Firm Overview Assignment
44 Part l Introduc tion to Strategic Management
potential competitors Companies tha t are currently not competing in the ind ustry but have the potential to do so.
Figure 2. l Competitive Forces
Ba rgaini ng pow er
of ...... supp liers
Risk of entry
1 Riv al ry amo ng
established firms in industry
Bargai ning ...... power
of buyers
I ' Threat of substitutes
Power o f complement
p roviders
Source: Based on "How Competitive Forces Shape Strategy," by Michael E. Porter, Harvard Business Review, March/ April 1979.
profits. T he strength of the six fo rces may change over time as industry conditions cha nge. Managers face the task of recognizing how cha nges in the six forces give rise to new opportunities and threats, a nd fo rmulating appropriate strategic responses. In addition, it is possible for a company, through its choice of strategy, to alter the strength of one or more of the forces to its advantage. T his is discussed in the follow- ing chapters.
2-3a Risk of Entry by Potential Competitors Potential competitors are companies that are not currently competing in an industry but have the capability to do so if they choose. For example, in the last decade, cable television companies emerged as potential competitors to traditional phone compa- nies. New digital technologies have allowed cable companies to offer telephone and Internet service over the same cables that transmit television shows.
Established companies already operating in an industry often attempt to discour- age potential competitors fro m entering the industry because their entry makes it more difficult for the established companies to protect their share of the market and generate profits. A high risk of entry by potential competitors represents a threat to the profitability of established companies. T he risk of entry by potential competitors is a function of how attractive the industry is (for example, how profitable or growing the industry is), and the height of barriers to entry (that is, those factors that make it costly for companies to enter an industry).
The greater the costs potential competitors must bear to enter an industry, the greater the barriers to entry and the weaker this competitive force. High entry barri- ers may keep potential com petitors out of an industry even when industry profits are
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C ha pter 2 External Analysis : The Identificatio n of Opportu nities and Threats 45
high. Important barriers to entry include economies of scale, brand loyalty, absolute cost advantages, customer switching costs, and government regulation. 2 An important strategy is building barriers to entry (in the case of incumbent firms) or finding ways to circumvent those barriers (in the case of new entrants). We discuss this topic in more detail in subsequent chapters.
Economies of Scale Economies of scale arise when unit costs fall as a firm expands its output. Sources of scale economies include: (I) cost reductions gained through mass- producing a standardized output; (2) discounts on bulk purchases of raw material inputs and component parts; (3) the advantages gained by spreading fixed production costs over a large production volume; and (4) the cost savings associated with distrib- uting, marketing, a nd advertising costs over a large volume of output. For example, the economies of scale enjoyed by incumbent firms in the airline industry a re fairly large and include the ability to cover the fixed costs of purchasing aircraft. This con- stitutes a barrier to new entry into the market. More generally, if the cost advantages from economies of scale are significant, a new company that enters the industry and produces on a small scale suffers a significant cost disadvantage relative to established companies. If the new company decides to enter on a la rge scale in an attempt to obtain these economies of scale, it must raise the capital required to build la rge-scale production facilities and bear the high risks associated with such an investment. In addition, an increased supply of products will depress prices and result in vigorous retaliation by established companies, which constitutes a further risk of la rge-scale entry. For these reasons, the threat of entry is reduced when established companies achieve economies of scale.
Brand loyalty Brand loyalty exists when consumers have a preference for the prod- ucts of established companies. A company can create brand loyalty by continuously advertising its brand-name products and company name, patent protection of its products, product innovation achieved through compa ny research and development (R&D) programs, an emphasis on high-quality products, a nd exceptional after-sales service. Significant brand loyalty makes it difficult for new entrants to take ma rket share away from established companies. Thus, it reduces the threat of entry by poten- tial competitors; they may see the task of breaking down well-established customer preferences as too costly. In the smartphone business, for example, Apple generated such strong brand loyalty with its iPhone offering and related products that Micro- soft found it very difficult to attract customers away from Apple and build demand for its Windows phone, introduced in late 2011. Despite its financial might, 5 years after launching the Windows phone, Microsoft's U.S. market share remained mired at under 4%, and in 2016 it exited the market.3
Absolute Cost Advantages Sometimes established compa nies have an absolute cost advantage relative to potential entrants, mea ning that entrants cannot expect to match the established companies' lower cost structure. Absolute cost advantages a rise from three main sources: (1) superior production operations and processes due to accumu- lated experience, patents, or trade secrets; (2) control of particular inputs required for production, such as labor, materials, equipment, or management skills, that are limited in supply; and (3) access to cheaper funds because existing companies represent lower risks than new entrants. If established compa nies have a n absolute cost advantage, the threat of entry as a competitive force weakens.
