Response

CHAPTER 3

External Analysis: The Identification of Opportunities and Threats

LEARNING OBJECTIVES SEQ NL1 \r 0 \h

1 seq NL_a \r 0 \h . Discuss the forces that shape competition in an industry environment.

2. Discuss the strategic importance of each of Porter’s Five Forces, including potential new entrants, degree of rivalry, the power of buyers and suppliers, and the threat of substitutes.

3 seq NL_a \r 0 \h . Describe the concepts of strategic groups and mobility barriers, highlighting their competitive implications.

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LECTURE OUTLINE SEQ NL1 \r 0 \h

I seq NLA \r 0 \h . Overview SEQ NL_a \r 0 \h

A seq NL1 \r 0 \h . For a company to succeed, its strategy must either fit the industry environment in which it operates, or the company must be able to reshape the industry environment in which it operates to its advantage through its choice of strategy. Companies typically fail when their strategy no longer fits the environment in which they operate.

· Example of a strategy to “fit” the environment:

· Canon sees an environmental trend (towards digital imaging and away from chemical processing) and adopts the strategy of diversification (through acquiring a new business that has digital imaging capabilities) to respond to the trend.

· Example of a strategy to “reshape” the environment:

· Walt Disney faced a threatening external condition (powerful buyers—TV stations weren’t interested in playing Disney programming any more). Disney adopted a strategy of vertical integration (they bought several TV stations) to “reshape” the force in their favor.

B seq NL1 \r 0 \h . To achieve a good fit, managers must understand the forces that shape competition in their external environment. This understanding enables them to identify strategic opportunities and threats. Opportunities arise when a company can take advantage of conditions in its environment to formulate and implement strategies that enable it to become more profitable. Threats arise when conditions in the external environment endanger the integrity and profitability of the company’s business.

II seq NLA \r 0 \h . Analyzing Industry Structure

A seq NL1 \r 0 \h . An industry can be defined as a group of companies offering products or services that are close substitutes for each other. Close substitutes are products or services that satisfy the same basic consumer need. Firms within the same industry are rivals, also called competitors.

1 seq NL_a \r 0 \h . A correct industry definition can be the difference between success and failure.

2 seq NL_a \r 0 \h . Managers just define industries based on the customer need (the demand side of the market) and not the products the industry offers (the supply side of the market).

III seq NLA \r 0 \h . Porter’s Five Forces Model

A seq NL1 \r 0 \h . This model was devised by Michael Porter to describe forces that shape competition within an industry and help to identify strategic opportunities and threats. The stronger each of these forces is, the more established companies are limited in their ability to raise prices and earn greater profits. A strong competitive force is a threat because it depresses profits. A weak competitive force is an opportunity because it allows the company to earn greater returns.

See Figure 3.1: Porter’s Five Forces Model

B seq NL1 \r 0 \h . One of Porter’s Five Forces is the risk of entry by potential competitors. Potential competitors are companies that are currently not competing in the industry but have the capability to do so. New entry into an industry expands supply. This in turn depresses prices and profits. Thus a high risk of new entry constitutes a strategic threat. A low risk of new entry allows established companies to raise their prices, so it constitutes an opportunity. seq NL_a \r 0 \h The risk of entry by potential competitors is a function of the height of barriers to entry. The height of barriers to entry is determined by several factors.

1 seq NL_a \r 0 \h . Potential competitors are also discouraged when established companies have economies of scale—that is, when established companies are able to produce at a lower cost than the new entrants due to their larger size and greater experience.

· As companies produce more and more product, the unit cost of each product goes down. Established companies can have substantially lower unit costs than a potential new entrant. This fact discourages entry by the new competitor.

2 seq NL_a \r 0 \h . The extent to which established companies have brand loyalty from their customers is one factor. Loyal customers would discourage potential competitors.

· A new entrant would have to do things like providing deep discounts, giving out free samples, mass market ad campaigns, etc. These things cost money and there is no guarantee that the brand loyal customers will be lured away.

