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Ling. Eks
Ling. Eks
The Identification of
Opportunities and Threats
3
C H A P T E R O U T L I N E
L E A R N I N G O B J E C T I V E S
After reading this chapter you should be • Discuss how industries evolve over
able to: time, with reference to the industry life
• Review the main technique used to ana- cycle model.
lyze competition in an industry environ- • Show how trends in the macro-
ment, the five forces model. environment can shape the nature
• Explore the concept of strategic groups of competition in an industry.
and illustrate its implications for industry
analysis.
56 Part 2 The Nature of Competitive Advantage
OVERVIEW
The starting point of strategy formulation is an analysis of the forces that shape
competition in the industry in which a company is based. The goal of such an analy-
sis is to gain an understanding of the opportunities and threats confronting the firm
and to use this understanding to identify strategies that will enable the company to
outperform its rivals. 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.
This chapter begins with an analysis of the industry environment. First, it exam-
ines concepts and tools for analyzing the competitive structure of an industry and
identifying industry opportunities and threats. Second, it analyzes the competitive
implications that arise when groups of companies within an industry pursue similar
and different kinds of competitive strategies. Third, it explores the way an industry
evolves over time and the accompanying changes in competitive conditions. Fourth,
it looks at the way in which forces in the macroenvironment affect industry struc-
Opportunities ture and influence opportunities and threats. By the end of the chapter, you will
Opportunities arise understand that to succeed, a company must either fit its strategy to the external
when a company environment in which it operates or must be able to reshape the environment to its
can take advantage advantage through its chosen strategy.
of conditions in
its environment
to formulate and
implement strategies
that enable it to
Analyzing Industry Structure
become more An industry can be defined as a group of companies offering products or services
profitable. that are close substitutes for each other, that is, products or services that satisfy the
Threats same basic customer needs. A company’s closest competitors, its rivals, are those that
serve the same basic customer needs. For example, carbonated drinks, fruit punches,
Threats arise when
and bottled water can be viewed as close substitutes for each other because they
conditions in the
serve the same basic customer needs for refreshing and cold nonalcoholic beverages.
external environment
Thus, we can talk about the soft drink industry, whose major players are Coca-Cola,
endanger the integrity
PepsiCo, and Cadbury Schweppes. Similarly, desktop computers and notebook com-
and profitability of the
puters satisfy the same basic need that customers have for computer hardware on
company’s business.
which to run personal productivity software; browse the Internet; send e-mail; play
Industry games; and store, display, and manipulate digital images. Thus, we can talk about the
A group of companies personal computer industry, whose major players are Dell, HP, Lenovo (the Chinese
offering products or company that purchased IBM’s personal computer business), and Apple Computer.
services that are close The starting point of external analysis is to identify the industry that a company
substitutes for each competes in. To do this, managers must begin by looking at the basic customer needs
other—that is, products their company is serving—that is, they must take a customer-oriented view of their
or services that business as opposed to a product-oriented view (see Chapter 2). The basic customer
satisfy the same basic needs that are served by a market define an industry’s boundary. It is important for
customer needs. managers to realize this, for if they define industry boundaries incorrectly, they may
be caught flat-footed by the rise of competitors that serve the same basic customer
Competitors needs with different product offerings. For example, Coca-Cola long saw itself as
Enterprises that being in the carbonated soft drink industry, whereas in fact it was in the soft drink
serve the same basic industry, which includes noncarbonated soft drinks. In the mid-1990s, Coca-Cola
customer needs. was caught by surprise by the rise of customer demand for bottled water and fruit
Chapter 3 External Analysis: The Identification of Opportunities and Threats 57
Risk of entry
by potential
competitors
Intensity of
Bargaining Bargaining
rivalry among
power of power of
established
suppliers buyers
firms
Threat of
substitutes
Data Source: Adapted and reprinted by permission of Harvard Business Review. From Michael
E. Porter, “How Competitive Forces Shape Strategy,” Harvard Business Review, March/April 1979.
© 1979 by the President and Fellows of Harvard College. All rights reserved.
drinks, which began to cut into the demand for sodas. Coca-Cola moved quickly to
respond to these threats, introducing its own brand of water, Dasani, and acquiring
orange juice maker Minute Maid. By defining its industry boundaries too narrowly,
Coca-Cola almost missed the rapid rise of the noncarbonated soft drinks segment of
the soft drinks market.
