industry and regional specialists when setting up and executing deals.

Wasserstein studied at Harvard University's business and law schools and at Cambridge University, helped lead First Boston's M&A practice, cofounded the investment-banking firm Wasserstein Perella Group, and then joined Lazard, which he famously took public in 2005 after disassembling a century and a half of family ownership. He is the 2007 recipient of Harvard Law School's Great Negotiator Award. Features

Transforming Giants

Rosabeth Moss Kanter Reprint: R0801B

Large corporations have long been seen as lumbering, inflexible, bureaucratic--and clueless about global developments. But recently some multinationals seem to be transforming themselves: They're engaging employees, moving quickly, and introducing innovations that show true connection with the world.

Harvard Business School's Kanter ventured with a research team inside a dozen global giants--including IBM, Procter & Gamble, Omron, CEMEX, Cisco, and Banco Real--to discover what has been driving the change. After conducting more than 350 interviews on five continents, she and her colleagues came away with a strong sense that we are witnessing the dawn of a new model of corporate power: The coordination of actions and decisions on the front lines now appears to stem from widely shared values and a sturdy platform of common processes and technology, not from top-down decrees. In particular, the values that engage the passions of far-flung workforces stress openness, inclusion, and making the world a better place. Through this shift in what might be called their guidance systems, the companies have become as creative and nimble as much smaller ones, even while taking on social and environmental challenges of a scale that only large enterprises could attempt.

IBM, for instance, has created a nonprofit partnership, World Community Grid, through which any organization or individual can donate unused computing power to research projects and see what is being done with the donation in real time. IBM has gained an inspiring showcase for its new technology, helped business partners connect with the company in a positive way, and offered individuals all over the globe the chance to contribute to something big.

Mastering the Management System

Robert S. Kaplan and David P. Norton Reprint: R0801D

Companies have always found it hard to balance pressing operational concerns with long-term strategic priorities. The tension is critical: World-class processes won't lead to success without the right strategic direction, and the best strategy in the world will get nowhere without strong operations to execute it. In this article, Kaplan, of Harvard Business School, and Norton, founder and director of the Palladium Group, explain how to effectively manage both strategy and operations by linking them tightly in a closed-loop management system.

The system comprises five stages, beginning with strategy development, which springs from a company's mission, vision, and value statements, and from an analysis of its strengths, weaknesses, and competitive environment. In the next stage, managers translate the strategy into objectives and initiatives with strategy maps, which organize objectives by themes, and balanced scorecards, which link objectives to performance metrics. Stage three involves creating an operational plan to accomplish the objectives and initiatives; it includes targeting process improvements and preparing sales, resource, and capacity plans and dynamic budgets. Managers then put plans into action, monitoring their effectiveness in stage four. They review operational, environmental, and competitive data; assess progress; and identify barriers to execution. In the final stage, they test the strategy, analyzing cost, profitability, and correlations between strategy and performance. If their underlying assumptions appear faulty, they update the strategy, beginning another loop.

The authors present not only a comprehensive blueprint for successful strategy execution but also a managerial tool kit, illustrated with examples from HSBC Rail, Cigna Property and Casualty, and Store 24. The kit incorporates leading management experts' frameworks, outlining where they fit into the management cycle.

The Five Competitive Forces That Shape Strategy

Michael E. Porter Reprint: R0801E

In 1979, a young associate professor at Harvard Business School published his first article for HBR, "How Competitive Forces Shape Strategy." In the years that followed, Michael Porter's explication of the five forces that determine the long-run profitability of any industry has shaped a generation of academic research and business practice. In this article, Porter undertakes a thorough reaffirmation and extension of his classic work of strategy formulation, which includes substantial new sections showing how to put the five forces analysis into practice.

The five forces govern the profit structure of an industry by determining how the economic value it creates is apportioned. That value may be drained away through the rivalry among existing competitors, of course, but it can also be bargained away through the power of suppliers or the power of customers or be constrained by the threat of new entrants or the threat of substitutes. Strategy can be viewed as building defenses against the competitive forces or as finding a position in an industry where the forces are weaker. Changes in the strength of the forces signal changes in the competitive landscape critical to ongoing strategy formulation.

In exploring the implications of the five forces framework, Porter explains why a fast-growing industry is not always a profitable one, how eliminating today's competitors through mergers and acquisitions can reduce an industry's profit potential, how government policies play a role by changing the relative strength of the forces, and how to use the forces to understand complements. He then shows how a company can influence the key forces in its industry to create a more favorable structure for itself or to expand the pie altogether. The five forces reveal why industry profitability is what it is. Only by understanding them can a company incorporate industry conditions into strategy.

Innovation Killers: How Financial Tools Destroy Your Capacity to Do New Things

Clayton M. Christensen, Stephen P. Kaufman, and Willy C. Shih Reprint: R0801F

Most companies aren't half as innovative as their senior executives want them to be (or as their marketing claims suggest they are). What's stifling innovation? There are plenty of usual suspects, but the authors finger three financial tools as key accomplices.

Discounted cash flow and net present value, as commonly used, underestimate the real returns and benefits of proceeding with an investment. Most executives compare the cash flows from innovation against the default scenario of doing nothing, assuming--incorrectly--that the present health of the company will persist indefinitely if the investment is not made. In most situations, however, competitors' sustaining and disruptive investments over time result in deterioration of financial performance.

Fixed- and sunk-cost conventional wisdom confers an unfair advantage on challengers and shackles incumbent firms that attempt to respond to an attack. Executives in established companies, bemoaning the expense of building new brands and developing new sales and distribution channels, seek instead to leverage their existing brands and structures. Entrants, in contrast, simply create new ones. The problem for the incumbent isn't that the challenger can spend more; it's that the challenger is spared the dilemma of having to choose between full-cost and marginal-cost options.

The emphasis on short-term earnings per share as the primary driver of share price, and hence shareholder value creation, acts to restrict investments in innovative long-term growth opportunities.

These are not bad tools and concepts in and of themselves, but the way they are used to evaluate investments creates a systematic bias against successful innovation. The authors recommend alternative methods that can help managers innovate with a much more astute eye for future value.

Why Mentoring Matters in a Hypercompetitive World

Thomas J. DeLong, John J. Gabarro, and Robert J. Lees Reprint: R0801H

Professional service firms (PSFs), like so many other companies, are juggling the modern challenges of global competition, increased regulation, and rapid employee turnover. In a people-oriented industry, attrition has special import. DeLong and Gabarro, of Harvard Business School, along with former Morgan Stanley and Ernst & Young executive Lees, argue that a PSF can gain a much-needed competitive edge by renewing its focus on mentoring. The authors' in-depth interviews with professionals from more than 30 PSFs have yielded four principles for firms to heed as they rediscover this lost art.

First, mentoring is personal. Rather than relying on standardized programs, mentors must frequently--and fairly--provide authentic advice and nurturing. Partners at PSFs know how to use their ample people skills effectively with clients; the benefits of using them with junior colleagues are even greater.

Second, not everyone is an A player. A small dose of attention given to a B player goes at least as far as a large one offered to an A player. Since B players constitute about 70% of PSF staff, that's time well spent.

Third, choice assignments are in short supply, which limits the number of learning opportunities available for associates. Good alternatives include shadowing senior professionals on assignments and taking on research or other projects that are not client-related but that nonetheless build expertise.

Finally, mentoring is a two-way street. Protégés should not only learn from their senior counterparts, but also be taught to attract mentors--and to co-mentor one another.

Where Will We Find Tomorrow's Leaders?

A Conversation with Linda A. Hill Reprint: R0801J

Unless we challenge long-held assumptions about how business leaders are supposed to act and where they're sup-posed to come from, many people who could become effective global leaders will remain invisible, warns Harvard Business School professor Hill. Instead of assuming that leaders must exhibit take-charge behavior, broaden the definition of leadership to include creating a context in which other people are willing and able to guide the organization. And instead of looking for the next generation of global leaders in huge Western corporations and elite business schools, expand the search to developing countries.

In this conversation with HBR senior editor Paul Hemp, Hill describes the changing nature of leadership and what we can learn from parts of the world where people have not, until recently, had opportunities to become globally savvy executives. In South Africa, for instance, the African National Congress has provided rigorous leadership preparation for many black executives. Hill has also observed two approaches--in developed and developing economies alike--that she believes will be necessary in an increasingly complex business environment. The first, leading from behind, involves letting people hand off the reins to one another, depending on their strengths, as situations change. The second, leadership as collective genius, calls for both unleashing and harnessing individuals' collective talents, particularly to spur innovation.

Through her descriptions of these approaches in such companies as Sekunjalo Investments, HCL Technologies, and IBM, Hill highlights the challenges of finding and preparing people who can lead by stepping back and letting others come forward to make their own judgments and take risks.

Putting Leadership Back into Strategy

A CEO must be the steward of a living strategy that defines what the firm is and what it will become.

by Cynthia A. Montgomery

Strategy is not what it used to be--or what it could be. In the past 25 years it has been presented, and we have come to think of it, as an analytical problem to be solved, a left-brain exercise of sorts. This perception, combined with strategy's high stakes, has led to an era of specialists--legions of MBAs and strategy consultants--armed with frameworks and techniques, eager to help managers analyze their industries or position their firms for strategic advantage.

This way of thinking about strategy has generated substantial benefits. We now know far more than before about the role market forces play in industry profitability and the importance of differentiating a firm from its competitors. These gains have come in large part from the infusion of economics into the study of strategy. That merger added much-needed theory and empirical evidence to strategy's underpinnings, providing considerable rigor and substance. But the benefits have not come without costs. A host of unintended consequences have developed from what in its own right could be a very good thing. Most notably, strategy has been narrowed to a competitive game plan, divorcing it from a firm's larger sense of purpose; the CEO's unique role as arbiter and steward of strategy has been eclipsed; and the exaggerated emphasis on sustainable competitive advantage has drawn attention away from the fact that strategy must be a dynamic tool for guiding the development of a company over time.

To redress these issues, we need to think about strategy in a new way--one that recognizes the inherently fluid nature of competition and the attendant need for continuous, not periodic, leadership.

