Chapter 04

Key Work feature: Differential firm performance

The debate that surrounds differential firm performance seeks to answer the question, why do firms with similar resources that face the same industry structure perform differently. Porter’s work on industry and competitor analysis has ignited a debate about what is it that drives an organization’s performance. For Porter (1980) the answer is the industry context within which the firm finds itself. However for others, internal capabilities that reside inside the organization, may more readily account for how well that organization performs. The debate that surrounds differential firm performance is important because if Porter and the positioning school are correct then the main focus of an organization’s strategy should be the characteristics of its industry. If, on the other hand those who advocate a resource-based view of strategy are correct then the focus of an organization’s strategy must be the characteristics of its own organization.

For Porter the attractiveness or profitability of an industry is determined by his five forces framework. This is an analytical tool for assessing the competitive environment. It enables an organization to determine the attractiveness of a particular industry by examining the interaction of five competitive forces. The combined strength of these five forces will ultimately determine an organization's return on investment within a given industry. The five forces are: (1) threat of new entrants; (2) bargaining power of buyers; (3) bargaining power of suppliers; (4) threat of substitute products or services, and (5) intensity of rivalry among firms in an industry.

By examining all five competitive forces an organisation is able to assess its ability to compete effectively in an industry. Porter sees an organization as capable of adopting a strategy which allows it to position itself within an industry to take advantage of the prevailing industry structure. If an organization adopts this positioning approach it is effectively faced with a limited number of strategies on which to compete. A criticism levelled against Porter’s focus on industry analysis is that it diverts attention away from differential firm performance to matching the organisation’s resources to the needs of its external environment. The five forces framework is based on an economic theory known as the ‘Structure-Conduct-Performance’ (SCP) model. This states that the structure of an industry determines an organisation’s competitive behaviour (conduct), which in turn determines its profitability (performance). Therefore for Porter differential firm performance is determined by how well an organization can mitigate or change the five forces that exist within its industry to its favour. If this is the case then strategy formulation simply needs to be based around weakening the effects of the five forces.

There is empirical support for and against Porter’s emphasis on industry structure. For example, Rumelt (1991) argues that the defining factor in differential firm performance is more to do with factors at the individual firm level such as its resources and the strategy being adopted. Hawawini et al, (2003) contest this arguing that the external environment or industry effects are more important than firm-specific factors. If Rumelt is correct it has implications for exactly what the firm should be focusing its strategic attention on and provides a broader arena for the importance of strategic formulation. It is therefore not surprising to find that strategic management as a discipline has become increasingly concerned with the internal environment of the organization. The perceived inability of Porter’s structural analysis to answer the differential firm performance question has, in part, led to the ascendancy of the resource-based view of strategy associated with the work of Prahalad and Hamel (1990), Grant (1991), and Kay (1993).

For Porter, the aim of competitive strategy is to find a position within the industry that an organization can effectively defend against the impact of the five forces, or to try to influence the five forces in its favour. Managers therefore need to be aware of the relative impact of each of the five forces on their industry structure. They can then ascertain their ability to influence the forces with the greatest impact on their industry structure through their strategy formulation. The resource-based view of strategy would argue that sustainable competitive advantage derives from an organization’s ability to create core competencies (Prahalad and Hamel, 1990) or distinctive capabilities (Kay, 1993) from its resources. It is these core competencies and distinctive capabilities which competitors cannot readily imitate that are the source of differential firm performance. This therefore requires an organization to look inside – within itself – for the primary reason for its differential performance.

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Oxford University Press, Online Resource Centre, Chapter 04.

Chapter 04