economies of scale Reductions in unit costs attributed to large output
brand loyalty Preference of consu mers for the products of established com panies.
absolute cost advantage A cost advan tag e tha t is en joyed by incumbents in an industry and tha t new entrants cannot expect to match.
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46 Part l Introduction to Strategic Management
switching costs Costs that consumers must bear to switch from the p ro ducts offered by o ne establi shed company to the produc ts offered by a new entra nt.
Customer Switching Costs Switching costs arise when a cust omer invests time, energy, and money switch ing from t he products offered by one established company to the prod ucts offered by a new entrant. When switching costs are high, custom- ers can be locked in to the product offerings of established companies, even if new entrants offer better products.4 A fam iliar example of switching costs concerns the costs associated with switching from one computer operating system to another. If a person currently uses Microsoft's Windows operating system and has a library of related software applications a nd document fi les, it is expensive for that person to switch to another computer operating system. To effect the change, this person would need to purchase a new set of software applications and convert all existing document files to the new system's format. Faced with such a commitment of money and time, most people are unwilling to make the switch unless the competing operating system offers a substantial leap forward in performance. Thus, the higher the switching costs, the higher the barrier to entry for a company attempting to promote a new computer operating system.
Government Regulations Government regulations can constitute a maj o r entry barrier for many industries. For example, until the mid- I 990s, U.S. government regulations prohibited provider s of long-distance telephone service from compet- ing for local telephone service, and vice versa. O ther potential providers of tele- phone service, including cable television service companies such as Time Warner and Comcast (which could have used their cables to carry telephone traffic as well as TV signals), were prohibited from entering the market altogether. These regula- tory barriers to entry significantly reduced the level of competition in both the local and long-dis tance telephone markets, enabling telep hone companies to earn higher profits than they might have otherwise. All this changed in 1996, when the gov- ernment significantly deregulated the industry. In the months that followed, local, long-distance, and cable TV companies all announced their intention to enter each other 's markets, and a host of new players entered the ma rket as well. The competi- tive forces model predicts that falling entry barriers due to government deregula- tion will result in significant new entry, an increase in the intensity of industry competition, and lower industry profit rates, a nd that is what occurred here. As described in the Opening Case, the same also happened in the U.S. airline industry following deregulation in 1978.
Summary In summary, if established companies have built brand loyalty for their products, have an absolute cost advantage over potential competitors, have signifi- cant scale economies, are the beneficiaries of high switching costs, or enjoy regula- tory protection, the risk of entry by potential competitors is greatly diminished ; it is a weak competitive force. Consequently, established companies can charge higher prices, and industry profits are therefore higher. Evidence from academic research suggests that the height of barriers to entry is one of the most important determi- nants of profit rates within an industry. 5 Clea rly, it is in the interest of established companies to pursue strategies consistent with raising entry barriers to secure these profits. Additionally, potential new entrants must find strategies that a ll ow them to circumvent barriers to entry. For an example of a company that did this, see Strategy in Action 2.1, which looks at how the Cott Corporation circumvented barriers to entry in the soft-drink industry.
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Chapter 2 External Analysis : The Identification of Opportunities and Threats 47
2.1 STRATEGY IN ACTION Circumventing Entry Barriers into the Soft Drink Industry Two companies have long dom inated the carbonated soft d rink industry: Coca-Cola and PepsiCo. By spend- ing la rge sums o f money on advertising and promotion, these two giants have c reated sign ificant brand loya lty and made it very difficu lt for new competitors to enter the industry and take away market sha re. When new competitors have tr ied to en ter, both compan ies have responded by cutting prices, forcing new entrants to cu rtai l expa nsion p lans.