Once the boundaries of an industry have been identified, the task facing manag-
ers is to analyze competitive forces in the industry environment to identify oppor-
tunities and threats. Michael E. Porter’s well-known framework, known as the five
forces model, helps managers with this analysis.1 His model, shown in Figure 3.1,
focuses on five forces that shape competition within an industry: (1) the risk of entry
by potential competitors, (2) the intensity of rivalry among established companies
within an industry, (3) the bargaining power of buyers, (4) the bargaining power of
suppliers, and (5) the closeness of substitutes to an industry’s products.
Porter argues that the stronger each of these forces, the more limited the ability
of established companies to raise prices and earn greater profits. Within Porter’s
framework, a strong competitive force can be regarded as a threat because it de-
presses profits. A weak competitive force can be viewed as an opportunity because it
allows a company to earn greater profits. The strength of the five forces may change
through time as industry conditions change. The task facing managers is to recog-
nize how changes in the five forces give rise to new opportunities and threats and to
formulate 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 five forces
to its advantage.
58 Part 2 The Nature of Competitive Advantage
Economies of Scale Economies of scale arise when unit costs fall as a firm ex-
pands its output. Sources of scale economies include (1) cost reductions gained
through mass-producing a standardized output, (2) discounts on bulk purchases of
Potential Competitors raw material inputs and component parts, (3) the advantages gained by spreading
Companies that are not fixed production costs over a large production volume, and (4) the cost savings asso-
currently competing in ciated with spreading marketing and advertising costs over a large volume of output.
an industry but have If the cost advantages from economies of scale are significant, a new company that
the capability to do so enters the industry and produces on a small scale suffers a significant cost disad-
if they choose. vantage relative to established companies. If the new company decides to enter on a
large scale in an attempt to obtain these economies of scale, it has to raise the capital
Barriers to Entry
required to build large scale production facilities and bear the high risks associated
Factors that make it with such an investment. A further risk of large-scale entry is that the increased sup-
costly for companies ply of products will depress prices and result in vigorous retaliation by established
to enter an industry. companies. For these reasons, the threat of entry is reduced when established com-
Economies of Scale panies have economies of scale.
Reductions in unit costs
attributed to a larger Brand Loyalty Brand loyalty exists when consumers have a preference for the
output. products of established companies. A company can create brand loyalty through
continuous advertising of its brand-name products and company name, patent pro-
Brand Loyalty tection of products, product innovation achieved through company research and
Preference of development programs, an emphasis on high product quality, and good after-sales
consumers for the service. Significant brand loyalty makes it difficult for new entrants to take market
products of established share away from established companies. Thus, it reduces the threat of entry by po-
companies. tential competitors since they may see the task of breaking down well-established
Chapter 3 External Analysis: The Identification of Opportunities and Threats 59
customer preferences as too costly. In the market for colas, for example, consumers
have a strong preference for the products of Coca-Cola and PepsiCo which makes it
difficult for other enterprises to enter this market (despite this, the Cott Corporation
has succeeded in entering the soft drink market—see the Strategy in Action).
face a lower cost of capital.4 If established companies have an absolute cost advan-
tage, the threat of entry as a competitive force is weaker.
Customer Switching Costs Switching costs arise when it costs a customer time,
energy, and money to switch from the products offered by one established company
to the products 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.5 A familiar 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 re-
lated software applications (e.g., word processing software, spreadsheet, games) and
document files, it is expensive for that person to switch to another computer operat-
ing system. To effect the change, this person would have to buy a new set of software
applications and convert all existing document files to run with the new system.