The Road to Here

Fifty years ago strategy was taught as part of the general management curriculum in business schools. In the academy as well as in practice, it was identified as the most important duty of the chief executive officer--the person with overarching responsibility for setting a company's course and seeing the journey through. This vital role encompassed both formulation and implementation: thinking and doing combined.

Although strategy had considerable breadth then, it didn't have much rigor. The ubiquitous SWOT model taught managers to assess a company's internal strengths and weaknesses and the opportunities and threats in its external environment, but the tools for doing so were pedestrian by any measure.

Advances over the next few decades not only refined the tools but spawned a new industry around strategy. Corporate-planning departments emerged and introduced formal systems and standards for strategic analysis. Consulting firms added their own frameworks, among them the Boston Consulting Group's influential growth-share matrix and McKinsey's 7-S framework. Academics weighed in, unleashing the power of economic analysis on problems of strategy and competition.

It has been a heady period, and the strategy tool kit is far richer because of it. That said, something has been lost along the way. While gaining depth, strategy has lost breadth and stature. It has become more about formulation than implementation, and more about getting the idea right at the outset than living with a strategy over time.

The teaching of strategy has both led and followed suit. At many top business schools, general management departments have been replaced by strategy groups made up of experts who delve into the economics of competitive advantage but rarely acknowledge the unique role leaders play in the process of formulating and implementing strategy. When the head of the strategy group at one major business school was asked recently to describe the common denominator among faculty members in his department, he replied, "We are a group of economists with a lively interest in business." An honest man and a telling comment.

Pulled apart and set on its own in this way, strategy both gains and loses. In terms of analytical precision, it is a big plus; organizationally, it is not. What we have lost sight of is that strategy is not just a plan, not just an idea; it is a way of life for a company. Strategy doesn't just position a firm in its external landscape; it defines what a firm will be. Watching over strategy day in and day out is not only a CEO's greatest opportunity to outwit the competition; it is also his or her greatest opportunity to shape the firm itself.

Strategy and Being

In "How to Evaluate Corporate Strategy," an article that appeared in this magazine in 1963, the Harvard Business School lecturer Seymour Tilles proposed that of all the questions a chief executive is required to answer, one predominates: What kind of company do you want yours to be? He elaborated:

If you ask young men what they want to accomplish by the time they are 40, the answers you get fall into two distinct categories. There are those--the great majority--who will respond in terms of what they want to have. This is especially true of graduate students of business administration. There are some men, however, who will answer in terms of the kind of men they hope to be. These are the only ones who have a clear idea of where they are going.

The same is true of companies. For far too many companies, what little thinking goes on about the future is done primarily in money terms. There is nothing wrong with financial planning. Most companies should do more of it. But there is a basic fallacy in confusing a financial plan with thinking about the kind of company you want yours to become. It is like saying, "When I'm 40, I'm going to be rich." It leaves too many basic questions unanswered. Rich in what way? Rich doing what?

As strategy has striven to become a science, we have allowed this fundamental point to slip away. We need to reinstate it.

In 1996 Adam Brandenburger and Barry Nalebuff got close to this idea in their book Co-opetition, which recognized that in order to claim value, firms must first create value. This requires bringing something new to the world, something customers want that is different from or better than what others are providing.

To press their point, Brandenburger and Nalebuff urged managers to consider the world with their firm versus the world without it. The difference (if there is one) is the firm's unique added value--what would be lost to the world if the firm disappeared. Tilles might have described this as the firm's purpose, or its raison d'être. To say that a firm should have a clear sense of purpose may sound exceedingly philosophical. It is in fact exceedingly practical.

In the strategy portion of the Owner/President Management executive program at Harvard Business School, the notion of added value is core to everything we do. Early in the module, executives are asked to respond to the following questions:

• If your company were shuttered, to whom would it matter and why?
• Which of your customers would miss you the most and why?
• How long would it take for another firm to step into that void?

When the questions are presented, classrooms that minutes earlier were bursting with conversation fall silent--not because the questions are complex but because they are so basic and yet so difficult. Managers long accustomed to describing their companies by the industries they are in and the products they make often find themselves unable to say what is truly distinctive about their firms. For these leaders the challenge is a matter not of unearthing an existing purpose but of forging one.

The questions are as relevant to large multibusiness companies as they are to focused owner-led ones. As private equity firms proliferate and supply chains open up around the world, nothing is more important for complex corporate entities than a clear sense of purpose, a clear sense of why they matter. A board chairman at one such firm made the point bluntly when he asked, "What hot dish is this company bringing to the table?" He was issuing the same challenge.

Sam Palmisano, the CEO of IBM, is well aware of the importance of this sort of reflection. In 2003 he hosted a 72-hour online Values Jam in which he asked IBM's nearly 320,000 employees to weigh in on these questions: If our company disappeared tonight, how different would the world be tomorrow? Is there something about our company that makes a unique contribution to the world? (See "Leading Change When Business Is Good," HBR December 2004.)

In my experience, few leaders allow themselves to think about strategy at this level.

Purpose should be at the heart of strategy. It should give direction to every part of the firm--from the corporate office to the loading dock--and define the nature of the work that must be done. In "Unleashing the Power of Learning," a 1997 interview with HBR, John Browne, then the CEO of British Petroleum, put it this way: "A business has to have a clear purpose. If the purpose is not crystal clear, people in the business will not understand what kind of knowledge is critical and what they have to learn in order to improve performance....What do we mean by purpose? Our purpose is who we are and what makes us distinctive. It's what we as a company exist to achieve, and what we're willing and not willing to do to achieve it."

The most viable statements of purpose are easy to grasp and true to a company's distinctiveness. Pixar, one of the world's most innovative animation firms, says that it exists "to combine proprietary technology and world-class creative talent to develop computer-animated feature films with memorable characters and heartwarming stories that appeal to audiences of all ages." No films for mature audiences only. Lots of pushing the envelope. And who wouldn't recognize IKEA's intent to offer customers "a wide range of well-designed, functional home furnishing products at prices so low that as many people as possible will be able to afford them"? Sitting at the hub of the strategy wheel, purpose aligns all the functional pieces and draws the company into a logically consistent whole. Well understood, it serves as both a constraint on activity and a guide to behavior. As Michael Porter has argued, an effective strategy says not only what a firm will do but also, implicitly, what it will not do.

Forging a compelling organizational purpose is a close corporate equivalent to soul-searching. It does require the kind of careful analysis and left-brain thinking that MBAs have honed for a generation. Equally important to the task, however, is the right-brain activity in which managers are almost universally less well schooled. Creativity and insight are key, as is the ability to make judgments about a host of issues that can't be resolved through analysis alone.

Articulating and tending to a purpose-driven strategy so that it fills this role is no easy task. It is a human endeavor in the deepest sense of the term. Keeping all the parts of a company in proper balance while moving the enterprise forward is extraordinarily difficult. Even when they have substantial talent and a deep appreciation for the job, some CEOs ultimately don't get it right. Their legacies serve as sobering reminders of the complexities and the responsibilities of stewardship. (Witness BP's recent travails--the deficiencies in investments and operating practices that compromised workers' safety, threatened the environment, and contributed to Browne's abrupt departure from the company in 2007.) On the other hand, it is exactly these challenges that make the triumphs so rewarding.

Strategy and the Strategist

In most popular portrayals the strategist's job would seem to be finished once a carefully articulated strategy has been made ready for implementation. The idea has been formed, the next steps specified, the problem solved. But don't be fooled. The job of the strategist never ends. No matter how compelling a strategy is, or how clearly defined, it is unlikely to be a sufficient guide for a firm that aspires to a long and prosperous life.

Just as complete contracts are difficult to write with one's trading partners, so too complete strategies are difficult to specify in all their particulars. There will always be some choices that are not obvious. There will always be countless contingencies, good and bad, that cannot be fully anticipated. There will always be limits to communication and mutual understanding. As Oscar Wilde quipped, "Only the shallow know themselves." At heart, most strategies, like most people, involve some mystery.

Interpreting that mystery is an abiding responsibility of the chief strategist, the CEO. Sometimes this entails clarifying a point or helping an organization translate an idea into practice, such as what "best in class" will mean in that company and how it will be measured. Other times it entails much more: refashioning an element of the strategy, adding a previously missing piece, or reconsidering a commitment that no longer serves the company well. Whether you call this strategy implementation or strategy reformulation (the boundaries blur), it is arduous work and can't be separated from leadership of the firm.

Sidebar Icon The Missing Dimension (Located at the end of this article)

Ryanair provides a case in point. During its early years the Irish airline entered the Dublin-London market with full service priced at less than half the fares of incumbents British Airways and Aer Lingus. Ryanair's leaders didn't anticipate the ferocity with which its competitors would respond. When the resulting fare war brought Ryanair to its knees, its leaders didn't simply urge the airline to try harder. They revamped the strategy and transformed the company into a no-frills player with a true low-cost business model. This involved changing the airline's fleet as well as its cost, fare, and route structures. "Yes, Aer Lingus attacked us," Michael O'Leary, Ryanair's CEO since 1994, has said, "but we exposed ourselves." Reborn, Ryanair went on to become a major airline and one of the world's most profitable.

When confronted with challenges, the CEO must recognize the strategic significance of issues being raised and opportunities being contemplated and see them through the lens of the whole, even as those with narrower responsibilities may be seeing the same issues parochially. While faithfully translating purpose into practice, the CEO must also remain open to the idea that the purpose itself may need to change. The judgments made at these moments of transition can make or break a leader or a firm.

Lou Gerstner, Palmisano's legendary predecessor, faced such a moment when he became CEO of a troubled IBM in 1993. To resurrect the company, he concluded, a radical shift in its mind-set was necessary. This required taking a fearless moral inventory of the business, realistically evaluating the firm's core capabilities, and shedding everything else. After making this assessment, Gerstner announced that IBM would no longer concern itself with the invention of technology but instead would focus on application. The company would move beyond its long history of creating computer hardware in order to provide integrated information technology services and solutions. "History," Gerstner has written, "shows that truly great and successful companies go through constant and sometimes difficult self-renewal of the base business."

