Business Strategy: Industry Analysis

• This chapter and the next explores the external environment of the firm to identify the sources of profit in the external environment
• Chapter one observed that profound understanding of the competitive environment is a critical ingredient of a successful strategy
• Business strategy is essentially a quest for profit
• The firm's proximate environment is its industry, making industry analysis focus
• Industry analysis is relevant to corporate-level and business-level strategies

Corporate Strategy

• Corporate strategy decides which industries a firm should engage in
• Corporate strategy decides allocating resources among industries
• Decisions require assessment of the attractiveness of different industries in terms of profit potential
• Objective of this chapter is to understand how the competitive structure of an industry determines its profitability

Business Strategy

• Business strategy is concerned with establishing competitive advantage
• Analyzing customer needs and preferences to identify the general sources of competitive advantage, called key success factors

Chapter Objectives

• Appreciate that the firm's industry forms the core of its external environment and understand that its characteristics and dynamics are essential components of strategy analysis
• Identify the main structural features of an industry and understand how they impact the intensity of competition and overall level of profitability in the industry
• Apply industry analysis to explain the level of profitability in an industry and predict how profitability is likely to change in the future
• Develop strategies that position the firm most favorably in reaction to competition
• Develop strategies that influence industry structure in order to enhance industry attractiveness

Environmental Analysis

• The business environment of the firm consists of all the external influences that impact its decisions and its performance
• Managers should monitor and analyze environmental conditions
• A system or framework for organizing information is needed
• PEST analysis classifies environmental influences by source, considering the political, economic, social, and technological factors that impact a firm

PEST Analysis and Similar Approaches

• PEST analysis and similar approaches to macrolevel environmental scanning are useful in keeping a firm alert - may result in information overload
• Prerequisite for effective environmental analysis is to distinguish the vital from the merely important
• For a firm to make a profit, it must create value for customers, understand its customers, and acquire inputs from suppliers
• To generate profitability depends on the intensity of competition

Core Business Environment

• Formed by relationships with three sets of players: customers, suppliers, and competitors
• This is its industry environment.
• Macrolevel factors: general economic trends, changes in demographic structure, political events, and new technologies are unimportant for strategy analysis
• Identifying and exploiting sources of profit means asking “What determines the level of profit in an industry?"
• For a firm to make profit, it must create value for the customer -- created when the price the customer is willing to pay for a product exceeds the costs incurred by the firm.
• The value created is distributed between customers and producers by the forces of competition.
• The stronger the competition is among producers, the more value is received by customers as consumer surplus (the difference between the price they actually pay and the maximum price they would have been willing to pay) and the less is received by producers (as producer surplus or economic rent).

Profits Earned

Profits earned by the firms in an industry determined by three factors:

• The value of the product to customers
• The intensity of competition
• The bargaining power of industry members relative to their suppliers and buyers
• Industry analysis brings all three factors into a single analytic framework.

Analyzing Industry Attractiveness

• Some industries earn consistently high rates of profit while others fail to cover their cost of capital
• Industry profitability is neither random nor the result of entirely industry-specific influences, rather, it is determined by the systematic influences of the industry's structure
• Industrial organization (IO) economics provides the theory of how industry structure drives competitive behavior and determines industry profitability
• Two reference points are the theory of monopoly and the theory of perfect competition

Monopoly vs Perfect Competition

• Monopoly: A single firm is protected by high barriers to entry
• Perfect Competition: Many firms supply a homogeneous product and there are no entry barriers
• Monopoly and perfect competition form end points of a spectrum of industry structures.
• A monopolist can appropriate as profit the full amount of the value it creates
• Under perfect competition, the rate of profit falls to a level that just covers firms' cost of capital
• Some real-world industries are close to being monopolies, example Microsoft
• Other industries are close to being perfectly competitive, such as the US farm sector, example being industries dominated by a few major companies

Porter's Five Forces Competition Framework

• Michael Porter's five forces of competition framework is the most widely used tool for analyzing competition within industries
• Industry profitability is determined by five sources of competitive pressure
• Five forces of competition include “Horizontal” competition: substitutes, entrants, and established rivals and two sources of "vertical” competition between the power of suppliers and buyers

Competition from Substitutes

• The price that customers are willing to pay for a product depends on the availability of substitute products and the absence of close substitutes means consumers are comparatively insensitive to price (demand is inelastic with respect to price)
• The existence of close substitutes means that customers will switch to substitutes in response to price increases for the product (demand is elastic with respect to price)

Threat of Entry

• If an industry earns a return on capital in excess of its cost of capital, it will attract entry from new firms and established firms diversifying from other industries
• If entry is unrestricted, profitability will fall toward its competitive level
• Beer brewing has seen a flood of new entrants in recent years
• Threat of entry rather than actual entry may be sufficient to ensure competitive price levels
• An industry where no barriers to entry or exit exist is contestable
• Prices and profits tend toward the competitive level, regardless of the number of firms within the industry
• Contestability depends on the absence of sunk costs
• Making an industry is vulnerable to “hit and run" entry whenever established firms raise their prices above the competitive level
• New entrants must surmount barriers to entry: disadvantages that new entrants face relative to established firms determining the height of a barrier to entry