Faced with such an expense 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 are, the higher is the barrier to
entry for a company attempting to promote a new computer operating system.
differentiate products in these industries, the best strategy for a company is to try to
minimize its costs so it will be profitable in a boom and survive any subsequent bust.
Alternatively, companies might try to adopt strategies that change the underlying
structure of fragmented industries and lead to a consolidated industry structure in
which the level of industry profitability is increased. How companies can do this is
something we shall consider in later chapters.
In consolidated industries, companies are interdependent, because one company’s
competitive actions or moves (with regard to price, quality, and so on) directly affect
the market share of its rivals, and thus their profitability. When one company makes
a move, this generally “forces” a response from its rivals, and the consequence of such
competitive interdependence can be a dangerous competitive spiral. Rivalry increases as
companies attempt to undercut each other’s prices or offer customers more value in their
products, pushing industry profits down in the process. The fare wars that have periodi-
cally created havoc in the airline industry provide a good illustration of this process.
Companies in consolidated industries sometimes seek to reduce this threat by
following the prices set by the dominant company in the industry.8 However, com-
panies must be careful, for explicit face-to-face price-fixing agreements are illegal.
(Tacit, indirect agreements, arrived at without direct or intentional communication,
are legal). Instead, companies set prices by watching, interpreting, anticipating, and
responding to each other’s behavior.
Exit Barriers Exit barriers are economic, strategic, and emotional factors that
prevent companies from leaving an industry.10 If exit barriers are high, companies
become locked into an unprofitable industry where overall demand is static or de-
clining. The result is often excess productive capacity, which leads to even more in-
tense rivalry and price competition as companies cut prices in the attempt to obtain
the customer orders needed to use their idle capacity and cover their fixed costs.11
Common exit barriers include the following:
• Investments in assets such as specific machines, equipment, and operating facili-
ties that are of little or no value in alternative uses or cannot be sold off. If a
company wishes to leave the industry, it has to write off the book value of these
assets.
• High fixed costs of exit, such as the severance pay, health benefits, and pensions
that have to be paid to workers who are being made redundant when a company
ceases to operate.
• Emotional attachments to an industry, as when a company’s owners or employees
are unwilling to exit from an industry for sentimental reasons or because of pride.
• Economic dependence on an industry because a company relies on a single indus-
try for its revenue and profit.
• The need to maintain an expensive collection of assets at or above some mini-
mum level in order to participate effectively in the industry.
• Bankruptcy regulations, particularly in the United States, where Chapter 11
bankruptcy provisions allow insolvent enterprises to continue operating and re-
organize themselves under bankruptcy protection. These regulations can keep un-
profitable assets in the industry, result in persistent excess capacity, and lengthen
the time required to bring industry supply in line with demand.
As an example of the effect of exit barriers in practice, consider the express mail and
parcel delivery industry. The key players in this industry such as FedEx and UPS rely
on the delivery business entirely for their revenues and profits. They have to 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 purpose. To meet
this guarantee, they need a nationwide network of air routes and ground routes, an
asset that is required in order to participate in the industry. If excess capacity devel-
ops 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, say,
Miami because that proportion of its network is underused. If it did that, it would
no longer be able to guarantee that it would be able to deliver packages to all major
locations in the United States, and its customers would switch to some other 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.
Finally, both UPS and FedEx managers and employees are emotionally tied to this
industry because they both were first movers in the ground and air segments of the
industry, respectively; their employees are also major owners of their companies’
stock; and, they are financially dependent on the fortunes of the delivery business.
Exit Barriers
The economic,
The Bargaining Power of Buyers
strategic, and emotional
The third of Porter’s five competitive forces is the bargaining power of buyers. An factors that prevent
industry’s buyers may be the individual customers who ultimately consume its prod- companies from leaving
ucts (its end users) or the companies that distribute an industry’s products to end an industry.