The CEO is the one who chooses a company's identity, who has responsibility for declining certain opportunities and pursuing others. In this sense he or she serves as the guardian of organizational purpose, watching over the entity, guiding its course, bringing it back to the center time and time again, even as the center itself evolves.^1 This is why the job of the strategist cannot be outsourced. This is why the job of the strategist is never done, and why the vigil the CEO keeps must be a constant one.

Strategy and Becoming

What, after all, is the strategist trying to achieve? The conventional wisdom would say a sustainable long-term competitive advantage. I challenge this view. Although critically important, competitive advantage is not the ultimate goal. That way of thinking mistakes the means for the end and sends managers off on an unachievable quest.

Competitive advantage is essential to strategy. But it is only part of a bigger story, one frame in a motion picture. The very notion that there is a strategic holy grail--a strategy brilliantly conceived, carefully implemented, and valiantly defended through time--is dangerous. It is akin to the complete-contract view, in which all the thinking is done at the beginning and the key job of the strategist is to get that analysis right. If this were so, the role of the strategist would be limited and easy to separate from the leadership of a firm. If this were so, the strategist wouldn't have to be concerned with how the organization gets from here to there--the execution challenge writ large--or how it will capitalize on the learning it accumulates along the way.

But this is not so. Great firms--Toyota, Nike, and General Electric, to name a few--evolve and change. So do great strategies. This is not to say that continuity has no value. It is not to say that great resources and great advantages aren't built over the long term. It is, however, to acknowledge that the world, both inside and outside the firm, changes not only in big, discontinuous leaps but in frequent, smaller ones as well.

An ancient Greek legend provides a powerful metaphor for this process. According to the legend, the ship that the hero Theseus sailed back to Athens after slaying the Minotaur in Crete was rebuilt over time, plank by plank. As each plank decayed, it was replaced by another, until every plank in the ship had been changed. Was it then still the same ship? If not, at what point--with which plank--did the ship's identity shift?

This metaphor captures the evolution of most companies. Corporate identities are changed not only by cataclysmic restructurings and grand pronouncements but also by decision after decision, year after year, captain after captain. An organic conception of strategy recognizes that whatever constitutes strategic advantage will eventually change. It recognizes the difference between defending a firm's added value as established at any given moment and ensuring that a firm is adding value over time. Holding too strongly to one competitive advantage or one purpose may result in the firm's being controlled by a perception of value long after that value has diminished in significance. It encourages managers to see their strategies as set in concrete and, when spotting trouble ahead, to go into defensive mode, hunkering down and protecting the status quo.

Apple Computer was caught in this trap for most of the 1990s. The company stubbornly stuck to its original strategy of producing high-end differentiated personal computers, convinced that it was adding value even as the intensely competitive marketplace told it otherwise. By the summer of 1997 Apple's share price was at a 10-year low, its market share had plummeted to about 3%, and industry pundits were trumpeting the company's demise. The strategy had performed so poorly that there was little left to defend. Only after Steve Jobs returned as CEO, reclaimed the best of what Apple once was (a passionate design company that believed technology could change the world), and took the firm into new businesses (digital audio players, cell phones, and retailing) with distinctive products did the company attract a new mass of passionately loyal customers and generate handsome returns. Plank by plank the company changed its identity while remaining in many respects the same. Fittingly, in January 2007 it dropped "Computer" from its name and became simply Apple Inc.

The need to create and re-create reasons for a company's continued existence sets the strategist apart from every other individual in the company. He or she must keep one eye on how the company is currently adding value and the other eye on changes, both inside and outside the company, that either threaten its position or present some new opportunity for adding value. Guiding this never-ending process, bringing perspective to the midst of action and purpose to the flow--not solving the strategy puzzle once--is the crowning responsibility of the CEO.

1. Kenneth R. Andrews, in The Concept of Corporate Strategy (Irwin, 1971), described one of the roles of the CEO as the "architect of organization purpose." I prefer the term "guardian of organizational purpose," because it encompasses both formulation and implementation, and because it implies a more ongoing responsibility. The Missing Dimension

Over the past few decades strategy has become a plan that positions a company in its external landscape. That's not enough. Strategy should also guide the development of the company--its identity and purpose--over time.

Mastering the Management System

Successful strategy execution has two basic rules: understand the management cycle that links strategy and operations, and know what tools to apply at each stage of the cycle.

by Robert S. Kaplan and David P. Norton

Not long after its successful IPO, the Conner Corporation (not its real name) began to lose its way. The company's senior executives continued their practice of holding monthly one-day management meetings, but their focus drifted.

The meetings' agenda called for a discussion of operational issues in the morning and strategic issues in the afternoon. But with the company under pressure to meet quarterly targets, operational items had started to crowd strategy out of the agenda. Inevitably, the review of actual monthly and forecast quarterly financial performance revealed revenues to be lower, and expenses to be higher, than targeted. The worried managers spent hours discussing how to close the gap through pricing initiatives, capacity downsizing, SG&A staff cuts, and sales campaigns. One executive noted, "We have no time for strategy. If we miss our quarterly numbers, we might cease to exist. For us, the long term is the short term."

Like Conner, all too many companies--including some well-established public corporations--have learned how Gresham's Law applies to their management meetings: Discussions about bad operations inevitably drive out discussions about good strategy implementation. When companies fall into this trap, they soon find themselves limping along, making or closely missing their numbers each quarter but never examining how to modify their strategy to generate better growth opportunities or how to break the pattern of short-term financial shortfalls. Analysts, investors, and board members start to question the imagination and commitment of the companies' management.

In our experience, however, breakdowns in a company's management system, not managers' lack of ability or effort, are what cause a company's underperformance. By management system, we're referring to the integrated set of processes and tools that a company uses to develop its strategy, translate it into operational actions, and monitor and improve the effectiveness of both. The failure to balance the tensions between strategy and operations is pervasive: Various studies done in the past 25 years indicate that 60% to 80% of companies fall short of the success predicted from their new strategies.

By creating a closed-loop management system, companies can avoid such shortfalls. (See the exhibit "How the Closed-Loop Management System Links Strategy and Operations.") The loop comprises five stages, beginning with strategy development, which involves applying tools, processes, and concepts such as mission, vision, and value statements; SWOT analysis; shareholder value management; competitive positioning; and core competencies to formulate a strategy statement. That statement is then translated into specific objectives and initiatives, using other tools and processes, including strategy maps and balanced scorecards. Strategy implementation, in turn, links strategy to operations with a third set of tools and processes, including quality and process management, reengineering, process dashboards, rolling forecasts, activity-based costing, resource capacity planning, and dynamic budgeting. As implementation progresses, managers continually review internal operational data and external data on competitors and the business environment. Finally, managers periodically assess the strategy, updating it when they learn that the assumptions underlying it are obsolete or faulty, which starts another loop around the system.

Sidebar Icon How the Closed-Loop Management System Links Strategy and Operations (Located at the end of this article)

A system such as this must be handled carefully. Often the breakdown occurs right at the beginning, with companies formulating grand strategies that they then fail to translate into goals and targets that their middle and lower managers understand and strive to achieve. Even when companies do formalize their strategic objectives, many still struggle because they do not link these objectives to tools that support the operational improvement processes that ultimately must deliver on the strategy's objectives. Or, like Conner, they decide to mix discussions of operations and strategy at the same meeting, causing a breakdown in the strategic-learning feedback loop.

In the following pages we draw upon our extensive research and experience advising companies, as well as nonprofit and public sector entities, to describe the design and implementation of a system for strategic planning, operational execution, and feedback and learning. We present a range of tools that managers can apply at the different stages, most developed by other management experts and some of our own design. (See "A Management System Tool Kit" for further reading on the tools discussed.) We will show how these can all be integrated in a system that links the management of strategy and operations.

Sidebar Icon A Management System Tool Kit (Located at the end of this article)

Stage 1: Develop the Strategy

The management cycle begins with articulating the company's strategy. This usually takes place at an annual offsite meeting during which the management team either incrementally improves an existing strategy or, on occasion, introduces an entirely new one. (Our experience suggests that strategies generally have three to five years of useful life.) Developing an entirely new strategy may take two sets of meetings, each lasting two to three days. At the first, executives should reexamine the company's fundamental business assumptions and its competitive environment. After some homework and research, the executives will hold the second set of meetings and decide on the new strategy. Typically, the CEO, other corporate officers, heads of business and regional units, and senior functional staff attend these strategy sessions. The agenda should explore the following questions:

What business are we in and why?

This question focuses managers on high-level strategy planning concepts. Before formulating a strategy, managers need to agree on their company's purpose (mission), its aspiration for future results (vision), and the internal compass that will guide its actions (values).

The mission is a brief statement, typically one or two sentences, that defines why the organization exists, especially what it offers to its customers and clients. The pharmaceutical firm Novartis presents a good example: "We want to discover, develop and successfully market innovative products to prevent and cure diseases, to ease suffering and to enhance the quality of life. We also want to provide a shareholder return that reflects outstanding performance and to adequately reward those who invest ideas and work in our company."

The vision is a concise statement that defines the mid- to long-term (three- to 10-year) goals of the organization. Cigna Property and Casualty, an insurance company division we worked with in the 1990s, stated its goal this way: "to be a top-quartile specialist within 5 years." Though short, this vision statement contained three vital components:

• Stretch goal: "top quartile" in profitability (at the time, Cigna P&C was at the bottom of the fourth quartile).
• Definition of market focus: "a specialist," not a general-purpose underwriter, as it was at the time.
• A time line for execution: "5 years" (a heartbeat in the slow-moving insurance industry).

The stretch goal in the vision statement should truly be a difficult reach for the company in its present position. The CEO has to take the lead here; indeed, one of the principal roles of an effective leader, as Jim Collins and Jerry Porras noted in Built to Last, is to formulate a "big, hairy, audacious goal (BHAG)" that challenges even well-performing organizations to become much better. The classic example is Jack Welch's challenge for every GE business unit to become number one or two in its industry. In determining a stretch goal, it pays to look at the financial market's expectations as a benchmark, since the company's share price usually contains an implicit estimate of future profitable growth, which can be well beyond that achievable through incremental improvements to existing businesses. If a company is setting a new goal, rather than reaffirming an established goal, managers may need to undertake pre-offsite research and engage in extensive discussion at the meeting.