However, in the early 1990s, the Cott Corporation , then a small Canadian bottli ng com pany, worked out a strategy for enteri ng the carbonated soft drink market. Colt's strategy was deceptively si mple. The company initially focused o n the cola segment o f the market. Cott struck a dea l with Roya l Crown (RC) Cola fo r exclusive globa l rights to its cola concentrate. RC Co la was a sma ll player in the U.S. cola market. Its products were recognized as high qual ity, but RC Cola had never been able to effectively challenge Coke or Peps i. N ext, Cott entered an agreement with a Canad ian grocery retai ler, Loblaw, to provide the retai ler with its own , priva te-label b ran d o f cola. The Loblaw private-label brand, known as "President's Choice," was priced low, became very successful , and took shares from both Coke and Pepsi .
Emboldened by this success, Cott tried to convince other retai lers to carry private-lab el co la. To retai lers, the val ue pro position was simple b ecause, unlike its major riva ls, Cott spent a lmost nothing on adverti sing and promotion. This constituted a ma jor sou rce of cost savings, which Cott passed on to retai lers in the fo rm
of lower p rices. Retai lers found that they could signifi- cantly undercut the price o f Coke and Pepsi colas and still make better profit margins on private-label brands than on branded colas.
Despite this compelling value proposition, few re- tailers were w i lli ng to sell private-lab el colas for fear of alienati ng Coca-Cola and Pepsi, whose products were a major draw for grocery store traffic. Colt's break- through came when it signed a dea l with Wa l-Mart to supply the retailing giant with a private-label cola , "Sam's Choice" (named after Wal-Mart founder Sam Walton ). Wal-Mart proved to be the perfect distribution channel for Cott. The retailer was just beginning to ap- pear in the grocery business, and consumers shopped at Wal-Mart not to buy branded merchandise, but to get low prices. As Wa l-Mart's grocery business g rew, so d id Colt's sa les. Cott soon added other flavors to its offerings, such as lemon-lime soda, which would compete w ith 7-Up and Spr ite. Moreover, by the late 1990s, other U.S. grocers pressured by Wal-Mart had also started to introduce private-label sodas and often turned to Cott to supply their needs.
By 2017, Colt's private-label customers included Wal-Mart, Kroger, Costco, and Safeway. Cott had rev- enues of $3.8 bi llion and accounted for 60% of all private-label sales of carbonated beverages in the Unit- ed States, and 6 to 7% o f overall sales of carbonated beverages in grocery stores, its core channel. A lthough Coca-Cola and PepsiCo remain dominant, they have lost i ncrementa l market share to Cott and other compa- nies that have followed Colt's strategy.
Sources: A. Kaplan, "Colt Corporation," Beverage World, June 15, 2004, p. 32; J. Popp, "2004 Soft Drink Report," Beverage Industry, t\l\arch 2004, pp. 13- 18; L. Sparks, "From Coco-Colonization to Copy Colting: The Colt Corporation ond Retailers Brand Soft Drinks in the UK and US," Agribusiness 13:2 lt\l\arch 19971: 153- 167; E. Cherney, "After Flot Soles, Colt Challenges Pepsi, Coco-Colo," The Woll Street Journal, January 8, 2003, pp. B 1, B8; "Colt Corporation Company Profile," Just Drinks, August 2006, pp. 19- 22; Colt Corp. 2016 Annual Report, www.colt.com.
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48 Part l Introduction to Strategic Management
2-3b Rivalry Among Established Companies The second competitive force is the intensity of rivalry among established companies within an industry. Rivalry refers to the competitive struggle between companies within an indus- try to gain market share. The competitive struggle can be fought using price, product design, advertising and promotional spending, direct-selling efforts, and after-sales service and support. Intense rivalry implies lower prices or more spending on non-price-competitive strategies, or both. Because intense rivalry lowers prices and raises costs, it squeezes profits out of an industry. Thus, intense rivalry among established companies constitutes a strong threat to profitability. Alternatively, if rivalry is less intense, companies may have the op- portunity to raise prices or reduce spending on non-price-competitive strategies, leading to higher industry profits. Four factors have a major impact on the intensity of rivalry among established companies within an industry: (1) industry competitive structure, (2) demand conditions, (3) cost conditions, and (4) the height of exit barriers in the industry.