64 Part 2 The Nature of Competitive Advantage
users, such as retailers and wholesalers. For example, while soap powder made by
Procter & Gamble and Unilever is consumed by end users, the principal buyers of
soap powder are supermarket chains and discount stores, which resell the product to
end users. The bargaining power of buyers refers to the ability of buyers 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. Thus, pow-
erful buyers should be viewed as a threat. Alternatively, when buyers are in a weak
bargaining position, companies in an industry can raise prices, and perhaps reduce
their costs by lowering product quality and service, and increase the level of industry
profits. Buyers are most powerful in the following circumstances:
• When the industry that is supplying a particular product or service is composed
of many small companies and the buyers are large and few in number. These
circumstances allow the buyers to dominate supplying companies.
• When the buyers purchase in large quantities. In such circumstances, buyers can
use their purchasing power as leverage to bargain for price reductions.
• When the supply industry depends on the buyers for a large percentage of its
total orders.
• When switching costs are low so that buyers can play off the supplying compa-
nies against each other to force down prices.
• When it is economically feasible for buyers to purchase an input from several
companies at once so that buyers can play off one company in the industry
against another.
• When buyers can threaten to enter the industry and produce the product them-
selves and thus supply their own needs, also a tactic for forcing down industry
prices.
The auto component supply industry, whose buyers are large automobile manufac-
turers such as GM, Ford, and Toyota, has historically been a good example of an
industry in which buyers have had a strong bargaining power and thus constituted
a strong competitive threat. Why? The suppliers of auto component are numerous
and typically small in scale; their buyers, the auto manufacturers, are large in size
and few in number. Additionally, to keep component prices down, both Ford and
GM have used the threat of manufacturing a component themselves rather than
buying it from auto component suppliers. The automakers have used their powerful
position to play off suppliers against each other, forcing down the price they have
to pay for component parts and demanding better quality. If a component supplier
objects, the automaker can use the threat of switching to another supplier as a bar-
gaining tool.
Bargaining Power Another issue is that the relative power of buyers and suppliers tends to change
of Buyers in response to changing industry conditions. For example, because of changes now
The ability of buyers to taking place in the pharmaceutical and health care industries, major buyers of phar-
bargain down prices maceuticals (hospitals and health maintenance organizations) are gaining power
charged by companies over the suppliers of pharmaceuticals and have been able to demand lower prices.
in the industry or to
raise the costs of
The Bargaining Power of Suppliers
companies in the
industry by demanding The fourth of Porter’s five competitive forces is the bargaining power of suppliers—
better product quality the organizations that provide inputs into the industry, such as materials, services, and
and service. labor (which may be individuals, organizations such as labor unions, or companies
Chapter 3 External Analysis: The Identification of Opportunities and Threats 65
that supply contract labor). The bargaining power of suppliers refers to the ability
of suppliers to raise input prices, or to raise the costs of the industry in other ways—
for example, by providing poor-quality inputs or poor service. Powerful suppliers
squeeze profits out of an industry by raising the costs of companies in the industry.
Thus, powerful suppliers are a threat. Alternatively, if suppliers are weak, companies
in the industry have the opportunity to force down input prices and demand higher-
quality inputs (e.g., more productive labor). As with buyers, the ability of suppliers
to make demands on a company depends on their power relative to that of the com-
pany. Suppliers are most powerful in the following situations:
• The product that suppliers sell has few substitutes and is vital to the companies
in an industry.
• The profitability of suppliers is not significantly affected by the purchases of
companies in a particular industry, in other words, when the industry is not an
important customer to the suppliers.
• Companies in an industry would experience significant switching costs if they
moved to the product of a different supplier because a particular supplier’s prod-
ucts are unique or different. In such cases, the company depends on a particular
supplier and cannot play suppliers off against each other to reduce price.