Finally, the values (often called core values) of a company prescribe the attitude, behavior, and character of an organization. Value statements, which are often lengthy, describe the desirable attitudes and behavior the company wants to promote as well as the forbidden conduct, such as bribery, harassment, and conflicts of interest, that employees should definitely avoid. These excerpts from the value statement of the internet service provider Earthlink illustrate the components of value statements:

• We respect the individual, and believe that individuals who are treated with respect and given responsibility respond by giving their best.
• We are frugal. We guard and conserve the company's resources with at least the same vigilance that we would use to guard and conserve our own personal resources.
• We are believers in the Golden Rule. In all our dealings we will strive to be friendly and courteous, as well as fair and compassionate.
• We feel a sense of urgency on any matters related to our customers. We own problems and we are always responsive. We are customer-driven.

The reaffirmation of mission, vision, and values puts executives in the right mind-set for considering the rest of the agenda and setting the company's fundamental guidelines.

What are the key issues we face in our business?

With mission, vision, and values established, managers undertake a strategic analysis of the company's external and internal situation. The management team studies the industry's economics using frameworks such as Michael Porter's five forces model (bargaining power of buyers; bargaining power of suppliers; availability of substitutes; threat of new entrants; and industry rivalry). The team assesses the external macroeconomic environment of growth, interest rates, currency movements, input prices, regulations, and general expectations of the corporation's role in society. Often this is described as a PESTEL analysis, encompassing political, economic, social, technological, environmental, and legal factors. Managers can then dive into competitiveness data and consider the dynamics of the company's financial, technological, and market performance relative to its industry and competitors.

After the external analysis, managers should assess the company's internal capabilities and performance. One approach is to use Michael Porter's value chain model, categorizing capabilities used in the processes that create markets; develop, produce, and deliver products and services; and sell to customers. Or the internal analysis could identify the distinctive resources and capabilities that give the firm a competitive advantage. Finally, unless managers are introducing an entirely new strategy, they will want to assess the performance of the current strategy, a topic we discuss more later.

The next step is to summarize the conclusions from the external and internal analyses in a classic SWOT matrix, assessing the ability of internal attributes and external factors to help or hinder the company's achievement of its vision. The aim here is to ensure that the strategy leverages internal strengths to pursue external opportunities, while countering weaknesses and threats (internal and external factors that undermine successful strategy execution). This analysis will reveal a series of issues that the strategy must address: the best role for new products and services; whether new partners need to be acquired; what new market segments the company might enter; and which customer segments are contracting. These issues will become the focus of the strategy formulation process, which often takes place at a subsequent meeting.

How can we best compete?

Finally, managers tackle the strategy formulation itself--the statement describing the strategy and how the company proposes to achieve it. In this step managers decide on a course of action that will create a sustainable competitive advantage by distinguishing the company's offering from competitors' and, ultimately, will lead to superior financial performance. The strategy must respond, in some form, to the following questions:

• Which customers or markets will we target?
• What is the value proposition that distinguishes us?
• What key processes give us competitive advantage?
• What are the human capital capabilities required to excel at these key processes?
• What are the technology enablers of the strategy?
• What are the organizational enablers required for the strategy?

Managers can draw upon an abundance of models and frameworks as they formulate the strategy. Michael Porter's original competitive advantage framework, for example, presented the strategy decision as a choice between whether to provide generic low-cost products and services or more differentiated and customized ones for specific market and customer segments. The Blue Ocean approach, popularized by W. Chan Kim and Renée Mauborgne, helps companies search for new market positions by creating new value propositions for a large customer base. Resource-based strategists (including those in the core competencies school) emphasize critical processes--such as innovation or continual cost reduction--that the company does better than competitors and can leverage into multiple markets and segments. Clay Christensen has identified how new entrants can disrupt established markets by offering an initially less capable product or service at a much lower price to attract a large customer base not targeted by the market leaders.

We are agnostic with respect to these frameworks; we have seen each one we've described be highly successful. Which among them is the right choice probably depends on a company's circumstances and its competitive analysis. The Porter and resource-based frameworks help companies leverage existing competitive positions or internal capabilities, whereas the Blue Ocean and disruptive technology frameworks help them search for entirely new positions.

Stage 2: Translate the Strategy

Once the strategy has been formulated, managers need to translate it into objectives and measures that can be clearly communicated to all units and employees. Our own work on developing strategy maps and balanced scorecards has contributed to this translation stage.

The strategy map provides a powerful tool for visualizing the strategy as a chain of cause-and-effect relationships among strategic objectives. The chain starts with the company's long-term financial objectives and then links down to objectives for customer loyalty and the company's value propositions. From there, it links to goals related to critical processes and, ultimately, to the people, the technology, and the organizational climate and culture required for successful strategy execution. Typically, a large corporation will create an overall corporate strategy map and then link it to strategy maps for each of its operating and functional units.

Even though a strategy map reduces a complex strategy statement to a single page, we have learned that many managers find the multiple objectives (typically, 15 to 25) on a map, along with their corresponding measures and targets, somewhat complex to understand and manage. Some of a map's objectives relate to short-term cost reduction and quality improvements while others reflect long-term innovation and relationship goals. Managers often find it challenging to balance these myriad objectives.

In our recent work, we've found that companies can simplify the structure and use of a strategy map by chunking it into three to five strategic themes. A strategic theme, typically a vertical slice within the map, consists of a distinct set of related strategic objectives. (For an example, see "Mapping Strategic Themes," a generic strategy map organized by three vertical strategic themes and a horizontal theme to cluster the learning and growth objectives.)

Sidebar Icon Mapping Strategic Themes (Located at the end of this article)

Strategic themes offer several advantages. At the business unit level, the theme structure allows unit managers to customize each theme to their local conditions and priorities, creating focus for their competitive situation while still keeping their objectives integrated with the overall strategy. Second, the vertical strategic themes typically deliver their benefits over different time periods, helping companies simultaneously manage short-, intermediate-, and long-term value-creating processes. Using themes, executives can plan and manage the key elements of the strategy separately but still have them operate coherently.

Once managers have developed the strategy map, they link it to another tool of our design: a balanced scorecard of performance metrics and targets for each strategic objective. We believe that if you don't measure progress toward an objective, you cannot manage and improve it. The balanced scorecard metrics allow executives to make better decisions about the strategy and quantitatively assess its execution.

A third step at Stage 2 involves identifying, and authorizing resources for, a portfolio of strategic initiatives intended to help achieve the strategy's objectives. A strategic initiative is a discretionary project or program, of finite duration, designed to close a performance gap. It might focus on, say, developing a customer loyalty program or training all employees in Six Sigma quality management tools.

In our original conception of the strategy map and the balanced scorecard, we encouraged companies to select initiatives independently for each objective. We came to realize, however, that by doing so, companies would fail to benefit from the integrated and cumulative impact of multiple, related strategic initiatives. Achieving an objective in the customer or financial realm generally requires complementary initiatives from different parts of the organization, such as human resources, information technology, marketing, distribution, and operations. Also, stand-alone cross-unit initiatives often have no clear owner or home in the organization. Starved for resources and lacking clear accountability for execution, the strategic initiatives wither away, thwarting the strategy's execution.

Companies with theme-based strategy maps avoid these problems by assigning a senior executive to lead each strategic theme. In this way, the company gains an accountability and reporting structure even for cross-business and cross-functional-unit objectives. The executive assigned to own each theme assumes the responsibility for devising and executing an entire portfolio of initiatives selected to achieve the theme's performance targets. The executive team authorizes the resources required for the various portfolios; we call the designated funds strategic expenditures (or StratEx). Committing funds to StratEx is similar to budgeting for research and development: Both categories represent spending on near-term actions expected to deliver mid- to long-term performance, and both are separate from the operating and capital expenditures (OpEx and CapEx, described in the next stage) that support current operations.

Stage 3: Plan Operations

With strategic metrics, targets, and initiative portfolios in place, the company next develops an operational plan that lays out the actions that will accomplish its strategic objectives. This stage starts with setting priorities for process improvement projects, followed by preparing a detailed sales plan, a resource capacity plan, and operating and capital budgets.

Process improvements.

The strategic initiatives developed in Stage 2 consist of the short-term projects (lasting as long as 12 to 18 months) selected to help achieve the strategy map's objectives. However, to execute their strategies, companies generally must also enhance the performance of their ongoing processes--measured, for example, by their responsiveness, speed, quality, and cost. Companies will get the biggest bang for their buck when they focus their business process management, total quality management, lean management, Six Sigma, and reengineering programs on processes directly related to the objectives on their strategy maps and scorecards. The goal is to align near-term process improvements with long-term strategic priorities.

Managers need to deconstruct each strategic process to identify the critical success factors and metrics that employees can focus on in their daily activities. Electronic and physical dashboards, displaying data on the key indicators of local process performance, will inform the actions of and provide feedback to employees attempting to achieve process performance targets. For example, one large pharmaceutical chain has a dashboard system that gives each store manager a customized, single page display of financial and operating metrics--those that a statistical analysis revealed have the highest correlation with aggregate store performance. The managers' dashboards also display monthly quartile rankings among comparable stores for six key metrics.

Sales plan.

Managers also must identify the resources required to implement their strategic plan. Before they can do that, they need to deconstruct their overall sales target into the expected quantity, mix, and nature of individual sales orders, production runs, and transactions. (For an illustration, see the example of Towerton Financial in "Breaking Down the Sales Target" in the sidebar "What Resources Do You Need to Implement Your Strategy?" Towerton is a composite of various firms we've worked with.) Companies with well-functioning ERP systems will have a historical record of product and customer mix and transaction volumes they can draw upon to do this. A company can start by simply grossing up last period's distribution of order sizes by the desired percentage change in sales. Using this baseline, the company's planners can modify the distribution to reflect expected changes in sales and ordering patterns, such as an increase in minimum order sizes and the additional sales from new lines of products or services or new markets. Finally, data-rich companies can easily embrace scenario planning to explore the sensitivity of their sales forecasts to alternative economic and competitive assumptions.

Sidebar Icon What Resources Do You Need to Implement Your Strategy? (Located at the end of this article)

Resource capacity plan.