Industry Competitive Structure The competitive structure of an industry refers to the number and size distribution of companies within it. Strategic managers determine the competitive structure at t he beginning of an industry analysis. Industry structures vary, and different structures have different implications for the intensity of rivalry. A fragmented industry consists of a large number of small or medium-sized companies, none of which is in a position to determine industry price. A consolidated ind ustry is dominated by a small number of large companies (an oligopoly) or, in extreme cases, by just one company (a monopoly), and such companies often are in a position to determine industry prices. Examples of fragmented industries are agriculture, dry cleaning, health clubs, real estate brokerage, and sun-tanning parlors. Consolidated industries include the aerospace, soft-drink, wireless service, and small-package express delivery indust ries. In the small-package express delivery industry, two firm s, United Parcel Service (UPS) and FedEx, account for over 85% of industry revenues in the United States.
Low-entry barriers and commodity-type products that are difficult to differentiate characterize many fragmented industries. This combination tends to result in boom-and- bust cycles as industry profits rapidly rise and fall. Low-entry barriers imply that new entrants will flood the market, hoping to profit from the boom that occurs when demand is strong and profits are high. The number of video stores, health clubs, and tanning par- lors that exploded onto the market during the 1980s and 1990s exemplifies this situation.
Often, the flood of new entrants into a booming, fragmented industry creates ex- cess capacity, and consequently companies cut prices. The difficulty of differentiat- ing their products from t hose of competitors can exacerbate this tendency. The result is a price war, which depresses industry profits, forces some companies out of busi- ness, and deters potential new entrants. For example, after a decade of expansion and booming profits, many health clubs are now finding t hat they have to offer large discounts in order to maintain their memberships. In general, the more commodity- like an industry's product, the more vicious the price war will be. The bust phase of this cycle continues unti l overall industry capacity is brought into line with demand (through bankruptcies), at which point prices may stabilize again .
A fragmented industry structure, then, constitutes a threat rather than an opportunity. Economic boom times in fragmented industries are often relatively short-lived because the ease of new entry can soon result in excess capacity, which in tum leads to intense price competition and the failure of less-efficient enterprises. Because it is often difficult to dif- ferentiate products in these industries, minimizing costs is the best strategy for a company that strives to be profitable in a boom and survive any subsequent bust. Alternatively,
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C ha pter 2 External A nalysis : The Identificatio n of Opportu ni ties and Threats 49
companies might try to adopt strategies that change the underlying structure of frag- mented industries and lead to a consolidated industry structure in which the level of in- dustry profitability is increased. f'Ne shall consider how companies can do this in later chapters.)
In consolidated industries, companies are interdependent because one company's competitive actions (for insta nce, changes in price or quality) directly affect the market sha re of its rivals and thus their profitability. One compa ny making a move can force a response from its rivals, and the consequence of such competitive interdependence can be a d angerous competitive spiral. Rivalry increases as companies attempt to undercut each other's prices or offer customers more value, pushing industry profits down in the process.
Companies in consolidated industri es som etimes seek to reduce this threat by m atching the prices set by the dominant company in the industry.6 H owever, care must be ta ken, for explicit, face-to-face, price-fixing agreem ents are illegal. (Tacit, indirect agreements, a rrived at wi tho ut direct or intentiona l communication , a re legal.) For the most pa rt, though , companies set prices by watching, interp reting, anticipating, a nd responding to one another's strategies. H owever, tacit price-lea dership agreements often break d own under adverse economic conditions, as occurred in the breakfas t cereal industr y, profiled in Strategy in Action 2.2.
Industry Demand The level o f industry demand is ano ther determinant of the inten- sity of rivalry/among established compa nies. Growing dem and from new customers or a dditional purchases by existing customers tend to m oderate competition by provid- ing greater scope for companies to compete fo r customers. G rowing demand tends to reduce rivalry because a ll companies can sell more witho ut ta king ma rket share away from other compa nies. High industry profits a re often the result. This was the case in the U.S. wireless telecommunications industry until recently. Conversely, stagnant or d eclining demand results in increased rivalry as com panies fi ght to maintain ma rket share and revenues (see Strategy in Action 2.2) . D em and stagnates when the m arket is saturated a nd replacement demand is not enough to offset the lack of first-time buy- ers. D em and declines when customers exit the marketplace, or when each customer purchases less. When dema nd is stagnating or declining, a company can grow only by ta king ma rket sha re away from its rivals. Stagna nt or declining demand constitutes a threat because for it increases the extent of rivalry between established compa nies.