3 seq NL_a \r 0 \h . Potential competitors are also discouraged when established companies enjoy an absolute cost advantage over potential entrants. Cost advantages might include factors such as patents, control of a specific raw material, or access to cheaper funds.

4 seq NL_a \r 0 \h . When customer switching costs—that is, costs that accrue to a consumer that intends to switch from the product offering of an established company to the product offering of a new entrant—are high, potential new entrants are discouraged.

· Here, don’t just think of dollars and cents costs. It includes the entire “hassle factor” of making the switch. Some of the hassles include: dealing with a new provider, learning to use the new technology, switching over your account information online, etc.

5 seq NL_a \r 0 \h . Government regulation, such as establishing a protected monopoly, tends to protect established firms, and thus constitutes a barrier to entry. When industries are deregulated, new entrants usually proliferate.

· I once lived in Cedar Key, FL. Back in the early 1990’s the government outlawed in-shore net fishing. This law was not that big of a deal for most commercial fishermen because they did their fishing further than 3 miles out to sea. The ban was restricted to fishing within 3 miles from shore. Unfortunately, Cedar Key fishermen made their living harvesting fish within the 3 mile range and the ban hurt them very badly. In response, the government opened up a program for these displaced fishermen and taught them how to harvest clams. Each “claimant” was then given a lease on a 1 acre parcel of underwater land on which they could start their clamming operation. The clams were grown, harvested and sold. The demand for them was huge because (for whatever reason) these clams had a very unique taste. These fishermen, now in the clamming business, started to make a lot of money. Once that happened, people around town started to say, “I want to do that too!” However, they could not enter the business because of government regulations. These 1 acre plots were only given to those that went through the hoops early on to get into the program. No further entry was allowed.

C seq NL1 \r 0 \h . Another of Porter’s Five Forces is rivalry among established companies. Strong rivalry tends to lower prices and raise costs, which constitutes a threat to established companies, whereas weak rivalry creates an opportunity to earn greater returns. The extent of rivalry among established firms depends on several factors.

1 seq NL_a \r 0 \h . One factor is industry competitive structure, which refers to the number and size distribution of companies within an industry. Structures vary from fragmented (made up of many small- and medium-sized companies) to consolidated (dominated by a small number of large companies). Different competitive structures have different implications for rivalry.

a seq NL_1_ \r 0 \h ) Many fragmented industries are characterized by low entry barriers and commodity-type products that are hard to differentiate. These characteristics tend to result in boom-and-bust cycles, with a flood of new entrants, excess capacity, and price wars, leading to low industry profits and exit from the industry. The more commodity-like an industry’s product, the more vicious will be the price war. The “bust” part of the cycle will continue until overall industry capacity is brought into line with demand (through bankruptcies), at which point prices may stabilize again.

· Does anyone remember the video rental business in the 1980’s? I do. I had purchased my VCR and went to the local video rental business down the street to go rent some movies. In order to do that, I had to pay a $125 “initiation fee” to the store. This got me in the club. I then had to pay a $20 per month “maintenance fee.” This kept me in the club. Finally, each movie was $5 per movie/night. Now, even as teenager, I thought, “hmmm... This place can’t cost more than a few hundred a month to rent….and all you need is a collection of used movies to rent out to people….and the man behind the counter is probably not being paid very much…and I just plunked down $150!.....I should get into this business!!”

· Consider also that “video rental” is a commodity-like product. That is, once all the video rental stores have the movies that people want to see, the only way to really compete with each other is through price.

· So, in this business you had low entry barriers (all that’s needed is a leased space, a collection of used movies, and a person to run the store) and the product was a commodity—the only way to lure customers is through price.

· Fast forward 6 months. Our little town had literally a dozen video rental stores. The last time I signed up at one of these stores to rent movies, I was not charged any fees. In fact, I was given a free gift (3 free movie rentals) just for signing up! The lowest I remember ever paying for movie rentals was $.99 for FIVE movies—all Five for $.99! Why did it get so cheap? Stores were everywhere and they would rather hand me five movies for 99 cents than have nothing. A “bust” ensued, as the industry became very unprofitable. Out of the ashes, 1 or 2 stores remained and prices started to go up again. Pretty soon, prices get high enough and people start to think, “hmmm…this space can’t cost too much to lease, all I need are some used movies to rent out, and the man behind the counter can’t make that much…etc.” The process starts again.