Armed with data about productivity from process improvements and likely sales numbers, companies can now estimate what resources they will need in the year ahead to execute on their strategic goals. Our preferred tool for this step is time-driven activity-based costing (TDABC). Activity-based costing's original use was to measure the cost and profitability of processes, products, and customers (as we will describe in Stage 5). The time-driven version of ABC adds a new capability, the ability to easily translate future sales numbers into a forecast of required resource capacity. At the heart of the TDABC model is a set of equations, based on historical experience, that describe how various transactions and demands consume the capacity of resources such as people, equipment, and facilities. A company that has such a model in place can update these equations for any productivity gains that have occurred or are anticipated from process improvements (determined during the first step in this stage). Managers then feed the new detailed sales plans (from the second step) into the updated model, to produce estimates of the demand for resources implied by the sales forecast. (See "Translating the Sales Plan into Resource Requirements" in the sidebar "What Resources Do You Need to Implement Your Strategy?" for a simplified example.) The company, seeing the capacity required to deliver on its strategic plan, can then authorize the quantity of people, equipment, and other resources to be supplied, including any buffer capacity to handle fluctuations or short-term spikes in demand.

Dynamic operating and capital budgets.

Once managers have determined the authorized level of resources for the future period, the financial implications become easy to calculate. In the Towerton Financial case used in the resource capacity exhibit, the company already knew the full monthly cost of each kind of personnel--brokers, account managers, financial planners, customer service representatives, and IT consultants--as well as the monthly cost for each server, the unit of computing capacity. To obtain the budget figures for each of the resources needed to meet the sales forecasts, Towerton's planners simply multiply the cost of each type of resource by the quantity it has decided to supply. Most of the resource capacity represents personnel costs and would be included in the OpEx budget. Increases in equipment resource capacity (such as Towerton's servers) would be reflected in the CapEx budget. The process quickly and analytically generates operating and capital budgets that grow logically and dynamically out of the sales and operating plans, rather than being imposed by fiat or through power negotiations. Since the company started with detailed revenue forecasts and now has the resource costs associated with delivering on them, simple subtraction will yield a detailed P&L for each product, customer, channel, and region. Companies that have shifted from an annual budgeting cycle to one with quarterly updates can use this process to obtain resource capacity plans for every period for which they have a sales forecast.

In a final budgeting step, the company authorizes the discretionary spending that does not have an immediate relationship with sales and operations, such as process improvement initiatives, advertising, promotion, research and development, training, and maintenance. The amount of such spending remains a judgment call for experienced executives and is not a decision that can yet be automated through an analytic model.

The company now has finished the integrated planning of strategy and operations, which encompasses the following steps: Formulate the strategy; translate it into linked objectives, measures, and targets; develop and fund the portfolio of strategic initiatives; identify the process improvement priorities; forecast sales consistent with the strategic plan; estimate the resource capacities required for those sales; authorize the spending on resources; and produce next period's pro forma income and detailed P&L statements. From here on, it is up to the managers to execute, learn, and adapt, moving the management cycle into its fourth stage.

Stage 4: Monitor and Learn

As companies implement their strategic and operational plans, they need to hold three types of meetings to monitor and learn from their results. First, managers should convene meetings that review the performance of operating departments and business functions and address problems that have arisen or persist. They also should hold strategy management meetings that review balanced scorecard performance indicators and initiatives to assess progress and identify barriers to strategy execution. Those two meetings make up Stage 4 of the system. In Stage 5, managers meet to assess the performance of the strategy itself and adapt it if necessary. The three meetings have different subject matter, different frequencies, and, often, different sets of attendees. (See the exhibit "Management Meetings 101" for a comparison of the meetings.)

Sidebar Icon Management Meetings 101 (Located at the end of this article)

Operational review meetings.

Management groups need to meet frequently--perhaps weekly, twice weekly, or even daily--to review their operating dashboards and reports on sales, bookings, and shipments, and to solve short-term issues that have recently arisen: complaints from important customers, late deliveries, defective production, mechanical breakdowns, the extended absence of a key employee, new sales opportunities. The speed at which new data are posted on operational dashboards is the central factor in determining meeting frequency: If the company has a short operations cycle, with new data posted hourly and daily, then a daily review promotes rapid learning and problem solving. But for a product development group, progress against milestones and stage gates may be better evaluated monthly.

The people attending an operational review typically come from within a single department, function, or process. A unit's salespeople, for example, will meet (often via conference calls and webcasts) to discuss the sales pipeline, recent sales closings, and new customer opportunities and problems. Operations people review production problems, including defects, yields, bottlenecks, maintenance and repair schedules, equipment breakdowns, downtime, scheduling, expediting, supplier concerns, and distribution. Finance personnel address short-term cash flow issues, including collections on receivables, late payments to suppliers, treasury operations, and banking relationships. The top management group may meet monthly to review overall financial performance.

Smaller companies, without functional departments, may have only a single monthly operating meeting, corresponding to the frequency with which they close their books. In general, however, we recommend gearing operating review meeting frequency to the operating cycle of the department and business, so management can respond to sales and operating data and to myriad other tactical issues in the most timely manner.

Ideally, operational meetings are short, highly focused, data driven, and action oriented. One company we've advised holds its operational reviews in a small room filled with whiteboards and flip charts but no chairs. Attendees post agenda topics and look over dashboards before the meeting, which lasts only as long as needed to discuss each issue, develop an action plan, and assign responsibility for carrying it out. Forcing everyone to stand signals that the meeting's purpose is not to spend time together, passively listening. It is to engage managers in active and brisk problem-solving discussions on the most pressing issues of the day.

Strategy review meetings.

The leadership team of a business unit must meet periodically to review the progress of its strategy. Operational issues, unless they are particularly significant and cross-functional, should not be discussed at this meeting. Attendance at strategy reviews should be compulsory for the unit's CEO and all members of its executive committee.

There's no clear consensus around the optimal frequency for these meetings, though most companies hold a monthly two- to three-hour strategy review meeting, to ensure that strategy remains top of mind. That works well when a management team works in one central location. Some companies, especially those with dispersed teams, hold their strategy review meetings quarterly. Strategy is a long-term commitment, and strategic initiatives such as developing new workforce competencies, redefining the brand, innovating new products, building new customer relationships, and reengineering key business processes typically take more than a month to yield measurable results. Quarterly meetings will probably require at least an entire day for active discussion of all strategic objectives and themes.

Many company units hold their monthly operational financial review on the same day as the strategy review, since the same people attend both. If that's the situation, it's essential to set distinctly different agendas for the two meetings. Otherwise, as in our opening example of the Conner Corporation, short-term operational and tactical issues will drive out discussions of strategy implementation.

Like operational reviews, strategy management meetings should not be spent listening to report presentations. Managers should come to the meetings already familiar with the data to be discussed, thinking about the issues that the gaps in recent performance raise, and formulating solutions to problems. At the meetings themselves, executive committee members should discuss the issues, explore their implications, and propose action plans.

Executives have to make a trade-off between breadth and depth at these reviews. In the early years of balanced scorecard implementations, we encouraged a full discussion of BSC measures at each strategy management meeting. It soon became apparent that the normal time reserved for a monthly meeting did not permit a full discussion of all the objectives, measures, and initiatives on a strategy map and scorecard. The solution, we discovered, came from the practice of using strategic themes to organize strategy maps: devote most of the meeting to a deep dive into one or two of the strategic themes.

That is precisely what happens at HSBC Rail, an operating unit of the HSBC Group, which purchases, leases, and maintains the locomotives and cars for the UK and other nations' railroad systems. Its monthly two-and-a-half-hour meeting brings together its strategy council, consisting of the CEO, the head of Finance, the head of Customer Service-Operations, the head of Customer Relationship Management-Sales, the head of Learning and Development, and the strategy management officer, who coordinates the data on the strategic measures and initiatives for each strategic theme in advance of the meeting. The data go into a monthly report that has a section for each strategic theme. The section contains the theme's strategy map, objectives, targets, and initiatives, with each component color-coded green (if the objective's target has been achieved), yellow (progress is slower than expected but doesn't require immediate senior management attention), or red (progress is off track and requires management attention to resolve critical issues). Each theme's section also contains evaluations and commentary from the theme owner about any performance gaps and proposed actions for addressing them.

The monthly meeting focuses on one (or at most two) strategic themes in depth. The agenda also allots time for one operational or strategic "hot topic" to ensure that urgent issues that fall outside the theme under discussion will be addressed. The February 2007 strategy council meeting was a typical HSBC Rail strategy review. (See the exhibit "A Model Strategy Review Agenda.") The strategy management officer started with an update on the action items from the previous month, indicating which had been accomplished and which were still under way. The CEO followed with a quick review of the unit's color-coded strategy map and offered his perspective on the business. Then, the attendees gave in-depth consideration for about 60 minutes to the Customer Relationship Management strategic theme. For the remaining themes, the council spent about five minutes each on any issues that had to be resolved before the scheduled deep dive on that theme. The meeting participants, who were already familiar with the data and ready to discuss the implications and to propose action plans, built constructively on the ideas presented during the meeting. The CEO questioned and probed, kept the meeting focused on the key issues, encouraged dialogue and debate, and ensured that the meeting stayed on schedule. The strategy management officer recorded each approved action item and the designated manager who would be accountable for following up on it.

HSBC's meetings--like all excellent strategy reviews--focus on whether strategy execution is on track, where problems are occurring in the implementation, why they're happening, what actions will correct them, and who will have responsibility for achieving targets. These meetings take the strategy as a given. They are not used, except in unusual circumstances, to question or adapt the strategy. That is what takes place in the final stage.

Stage 5: Test and Adapt the Strategy

From time to time managers will discover that some of the assumptions underlying their strategy are flawed or obsolete. When that happens, managers need to rigorously reexamine their strategy and adapt it, deciding whether incremental improvements will suffice or whether they need a new, transformational strategy. This process closes the loop of the management system. It generally occurs at the strategy development offsite described under Stage 1 but could occur during the year if the company experiences a major disruption or a new strategic opportunity. The strategy testing and adapting process introduces new inputs to the offsite: an analysis of the current economics of existing products and customers, statistical analyses of correlations among the strategy's performance measures, and consideration of new strategy options that have emerged since the previous strategy development meeting.