Cost Conditions The cost structure of firms in an industry is a third determinant of rivalry. In industries where fixed costs are high, profitability tends to be highly leveraged to sales volume, and the desire to grow volume can spark intense rivalry. Fixed costs are costs that must be paid before the firm makes a single sale. For example, before they can offer service, cable TV companies must lay cable in the ground; the cost of doing so is a fixed cost. Similarly, to offer express cou rier service, a company such as FedEx must first invest in planes, package-sorting facilities, and delivery trucks- all fixed costs that require significan t capital investmen t. In industries where the cost of production is high, firms cannot cover their fixed costs and will not be profitable if sales volume is low. T hus, they h ave an incentive to cut their prices and/or increase promotional spending to drive up sales volume in order to cover fixed costs. In situations where demand is not rapidly growing and many companies are simultaneously engaged in the same pursuits, the result can be intense rivalry and lower profits. Research suggests that the weakest firms in an industry often initiate such actions precisely because they are struggling to cover their fixed costs.7
Exit Barriers Exit barriers are economic, strategic, and emotional factors that pre- vent com panies from leaving a n industry. 8 If exit barriers are high, companies become
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50 Part l Introduction to Strategic Management
2.2 STRATEGY IN ACTION Price Wars in the Breakfast Cereal Industry For decades, the breakfast cereal industry was one of the most profitable in the United States. The industry has a consolidated structure dominated by Kellogg's, Genera l Mills, and Kraft Foods with its Post brand. Strong brand loyalty, coupled wi th control over the al- location of supermarket shelf space, helped to limit the potential for new entry. Meanwhile, steady demand growth of about 3% per annum kept industry revenues expanding . Ke llogg 's, which accounted for over 40% of the market share, acted as the price leader in the industry. Every year, Kellogg's increased cereal prices, its riva ls fol lowed, and industry profits remained high.
This favorable industry structure began to c hange in the 1990s, when growth in demand slowed -and then stagnated -as a latte and bagel or muffin replaced cereal as the American morning fare. Then came the rise of powerful discounters such as Wal-Mart (which entered the grocery industry in 1994) that began to ag- gressively promote their own cereal brands and priced them signi fica ntly below the brand-name cereals. As the decade progressed , other grocery cha ins such as Kroger's started to follow su it, and brand loyalty in the industry began to decline as customers realized that a $2.50 bag of wheat flakes from Wal-Mart tasted about the same as a $3.50 box of cornflakes from Kellogg's. As sales of c heaper, store-bra nd cereals began to take off, supermarkets, no longer as dependent on brand names to bring traffic into th eir stores, began to demand lower prices from th e branded cereal manufacturers .
For several years, manufacturers o f brand-name ce- reals tried to hold out against these adverse trends, but in the mid-1990s, the da m broke. In 1996, Kraft (then owned by Philip Morris) aggressively cut prices by 20% for its Post brand in an attempt to gain market share. Kel- logg's soon followed with a 19% price cu t on two-thirds of its brands, and General Mills quickly did th e same. The decades of taci t price collusion were official ly over.
If breakfast cerea l companies were hoping that price cuts would stimulate demand, they were wrong .
Instead , demand rema ined flat while revenues and margins followed price decreases, and operating mar- gins at Kellogg's dropped from 18% in 1995 to 10.2% in 1996-a trend also experienced by the other brand- name cereal manufacturers.
By 2000, conditions had worsened. Private-label sales continued to make inroads, gaining over 10% of the market. Moreover, sales of breakfast cereals start- ed to contract at 1 % per annum. To cap it off, an ag- gressive General Mi lls continued to launch expensive price-and-promotion campaigns in an attempt to take away share from the market leader. Kellogg's saw its market share slip to just over 30% in 2001 , behind the 31 % now held by General Mills. For the first time since 1906, Kellogg 's no longer led the market. Moreover, profits at all th ree major producers remained weak in the face of continued price discounting.