· Note that the issue is not the fact that the industry is fragmented per se—it is the underlying factors (low entry barriers, commodity like products, and excess capacity) that are the drivers of the “boom and bust cycles.”

b seq NL_1_ \r 0 \h ) Consolidated industries are interdependent, so that the competitive actions of one company directly affect the profitability of competitors, forcing a response from them. seq NL_1_ \r 0 \h The consequence can be price wars like those the airline industry has experienced. Thus interdependence is a major threat. This threat can be reduced when tacit price-leadership agreements exist within the industry and when companies are successful in emphasizing nonprice competition.

· Don’t get lulled into the thinking of “well, if fragmented industries are a threat then consolidated industries must be an opportunity.” That MAY be true, but it is far from guaranteed. We will be discussing this issue in a future chapter. For now, just think of it like this. If you are in a consolidated industry, you might be competing with 3-4 other major players. Since it is only just the 4-5 of you, it is easier to “tacitly collude,” in ways that keep the price of the product or service you are providing high. This might work for a while. This is what the U.S. automakers were doing for decades. Life was good. They just let the high-cost firm in the industry set their price and then all the others set theirs. If the high cost (not price—cost) provider of automobiles made a profit, this meant that all the others made that much more! Great deal for all! Also, there was no reason to become efficient in this environment—they just passed the costs onto the consumers. This worked great for them until Toyota and other overseas manufacturers entered. These manufacturers didn’t play this game and they had much lower costs and higher quality. The U.S. manufacturers experienced major losses and you are still reading about the effects to this day.

2 seq NL_a \r 0 \h . Demand conditions also determine the intensity of rivalry among established companies. Growing demand moderates competition by providing room for expansion. Declining demand results in more competition as companies fight to maintain revenues and market share.

3 seq NL_a \r 0 \h . Cost conditions are another determinant of rivalry between firms. High fixed costs lead to a focus on volume of sales in order to cover these costs. This focus on volume can spark intense rivalry if demand is weakening and too many firms are involved in providing the same products. This situation will prompt firms in the industry to lower prices in order to capture sufficient sales to cover costs.

4 seq NL_a \r 0 \h . Exit barriers are a serious competitive threat, especially when demand is declining. Economic, strategic, and emotional factors can keep companies competing in an industry even when returns are low. This in turn leads to excess capacity and price wars. seq NL_a \r 0 \h Exit barriers include:

a seq NL_1_ \r 0 \h ) investments in specialized assets

b seq NL_1_ \r 0 \h ) high fixed costs of exit such as severance pay

c seq NL_1_ \r 0 \h ) emotional attachments to an industry

d seq NL_1_ \r 0 \h ) economic dependence on a single industry

e seq NL_1_ \r 0 \h ) the need to maintain expensive assets in order to compete effectively in that industry

f) bankruptcy regulations that allow enterprises to continue operating under protection

I want to make a very important distinction before you read further on buyer and supplier power. Let’s look at the value-added chain for soft drinks. I say “value-added” chain because value is added at each stage of the process. It looks like this:

Raw Materials( Concentrate Producers(Bottlers(Supermarkets, Restaurants, etc( End user

Now, pretend that you are Coca-Cola. You are a “concentrate producer.” You buy things from suppliers, like sugar, that go into the production of your concentrate. YOUR RELATIONSHIP WITH THE SUGAR PRODUCERS IS THE FOCUS OF SUPPLIER POWER. That is, in analyzing “supplier power” you are looking at who has the power in the relationship. Is it the concentrate producers (i.e., Coca-Cola)? Or is it the sugar producers?

When looking at BUYER POWER, you would examine the relationship between concentrate producers (Coca-Cola) and the BOTTLERS. It is a totally different relationship! Now, with that in mind, see below to determine some of the factors that might make your suppliers (or your buyers) a threat.