Cost and profitability reports.

Anytime a company reviews its strategy, it should first understand the current economics of its existing strategy by examining activity-based costing reports that show the profit and loss of each product line, customer, market segment, channel, and region. Executives will then see where the existing strategy has succeeded and failed, and can formulate approaches to turning around loss operations and expanding the scope and scale of profitable operations.

Consider the experience of a large New York City bank with an overall profitable product line of demand and time deposits. Information from its aggregate profitability measurement system showed that all customers with balances greater than $25,000 were profitable, so the bank launched a major initiative to retain those clients. During the initiative, however, the bank conducted a more detailed ABC study to calculate the cost to serve and the profitability of all accounts. It learned that 35% of the households targeted for retention were unprofitable, with cumulative losses totaling more than $2 million. Unprofitable customers could be found in every balance tier up to $1 million, in fact. Managers at first could not believe that high-deposit individuals could be unprofitable. Further analysis revealed that unprofitable customers did a large number of transactions in the branches, the most expensive service channel, and kept most of their deposits in accounts that yielded low margins to the bank. Fortunately, the bank discovered this error in its strategy before it was too far along in its client retention initiative.

Unprofitability doesn't mean that a company should simply drop a customer or product, however. In our experience, companies find multiple ways--process improvements, repricing, and redefining relationships--to reduce or eliminate the losses from unprofitable products and customers, once a credible costing system has identified them.

Statistical analyses.

Companies, especially those with large numbers of similar operating units, can use statistical analysis to estimate correlations among strategy performance numbers. Such analysis will usually validate and quantify links between investments in, for example, employee skills or IT support systems, and customer loyalty and financial performance. Occasionally, however, the analysis can reveal that assumed linkages are not occurring, which should cause the executive team to question or reject at least part of the existing strategy. Companies that consistently measure strategy performance through tools such as the strategy map and balanced scorecard have ready access to the data needed for strategy validation and testing.

Take Store 24, one of New England's largest convenience store chains (now owned by Tedeschi Food Shops), which in 1998 implemented a new customer strategy called "Ban Boredom." Store 24's CEO believed that providing an entertaining shopping atmosphere, including frequent themes and promotions, would differentiate the shopping experience at the chain from its competitors'. The company created a strategy map and balanced scorecard to communicate and help implement the new strategy. Within two years, however, Store 24's executive team learned that the strategy was not working. Feedback from individual customers and focus groups led the chain to abandon the Ban Boredom strategy and replace it with an updated version of its previous strategy, which featured fast and efficient service.

A Harvard Business School faculty team (Dennis Campbell, Srikant Datar, Susan Kulp, and V.G. Narayanan) gained access to quarterly data from Store 24's 85 retail outlets and performed statistical analysis to see whether the company's executives could have recognized the flaws in the Ban Boredom strategy earlier. Looking at data from the first year of the strategy, the study found that better implementation of the Ban Boredom program was indeed negatively correlated with store performance, exactly the opposite of what the strategy had intended. The data also showed that differences in profits were best explained by variables not related to the strategy, including store managers' skills, local population, and local competition. By uncovering those (and several other) simple correlations, Store 24 management could have learned one year earlier than it actually did that the new strategy was not working. The managers would also have seen that the strategy would be successful only if all stores raised their crew skills to high levels, something that wasn't feasible given the 200% annual employee turnover rate typical of retail stores.

Emergent strategies.

The strategy offsite, beyond examining the performance of existing strategy, provides executives with a great opportunity to consider new strategy proposals that managers and employees throughout the enterprise may have suggested. Henry Mintzberg and Gary Hamel, in fact, argue against top-down strategy implementation, contending that the most innovative strategies emerge from within the organization. Not all such strategies are worth pursuing, however, and even if several seem promising, the executive team still needs to decide which, if any, to adopt.

If the executive team decides, based on analyses of the internal data, the competitive environment, and emerging strategy ideas, to alter the existing strategy, it should follow up by modifying the organization's strategy map and scorecard. That will launch another cycle of strategy translation and operational execution, with new targets, new initiatives, a new sales and operating plan, revised process improvement priorities, changed resource capacity requirements, and an updated financial plan. The new strategic and operational plans set the stage and establish the information requirements for next period's schedule of operational reviews, strategy reviews, and strategy testing and adaptation meetings.

• o o

Managers have always found it hard to balance near-term operational concerns with long-term strategic priorities. But such a balancing act comes with the job; it is an inherent tension that managers cannot avoid and must continually address. As a senior strategic planner at a Fortune 20 company told us, "You can have the best processes in the world, but if your governance processes don't provide the direction and course correction required to achieve your goals, success is a matter of luck." At the same time, a company can have the best strategy in the world, but it will get nowhere if managers cannot translate that strategy into operational plans and then execute the plans and achieve the performance targets.

Managers that carefully follow the recommendations we have laid out in this article will have a complete management system that helps them set clear strategic goals, allocate resources consistent with those goals, set priorities for operational action, quickly recognize the operational and strategic impact of those decisions, and, if necessary, update their strategic goals. The closed-loop management system enables executives to manage both strategy and operations, and to balance the tensions between them. How the Closed-Loop Management System Links Strategy and Operations

Most companies' underperformance is due to breakdowns between strategy and operations. This diagram describes how to forge tight links between them in a five-stage system. A company begins by developing a strategy statement and then translates it into the specific objectives and initiatives of a strategic plan. Using the strategic plan as a guide, the company maps out the operational plans and resources needed to achieve its objectives. As managers execute the strategic and operational plans, they continually monitor and learn from internal results and external data on competitors and the business environment to see if the strategy is succeeding. Finally, they periodically reassess the strategy, updating it if they learn that the assumptions underlying it are out-of-date or faulty, starting another loop around the system.

A Management System Tool Kit

Where to learn more about the concepts and frameworks described in this article

Develop the Strategy

Competitive Strategy

Michael E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance, Free Press, 1985 (republished with a new introduction, 1998)

Michael E. Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors, Free Press, 1980 (republished with a new introduction, 1998)

Michael E. Porter, "What Is Strategy?", Harvard Business Review November-December 1996

Chris Zook and James Allen, Profit from the Core: Growth Strategy in an Era of Turbulence, Harvard Business School Press, 2001

Resource-Based Strategy

Jay B. Barney, Gaining and Sustaining Competitive Advantage--3rd edition, Prentice-Hall, 2006

Jay B. Barney and Delwyn N. Clark, Resource-Based Theory: Creating and Sustaining Competitive Advantage, Oxford University Press, 2007

David J. Collis and Cynthia A. Montgomery, "Competing on Resources: Strategy in the 1990s", Harvard Business Review July-August 1995

Gary Hamel and C.K. Prahalad, Competing for the Future, Harvard Business School Press, 1994

Blue Ocean Strategy

W. Chan Kim and Renée Mauborgne, Blue Ocean Strategy: How to Create Uncontested Market Space and Make the Competition Irrelevant, Harvard Business School Press, 2005

Disruptive Strategy

Clayton M. Christensen and Michael E. Raynor, The Innovator's Solution: Creating and Sustaining Successful Growth, Harvard Business School Press, 2003

Emergent Strategy

Gary Hamel, "Strategy Innovation and the Quest for Value", Sloan Management Review Winter 1998

Henry Mintzberg, "Crafting Strategy", Harvard Business Review July-August 1987

Translate the Strategy

Robert S. Kaplan and David P. Norton, The Strategy-Focused Organization: How Balanced Scorecard Companies Thrive in the New Business Environment, Harvard Business School Press, 2000

Robert S. Kaplan and David P. Norton, Strategy Maps: Converting Intangible Assets into Tangible Outcomes, Harvard Business School Press, 2004

Robert S. Kaplan and David P. Norton, The Execution Premium: Linking Strategy to Operations for Competitive Advantage, Harvard Business School Press, 2008

Plan Operations

Process Improvement

Wayne W. Eckerson, Performance Dashboards: Measuring, Monitoring, and Managing Your Business, John Wiley & Sons, 2006

Michael Hammer, Beyond Reengineering: How the Process-Centered Organization Is Changing Our Work and Our Lives, HarperBusiness, 1996

Peter S. Pande, Robert P. Neuman, and Roland R. Cavanagh, The Six Sigma Way: How GE, Motorola, and Other Top Companies Are Honing Their Performance, McGraw-Hill, 2000

James P. Womack, Daniel T. Jones, and Daniel Roos, The Machine That Changed the World: The Story of Lean Production, Macmillan, 1990

Budgeting and Planning Resource Capacity

Jeremy Hope and Robin Fraser, Beyond Budgeting: How Managers Can Break Free from the Annual Performance Trap, Harvard Business School Press, 2003

Robert S. Kaplan and Steven R. Anderson, Time-Driven Activity-Based Costing: A Simpler and More Powerful Path to Higher Profits, Harvard Business School Press, 2007

Test and Adapt Strategy

Dennis Campbell, Srikant Datar, Susan L. Kulp, and V.G. Narayanan, "Testing Strategy Formulation and Implementation Using Strategically Linked Performance Measures", HBS Working Paper, 2006

Thomas H. Davenport and Jeanne G. Harris, Competing on Analytics: The New Science of Winning, Harvard Business School Press, 2007

Anthony J. Rucci, Steven P. Kirn, and Richard T. Quinn, "The Employee-Customer-Profit Chain at Sears", Harvard Business Review January-February 1998 Mapping Strategic Themes

This generic strategy map illustrates how a corporate strategy can be sliced into four themes, each with its own cause-and-effect relationships.

Real-life maps will be more complex but will still have the desirable property of making strategy much easier to understand and manage. The strategic themes provide a common structure that unit managers can use to develop their own maps within the big picture and a governance structure that assigns accountability for actions.

What Resources Do You Need to Implement Your Strategy?

It's critical for companies to factor their strategic goals into their operational planning. Here's how one company broke its sales forecast down into figures for each of the activities required to achieve it and used those figures to estimate the personnel and computing resources it would need in the next period.

Breaking Down the Sales Target

Towerton Financial, a financial services company, broke down a monthly sales target of about $7.9 million into subtargets for its four product lines: stock trading, mutual fund trading, investment management, and financial planning. It then broke each line's forecast down into the volume and mix of transactions that the company's most expensive resources (people and computing) would be expected to handle each month. That information helped the company's managers calculate the resources needed to achieve their sales goals.