In mid-2001 , General Mills final ly blinked and raised prices a modest 2% in response to its own rising costs . Competitors followed , signa ling -perhaps-that after a decade of costly price warfare, pricing discipline might once more emerge in the industry. Both Kellogg 's and General Mills tried to move further away from price competition by focusing on brand extensions, such as Special K conta ining berries and new varieties of Cheerios . Efforts w ith Special K helped Kellogg 's recap- ture market leadership from General Mills, and, more important, the renewed emphasis on non-p rice competi- tion halted years of damaging price warfare.
After a decade of relative peace, price wars broke out in 2010 once more in this industry. The trigge r, yet again, appears to have been falling demand for breakfast cereals due to substitutes such as a quick trip to th e local coffee shop. In the third quarter of 20 10, prices fell by 3 .6 % and un it volumes by 3.4%, leading to falling profit rates at Kellogg ' s. Both General Mills and Kellogg 's introduced new products in an attempt to boost demand and raise prices.
Sources: G . Morgenson, "Denial in Battle Creek," Forbes, October 7, 1996, p . 44; J. Muller, "Thinking out of the Cereal Box," Business Week, January 15, 2001, p. 54; A. Merrill, "General Mills Increases Prices," Star Tribune, June 5, 2001, p. l D; S. Reyes, "Big G, Kellogg's Attempt to Berry Each O ther," Brandweek, October 7, 2002 , p . 8; M . Andrejczak, "Kellogg's Profit Hurt by Cereal Price War," Market Watch, November 2, 2010.
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Chapter 2 External Analysis : The Identificatio n of Opportu nities and Threats 51
locked into an unprofitable industry where overall demand is static or declining. The result is often excess productive capacity, leading to even more intense rivalry and price competition as companies cut prices, attempting to obtain the customer orders needed to use their idle capacity and cover their fixed costs. 9 Common exit barriers include:
• Investments in assets such as specific machines, equipment, or operating facilities that are of little or no value in alternative uses, or cannot be later sold. If the com- pany wishes to leave the industry, it must write off the book value of these assets.
• High fixed costs of exit such as severance pay, health benefits, or pensions that must be paid to workers who are being made laid off when a company ceases to operate.
• Emotional attachments to an industry, such as when a company's owners or em- ployees are unwilling to exit an industry for sentimental reasons or because of pride.
• Economic dependence because a company relies on a single industry for its entire revenue and all profits.
• The need to maintain an expensive collection of assets at or above a minimum level in order to participate effectively in the industry.
• Bankruptcy regulations, particularly in the United States, where Chapter 11 bank- ruptcy provisions allow insolvent enterprises to continue operating and to reorga- nize under this protection. These regulations can keep unprofitable assets in the industry, result in persistent excess capacity, and lengthen the time required to bring industry supply in line with demand (see the Opening Case for an example).
As an example of exit barriers and effects in practice, consider the small-package express mail and parcel delivery industry. Key players in this industry such as FedEx a nd UPS rely entirely upon the delivery business for their revenues and profits. They must be able to guarantee their customers that they will deliver packages to all major localities in the United States, and much of their investment is specific to this pur- pose. To meet this guarantee, they need a nationwide network of air routes and gro und routes, an asset that is required in order to participate in the industry. If excess capac- ity develops in this industry, as it does from time to time, FedEx cannot incrementally reduce or minimize its excess capacity by deciding not to fly to and deliver packages in Miami, for example, because that portion of its network is underused. If it did, it would no longer be able to guarantee to its customers that packages could be delivered to all major locatio ns in the U nited States, and its customers would switch to a nother carrier. Thus, the need to maintain a nationwide network is an exit barrier that can result in persistent excess capacity in the air-express industry during periods of weak demand.
2-3c The Bargaining Power of Buyers The third competitive force is the bargaining power of buyers. An industry's buyers may be the individual customers who consume its products (end-users) or the com- panies that distribute a n industry's products to end-users such as retailers a nd whole- salers. For example, although soap powder made by Procter & Gamble (P&G) and U nilever is consumed by end-users, the principal buyers of soap powder are supermar- ket chains and discount stores, which resell the product to end-users. The bargaining power of buyers refers to their ability to bargain down prices charged by companies in the industry, or to raise the costs of companies in the industry by demanding better product quality and service. By lowering prices and raising costs, powerful buyers can squeeze profits out of an industry. Powerful buyers, therefore, should be viewed as a threat . Alternatively, when buyers are in a weak bargaining position, companies in an
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