D seq NL1 \r 0 \h . A third factor in Porter’s Five Forces Model is the bargaining power of buyers. Buyers can be individual consumers, other businesses, wholesalers, or retailers. Buyers can be viewed as a competitive threat when they force down prices or when they raise expenses by demanding higher quality and better service. The ability of buyers to make demands on a company depends on their power relative to that of the company. Buyers tend to be powerful when:

1 seq NL_a \r 0 \h . they are in industries that are more highly consolidated than the company’s industry

2 seq NL_a \r 0 \h . they purchase in large quantities or constitute a significant buyer for that industry

3 seq NL_a \r 0 \h . buyers can easily switch to a substitute product or an alternate supplier

4 seq NL_a \r 0 \h . buyers can readily produce the product themselves

E seq NL1 \r 0 \h . A fourth factor is the bargaining power of suppliers. Suppliers are any organization that supplies materials, services, or labor (such as labor unions) to the company. Suppliers are a threat when they are able to force up the price the company must pay for inputs or to reduce the quality of goods supplied. The ability of suppliers to make demands on a company depends on their power relative to that of the company. Suppliers tend to be powerful when:

1 seq NL_a \r 0 \h . the supplier’s product has no substitutes or is vital to the company

2 seq NL_a \r 0 \h . the company is not important to the supplier

3 seq NL_a \r 0 \h . the company has a switching cost to change suppliers

4 seq NL_a \r 0 \h . suppliers can readily enter the company’s industry

5 seq NL_a \r 0 \h . the company cannot readily enter the supplier’s industry

F seq NL1 \r 0 \h . A fifth factor is the threat of substitute products. The existence of adequate substitute products limit the price that companies in an industry can charge without losing their customers to makers of substitutes. The threat of substitutes tends to be greater when:

1 seq NL_a \r 0 \h . the substitute is a close one, equally adequate in filling customers’ needs

2 seq NL_a \r 0 \h . the price of the substitute is equal to or less than the company’s products

· Be careful here. In our everyday language we think of “substitute products” a bit differently. We might say that “using UPS is a substitute for using Federal Express—or, Coca Cola and Pepsi are substitutes.” This is not correctly analyzing the competitive force of substitute products. The friction between Coca-Cola and Pepsi would best be analyzed under “rivalry.” The “force” of substitute products we are talking about here cross industry boundaries. For example, sending an email is a substitute for air express service. Sending a fax is a substitute. Dropping the document in the mail is a substitute. There are lots of substitutes for air express service. What effect does this have? It keeps a lid on the price that companies can charge for the service.

IV seq NLA \r 0 \h . Strategic Groups Within Industries

A seq NL1 \r 0 \h . A strategic group is a group of companies within an industry that are pursuing the same basic strategy as the companies within the group, but different strategies than those of companies outside the group. The strategies may be based on a variety of factors, such as differences in quality, market segment served, or distribution channel utilized. Normally, a limited number of strategic groups capture the essence of strategic differences among companies within an industry.

See Figure 3.2: Strategic Groups in the Pharmaceutical Industry

B seq NL1 \r 0 \h . Strategic groups have several implications for internal analysis.

1 seq NL_a \r 0 \h . A company’s immediate competitors are those in its strategic group. Because all companies in a strategic group are pursuing similar strategies, consumers tend to view the products of such enterprises as direct substitutes for each other.

2 seq NL_a \r 0 \h . Different strategic groups can have a different standing with respect to the threats and opportunities they face from each of Porter’s five competitive forces. seq NL_1_ \r 0 \h Some strategic groups are more desirable than others, insofar as they are characterized by a lower level of threats and/or by greater opportunities.

3 seq NL_a \r 0 \h . Mobility barriers are factors that inhibit movement between groups. They are analogous to industry entry barriers and are based on the same factors: brand loyalty, absolute cost advantages, and economies of scale. Mobility barriers make it difficult for companies to move into another strategic group, and they also protect group members from entry by companies from other groups.

The rest of the chapter will be discussed next week.