Translating the Sales Plan into Resource Requirements

In this chart, Towerton Financial calculated the quantity of resources required to implement the sales plan at left, using a time-driven ABC model. The numbers under total hours show what Towerton would need from each kind of personnel or IT resource. (Note that the capacity of computing resources is measured by MIPS, not hours.) The next column indicates how many hours (or MIPS) are supplied monthly by one unit of each resource. The numbers for resource units required were obtained simply by dividing the total demand for each resource by the quantity supplied monthly by one unit of it. After examining the resource requirements under a range of assumptions, Towerton authorized the level of resource supply to be carried into the next period. In general, companies will want to supply somewhat more capacity than forecast, as shown in the column for resource units supplied; resource demands are not uniform throughout a period. As the final column shows, Towerton expects to operate at close to full capacity during the upcoming period. Knowing the cost of each resource unit, Towerton can quickly translate its operating plan into an overall profit plan and individual product line P&Ls.

Management Meetings 101

It's important to distinguish clearly among the various kinds of meetings that form the feedback and learning component of the management system. They require different frequencies and have very different agendas and informational requirements. Companies that try to double up these meetings in order to accommodate the availability of senior staff run the risk of having discussions of operational crises drive out consideration of strategic issues.

The Five Competitive Forces That Shape Strategy

Awareness of the five forces can help a company understand the structure of its industry and stake out a position that is more profitable and less vulnerable to attack.

by Michael E. Porter

cD- VIDEO: Watch the author describe the five forces and how to put this strategy framework into practice.

Editor's Note: In 1979, Harvard Business Review published "How Competitive Forces Shape Strategy" by a young economist and associate professor, Michael E. Porter. It was his first HBR article, and it started a revolution in the strategy field. In subsequent decades, Porter has brought his signature economic rigor to the study of competitive strategy for corporations, regions, nations, and, more recently, health care and philanthropy. "Porter's five forces" have shaped a generation of academic research and business practice. With prodding and assistance from Harvard Business School Professor Jan Rivkin and longtime colleague Joan Magretta, Porter here reaffirms, updates, and extends the classic work. He also addresses common misunderstandings, provides practical guidance for users of the framework, and offers a deeper view of its implications for strategy today.

In essence, the job of the strategist is to understand and cope with competition. Often, however, managers define competition too narrowly, as if it occurred only among today's direct competitors. Yet competition for profits goes beyond established industry rivals to include four other competitive forces as well: customers, suppliers, potential entrants, and substitute products. The extended rivalry that results from all five forces defines an industry's structure and shapes the nature of competitive interaction within an industry.

As different from one another as industries might appear on the surface, the underlying drivers of profitability are the same. The global auto industry, for instance, appears to have nothing in common with the worldwide market for art masterpieces or the heavily regulated health-care delivery industry in Europe. But to understand industry competition and profitability in each of those three cases, one must analyze the industry's underlying structure in terms of the five forces. (See the exhibit "The Five Forces That Shape Industry Competition.")

If the forces are intense, as they are in such industries as airlines, textiles, and hotels, almost no company earns attractive returns on investment. If the forces are benign, as they are in industries such as software, soft drinks, and toiletries, many companies are profitable. Industry structure drives competition and profitability, not whether an industry produces a product or service, is emerging or mature, high tech or low tech, regulated or unregulated. While a myriad of factors can affect industry profitability in the short run--including the weather and the business cycle--industry structure, manifested in the competitive forces, sets industry profitability in the medium and long run. (See the exhibit "Differences in Industry Profitability.")

Sidebar Icon Differences in Industry Profitability (Located at the end of this article)

Understanding the competitive forces, and their underlying causes, reveals the roots of an industry's current profitability while providing a framework for anticipating and influencing competition (and profitability) over time. A healthy industry structure should be as much a competitive concern to strategists as their company's own position. Understanding industry structure is also essential to effective strategic positioning. As we will see, defending against the competitive forces and shaping them in a company's favor are crucial to strategy.

Forces That Shape Competition

The configuration of the five forces differs by industry. In the market for commercial aircraft, fierce rivalry between dominant producers Airbus and Boeing and the bargaining power of the airlines that place huge orders for aircraft are strong, while the threat of entry, the threat of substitutes, and the power of suppliers are more benign. In the movie theater industry, the proliferation of substitute forms of entertainment and the power of the movie producers and distributors who supply movies, the critical input, are important.

The strongest competitive force or forces determine the profitability of an industry and become the most important to strategy formulation. The most salient force, however, is not always obvious.

For example, even though rivalry is often fierce in commodity industries, it may not be the factor limiting profitability. Low returns in the photographic film industry, for instance, are the result of a superior substitute product--as Kodak and Fuji, the world's leading producers of photographic film, learned with the advent of digital photography. In such a situation, coping with the substitute product becomes the number one strategic priority.

Industry structure grows out of a set of economic and technical characteristics that determine the strength of each competitive force. We will examine these drivers in the pages that follow, taking the perspective of an incumbent, or a company already present in the industry. The analysis can be readily extended to understand the challenges facing a potential entrant.

Sidebar Icon Industry Analysis in Practice (Located at the end of this article)

Threat of entry.

New entrants to an industry bring new capacity and a desire to gain market share that puts pressure on prices, costs, and the rate of investment necessary to compete. Particularly when new entrants are diversifying from other markets, they can leverage existing capabilities and cash flows to shake up competition, as Pepsi did when it entered the bottled water industry, Microsoft did when it began to offer internet browsers, and Apple did when it entered the music distribution business.

The threat of entry, therefore, puts a cap on the profit potential of an industry. When the threat is high, incumbents must hold down their prices or boost investment to deter new competitors. In specialty coffee retailing, for example, relatively low entry barriers mean that Starbucks must invest aggressively in modernizing stores and menus.

The threat of entry in an industry depends on the height of entry barriers that are present and on the reaction entrants can expect from incumbents. If entry barriers are low and newcomers expect little retaliation from the entrenched competitors, the threat of entry is high and industry profitability is moderated. It is the threat of entry, not whether entry actually occurs, that holds down profitability.

Barriers to entry.

Entry barriers are advantages that incumbents have relative to new entrants. There are seven major sources:

1. Supply-side economies of scale. These economies arise when firms that produce at larger volumes enjoy lower costs per unit because they can spread fixed costs over more units, employ more efficient technology, or command better terms from suppliers. Supply-side scale economies deter entry by forcing the aspiring entrant either to come into the industry on a large scale, which requires dislodging entrenched competitors, or to accept a cost disadvantage.

Scale economies can be found in virtually every activity in the value chain; which ones are most important varies by industry.^1 In microprocessors, incumbents such as Intel are protected by scale economies in research, chip fabrication, and consumer marketing. For lawn care companies like Scotts Miracle-Gro, the most important scale economies are found in the supply chain and media advertising. In small-package delivery, economies of scale arise in national logistical systems and information technology.

2. Demand-side benefits of scale. These benefits, also known as network effects, arise in industries where a buyer's willingness to pay for a company's product increases with the number of other buyers who also patronize the company. Buyers may trust larger companies more for a crucial product: Recall the old adage that no one ever got fired for buying from IBM (when it was the dominant computer maker). Buyers may also value being in a "network" with a larger number of fellow customers. For instance, online auction participants are attracted to eBay because it offers the most potential trading partners. Demand-side benefits of scale discourage entry by limiting the willingness of customers to buy from a newcomer and by reducing the price the newcomer can command until it builds up a large base of customers.

3. Customer switching costs. Switching costs are fixed costs that buyers face when they change suppliers. Such costs may arise because a buyer who switches vendors must, for example, alter product specifications, retrain employees to use a new product, or modify processes or information systems. The larger the switching costs, the harder it will be for an entrant to gain customers. Enterprise resource planning (ERP) software is an example of a product with very high switching costs. Once a company has installed SAP's ERP system, for example, the costs of moving to a new vendor are astronomical because of embedded data, the fact that internal processes have been adapted to SAP, major retraining needs, and the mission-critical nature of the applications.

4. Capital requirements. The need to invest large financial resources in order to compete can deter new entrants. Capital may be necessary not only for fixed facilities but also to extend customer credit, build inventories, and fund start-up losses. The barrier is particularly great if the capital is required for unrecoverable and therefore harder-to-finance expenditures, such as up-front advertising or research and development. While major corporations have the financial resources to invade almost any industry, the huge capital requirements in certain fields limit the pool of likely entrants. Conversely, in such fields as tax preparation services or short-haul trucking, capital requirements are minimal and potential entrants plentiful.

It is important not to overstate the degree to which capital requirements alone deter entry. If industry returns are attractive and are expected to remain so, and if capital markets are efficient, investors will provide entrants with the funds they need. For aspiring air carriers, for instance, financing is available to purchase expensive aircraft because of their high resale value, one reason why there have been numerous new airlines in almost every region.

5. Incumbency advantages independent of size. No matter what their size, incumbents may have cost or quality advantages not available to potential rivals. These advantages can stem from such sources as proprietary technology, preferential access to the best raw material sources, preemption of the most favorable geographic locations, established brand identities, or cumulative experience that has allowed incumbents to learn how to produce more efficiently. Entrants try to bypass such advantages. Upstart discounters such as Target and Wal-Mart, for example, have located stores in freestanding sites rather than regional shopping centers where established department stores were well entrenched.

6. Unequal access to distribution channels. The new entrant must, of course, secure distribution of its product or service. A new food item, for example, must displace others from the supermarket shelf via price breaks, promotions, intense selling efforts, or some other means. The more limited the wholesale or retail channels are and the more that existing competitors have tied them up, the tougher entry into an industry will be. Sometimes access to distribution is so high a barrier that new entrants must bypass distribution channels altogether or create their own. Thus, upstart low-cost airlines have avoided distribution through travel agents (who tend to favor established higher-fare carriers) and have encouraged passengers to book their own flights on the internet.