Principal Sources of Barriers to Entry

• Capital Requirements: Set-up costs can be so large as to discourage all but the largest companies
• Economies of Scale: Industries with high capital requirements for new entrants are also subject to economies of scale
• Absolute Cost Advantages: Established firms may have a cost advantage over entrants, irrespective of scale
• Product Differentiation: In an industry where products are differentiated, established firms possess the advantages of brand recognition and customer loyalty
• Access to Channels of Distribution: For many new suppliers of consumer goods, the principal barrier to entry is gaining distribution
• Governmental and Legal Barriers: Some of the most effective barriers to entry are created by government
• Retaliation: Potential entrants may also be deterred by expectations of retaliation by established firms

Importance of Barriers to Entry

• Industries protected by entry barriers tend to earn above-average rates of profit
• The effectiveness of barriers to entry depends on the resources and capabilities that potential entrants possess
• Barriers that are effective against new companies may be ineffective against established firms that are diversifying from other industries.

Rivalry between Established Competitors

• The major determinant of the overall state of competition and the general level of profitability is rivalry among the firms within the industry
• Intensity of price competition between established firms is the result of interactions between six factors:
  • Concentration: Seller concentration refers to the number and size distribution of firms competing within a market -- markets dominated by a single firm.
  • Diversity of Competitors: The ability of rival firms to avoid price competition by coordinating their prices depends on how similar they are in their origins, objectives, costs, and strategies
  • Product Differentiation: The more similar the offerings among rival firms, the more willing are customers to switch between them and the greater is the inducement for firms to cut prices to boost sales
  • Excess Capacity and Exit Barriers: Key is the balance between demand and capacity. Unused capacity encourages firms to offer price cuts to attract new business
  • Cost Conditions: Scale Economies and the Ratio of Fixed to Variable Costs: Where fixed costs are high relative to variable costs, firms will take on marginal business at any price that covers variable costs

Bargaining Power of Buyers

• The profit margin earned by the firms in an industry depends on the prices they can charge their customers.
• Customers will do all they can to exert downward pressure on these prices.
• The ability of buyers to drive down the prices they pay depends upon two factors: their price sensitivity and their bargaining power relative to the firms within the industry:
  • Buyers' Price Sensitivity: The extent to which buyers are sensitive to the prices they are charged depends on importance of the product as a proportion of buyers' total cost, the less differentiated the products of the supplying industry, the more willing are buyers to switch suppliers on the basis of price, the more intense the competition among buyers, the greater their eagerness to obtain preferential terms from their suppliers, the more critical an industry's product to the quality of the buyer's product or service, the less sensitive are buyers to the prices they are charged
  • Relative Bargaining Power: Bargaining power rests, ultimately, on the refusal to deal with the other party -- size and concentration of buyers relative to suppliers; buyers' information, capacity for vertical integration

Bargaining Power of Suppliers

• Analysis of supplier power is precisely analogous to analysis of buyer power
• The only difference is that it is now the firms in the industry that are the buyers and the producers of inputs that are the suppliers
• Relevant factors are the ease with which the firms in the industry can switch between different input suppliers and the relative bargaining power of each party
• Suppliers of commodities tend to lack bargaining power relative to their customers
• They may use cartels to boost their influence over prices.
• Suppliers of complex, technically sophisticated components may be able to exert considerable bargaining power.

Industry Analysis: Forecasting Industry Profitability

• Once we understand how industry structure determines current levels of industry profitability, we can use this analysis to forecast industry profitability in the future.

Identifying Industry Structure

• First stage of any industry analysis is to identify the key elements of the industry's structure
• Requires identifying the main players (producers, buyers, suppliers of inputs, and the producers of substitute goods) followed by distinguishing the key structural characteristics of each that will impact competition and bargaining power

Forecasting Industry Profitability

• Use industry analysis to understand why profitability has been low in some industries and high in others
• Key to predict the future
• Investment decisions will commit resources to an industry for years
• Current profitability is a poor indicator of future profitability
• An industry's profitability is determined by the structure of that industry
• Observations of the structural trends in an industry can be used to forecast likely changes in competition and profitability

To Predict Future Industry Profitability, Analysis Proceeds in 3 Stages

• Examine how the industry's current and recent levels of competition and profitability are a consequence of its present structure
• Identify the trends that are changing the industry's structure
• Identify how these structural changes will affect the five forces of competition and resulting profitability of the industry

Using Industry Analysis to Develop Strategy

• Understanding how industry structure influences competition, which in turn determines industry profitability, to develop firm strategies

Strategies to Alter Industry Structure

• Understanding how the structural characteristics of an industry determine the intensity of competition and the level of profitability provides a basis for identifying opportunities for changing industry structure to alleviate competitive pressures

Positioning the Company

• Requires recognizing and understanding the competitive forces that a firm faces within its industry allows managers
• Allows managers to position the firm where competitive forces are weakest.

Defining Industries

• Key challenge in industry analysis is defining the relevant industry
• The Standard Industrial Classification (SIC) is of limited use in identifying groups of firms that compete with one another.

Industries and Markets

• Economists define an industry as a group of firms that supplies a market
• Industry analysis looks at industry profitability being determined by competition in product markets and input markets
• In everyday usage, the term industry tends to refer to a fairly broad sector, whereas a market refers to the buyers and sellers of a specific product
• The five forces framework is to take account of competitors outside the industry box—either as the suppliers of substitutes or as potential entrants.