7. Restrictive government policy. Government policy can hinder or aid new entry directly, as well as amplify (or nullify) the other entry barriers. Government directly limits or even forecloses entry into industries through, for instance, licensing requirements and restrictions on foreign investment. Regulated industries like liquor retailing, taxi services, and airlines are visible examples. Government policy can heighten other entry barriers through such means as expansive patenting rules that protect proprietary technology from imitation or environmental or safety regulations that raise scale economies facing newcomers. Of course, government policies may also make entry easier--directly through subsidies, for instance, or indirectly by funding basic research and making it available to all firms, new and old, reducing scale economies.

Entry barriers should be assessed relative to the capabilities of potential entrants, which may be start-ups, foreign firms, or companies in related industries. And, as some of our examples illustrate, the strategist must be mindful of the creative ways newcomers might find to circumvent apparent barriers.

Expected retaliation.

How potential entrants believe incumbents may react will also influence their decision to enter or stay out of an industry. If reaction is vigorous and protracted enough, the profit potential of participating in the industry can fall below the cost of capital. Incumbents often use public statements and responses to one entrant to send a message to other prospective entrants about their commitment to defending market share.

Newcomers are likely to fear expected retaliation if:

• Incumbents have previously responded vigorously to new entrants.
• Incumbents possess substantial resources to fight back, including excess cash and unused borrowing power, available productive capacity, or clout with distribution channels and customers.
• Incumbents seem likely to cut prices because they are committed to retaining market share at all costs or because the industry has high fixed costs, which create a strong motivation to drop prices to fill excess capacity.
• Industry growth is slow so newcomers can gain volume only by taking it from incumbents.

An analysis of barriers to entry and expected retaliation is obviously crucial for any company contemplating entry into a new industry. The challenge is to find ways to surmount the entry barriers without nullifying, through heavy investment, the profitability of participating in the industry.

The power of suppliers.

Powerful suppliers capture more of the value for themselves by charging higher prices, limiting quality or services, or shifting costs to industry participants. Powerful suppliers, including suppliers of labor, can squeeze profitability out of an industry that is unable to pass on cost increases in its own prices. Microsoft, for instance, has contributed to the erosion of profitability among personal computer makers by raising prices on operating systems. PC makers, competing fiercely for customers who can easily switch among them, have limited freedom to raise their prices accordingly.

Companies depend on a wide range of different supplier groups for inputs. A supplier group is powerful if:

• It is more concentrated than the industry it sells to. Microsoft's near monopoly in operating systems, coupled with the fragmentation of PC assemblers, exemplifies this situation.
• The supplier group does not depend heavily on the industry for its revenues. Suppliers serving many industries will not hesitate to extract maximum profits from each one. If a particular industry accounts for a large portion of a supplier group's volume or profit, however, suppliers will want to protect the industry through reasonable pricing and assist in activities such as R&D and lobbying.
• Industry participants face switching costs in changing suppliers. For example, shifting suppliers is difficult if companies have invested heavily in specialized ancillary equipment or in learning how to operate a supplier's equipment (as with Bloomberg terminals used by financial professionals). Or firms may have located their production lines adjacent to a supplier's manufacturing facilities (as in the case of some beverage companies and container manufacturers). When switching costs are high, industry participants find it hard to play suppliers off against one another. (Note that suppliers may have switching costs as well. This limits their power.)
• Suppliers offer products that are differentiated. Pharmaceutical companies that offer patented drugs with distinctive medical benefits have more power over hospitals, health maintenance organizations, and other drug buyers, for example, than drug companies offering me-too or generic products.
• There is no substitute for what the supplier group provides. Pilots' unions, for example, exercise considerable supplier power over airlines partly because there is no good alternative to a well-trained pilot in the cockpit.
• The supplier group can credibly threaten to integrate forward into the industry. In that case, if industry participants make too much money relative to suppliers, they will induce suppliers to enter the market.

The power of buyers.

Powerful customers--the flip side of powerful suppliers--can capture more value by forcing down prices, demanding better quality or more service (thereby driving up costs), and generally playing industry participants off against one another, all at the expense of industry profitability. Buyers are powerful if they have negotiating leverage relative to industry participants, especially if they are price sensitive, using their clout primarily to pressure price reductions.

As with suppliers, there may be distinct groups of customers who differ in bargaining power. A customer group has negotiating leverage if:

• There are few buyers, or each one purchases in volumes that are large relative to the size of a single vendor. Large-volume buyers are particularly powerful in industries with high fixed costs, such as telecommunications equipment, offshore drilling, and bulk chemicals. High fixed costs and low marginal costs amplify the pressure on rivals to keep capacity filled through discounting.
• The industry's products are standardized or undifferentiated. If buyers believe they can always find an equivalent product, they tend to play one vendor against another.
• Buyers face few switching costs in changing vendors.
• Buyers can credibly threaten to integrate backward and produce the industry's product themselves if vendors are too profitable. Producers of soft drinks and beer have long controlled the power of packaging manufacturers by threatening to make, and at times actually making, packaging materials themselves.

A buyer group is price sensitive if:

• The product it purchases from the industry represents a significant fraction of its cost structure or procurement budget. Here buyers are likely to shop around and bargain hard, as consumers do for home mortgages. Where the product sold by an industry is a small fraction of buyers' costs or expenditures, buyers are usually less price sensitive.
• The buyer group earns low profits, is strapped for cash, or is otherwise under pressure to trim its purchasing costs. Highly profitable or cash-rich customers, in contrast, are generally less price sensitive (that is, of course, if the item does not represent a large fraction of their costs).
• The quality of buyers' products or services is little affected by the industry's product. Where quality is very much affected by the industry's product, buyers are generally less price sensitive. When purchasing or renting production quality cameras, for instance, makers of major motion pictures opt for highly reliable equipment with the latest features. They pay limited attention to price.
• The industry's product has little effect on the buyer's other costs. Here, buyers focus on price. Conversely, where an industry's product or service can pay for itself many times over by improving performance or reducing labor, material, or other costs, buyers are usually more interested in quality than in price. Examples include products and services like tax accounting or well logging (which measures below-ground conditions of oil wells) that can save or even make the buyer money. Similarly, buyers tend not to be price sensitive in services such as investment banking, where poor performance can be costly and embarrassing.

Most sources of buyer power apply equally to consumers and to business-to-business customers. Like industrial customers, consumers tend to be more price sensitive if they are purchasing products that are undifferentiated, expensive relative to their incomes, and of a sort where product performance has limited consequences. The major difference with consumers is that their needs can be more intangible and harder to quantify.

Intermediate customers, or customers who purchase the product but are not the end user (such as assemblers or distribution channels), can be analyzed the same way as other buyers, with one important addition. Intermediate customers gain significant bargaining power when they can influence the purchasing decisions of customers downstream. Consumer electronics retailers, jewelry retailers, and agricultural-equipment distributors are examples of distribution channels that exert a strong influence on end customers.

Producers often attempt to diminish channel clout through exclusive arrangements with particular distributors or retailers or by marketing directly to end users. Component manufacturers seek to develop power over assemblers by creating preferences for their components with downstream customers. Such is the case with bicycle parts and with sweeteners. DuPont has created enormous clout by advertising its Stainmaster brand of carpet fibers not only to the carpet manufacturers that actually buy them but also to downstream consumers. Many consumers request Stainmaster carpet even though DuPont is not a carpet manufacturer.

The threat of substitutes.

A substitute performs the same or a similar function as an industry's product by a different means. Videoconferencing is a substitute for travel. Plastic is a substitute for aluminum. E-mail is a substitute for express mail. Sometimes, the threat of substitution is downstream or indirect, when a substitute replaces a buyer industry's product. For example, lawn-care products and services are threatened when multifamily homes in urban areas substitute for single-family homes in the suburbs. Software sold to agents is threatened when airline and travel websites substitute for travel agents.

Substitutes are always present, but they are easy to overlook because they may appear to be very different from the industry's product: To someone searching for a Father's Day gift, neckties and power tools may be substitutes. It is a substitute to do without, to purchase a used product rather than a new one, or to do it yourself (bring the service or product in-house).

When the threat of substitutes is high, industry profitability suffers. Substitute products or services limit an industry's profit potential by placing a ceiling on prices. If an industry does not distance itself from substitutes through product performance, marketing, or other means, it will suffer in terms of profitability--and often growth potential.

Substitutes not only limit profits in normal times, they also reduce the bonanza an industry can reap in good times. In emerging economies, for example, the surge in demand for wired telephone lines has been capped as many consumers opt to make a mobile telephone their first and only phone line.

The threat of a substitute is high if:

• It offers an attractive price-performance trade-off to the industry's product. The better the relative value of the substitute, the tighter is the lid on an industry's profit potential. For example, conventional providers of long-distance telephone service have suffered from the advent of inexpensive internet-based phone services such as Vonage and Skype. Similarly, video rental outlets are struggling with the emergence of cable and satellite video-on-demand services, online video rental services such as Netflix, and the rise of internet video sites like Google's YouTube.
• The buyer's cost of switching to the substitute is low. Switching from a proprietary, branded drug to a generic drug usually involves minimal costs, for example, which is why the shift to generics (and the fall in prices) is so substantial and rapid.

Strategists should be particularly alert to changes in other industries that may make them attractive substitutes when they were not before. Improvements in plastic materials, for example, allowed them to substitute for steel in many automobile components. In this way, technological changes or competitive discontinuities in seemingly unrelated businesses can have major impacts on industry profitability. Of course the substitution threat can also shift in favor of an industry, which bodes well for its future profitability and growth potential.

Rivalry among existing competitors.

Rivalry among existing competitors takes many familiar forms, including price discounting, new product introductions, advertising campaigns, and service improvements. High rivalry limits the profitability of an industry. The degree to which rivalry drives down an industry's profit potential depends, first, on the intensity with which companies compete and, second, on the basis on which they compete.

The intensity of rivalry is greatest if:

• Competitors are numerous or are roughly equal in size and power. In such situations, rivals find it hard to avoid poaching business. Without an industry leader, practices desirable for the industry as a whole go unenforced.
• Industry growth is slow. Slow growth precipitates fights for market share.
• Exit barriers are high. Exit barriers, the flip side of entry barriers, arise because of such things as highly specialized assets or management's devotion to a particular business. These barriers keep companies in the mark