• Suppliers can threaten to enter their customers’ industry and use their inputs to
produce products that would compete directly with those of companies already
in the industry.
• Companies in the industry cannot threaten to enter their suppliers’ industry and
make their own inputs as a tactic for lowering the price of inputs.
An example of an industry in which companies are dependent on a powerful sup-
plier is the personal computer industry. Personal computer firms are heavily depen-
dent on Intel, the world’s largest supplier of microprocessors for PCs. The industry
standard for personal computers runs on Intel’s microprocessor chips. Intel’s com-
petitors, such as Advanced Micro Devices (AMD), must develop and supply chips
that are compatible with Intel’s standard. Although AMD has developed competing
chips, Intel still supplies about 85% of the chips used in PCs primarily because only
Intel has the manufacturing capacity required to serve a large share of the market.
It is beyond the financial resources of Intel’s competitors, such as AMD, to match
the scale and efficiency of Intel’s manufacturing systems. This means that while
PC manufacturers can buy some microprocessors from Intel’s rivals, most notably
AMD, they still have to turn to Intel for the bulk of their supply. Because Intel is in
a powerful bargaining position, it can charge higher prices for its microprocessors Bargaining Power
than would be the case if its competitors were more numerous and stronger (i.e., if of Suppliers
the microprocessor industry were fragmented). The ability of suppliers
to raise the price of
Substitute Products inputs or to raise the
costs of the industry in
The final force in Porter’s model is the threat of substitute products: the products other ways.
of different businesses or industries that can satisfy similar customer needs. For ex-
ample, companies in the coffee industry compete indirectly with those in the tea and Substitute Products
soft drink industries because all three serve customer needs for nonalcoholic drinks. The products of
The existence of close substitutes is a strong competitive threat because this limits different businesses
the price that companies in one industry can charge for their product, and thus in- or industries that can
dustry profitability. If the price of coffee rises too much relative to that of tea or soft satisfy similar customer
drinks, coffee drinkers may switch to those substitutes. needs.
66 Part 2 The Nature of Competitive Advantage
If an industry’s products have few close substitutes, so that substitutes are a weak
Ethical Dilemma competitive force, then, other things being equal, companies in the industry have
You are a strategic analyst the opportunity to raise prices and earn additional profits. For example, there is no
at a successful hotel enter- close substitute for microprocessors, which gives companies like Intel and AMD the
prise that has been gener-
ability to charge higher.
ating substantial excess
cash flow. Your CEO in-
structed you to analyze the
competitive structure of Porter’s Model Summarized
closely related industries to
find one that the company
The systematic analysis of forces in the industry environment using the Porter frame-
could enter, using its cash work is a powerful tool that helps managers to think strategically. It is important to
reserve to build a sustain- recognize that one competitive force often affects the others, so that all forces need
able position. Your analysis, to be considered and thought about when performing industry analysis. Indeed, in-
using Porter’s five forces
model, suggests that the
dustry analysis leads managers to think systematically about the way their strategic
highest profit opportunities choices will both be affected by the forces of industry competition and how their
are to be found in the gam- choices will affect the five forces and change conditions in the industry. For an ex-
bling industry. You realize ample of industry analysis using Porter’s framework, see the Running Case.
that it might be possible to
add casinos to existing ho-
tels, lowering entry costs
into this industry. However,
you personally have strong
moral objections to gam-
bling. Should your own Strategic Groups within Industries
personal beliefs influence
your recommendations to Companies in an industry often differ significantly from each other with respect to
the CEO? the way they strategically position their products in the market in terms of such fac-
tors as the distribution channels they use, the market segments they serve, the quality
of their products, technological leadership, customer service, pricing policy, advertis-
ing policy, and promotions. As a result of these differences, within most industries, it
is possible to observe groups of companies in which each company follows a strategy
that is similar to that pursued by other companies in the group, but different from
the strategies followed by companies in other groups. These different groups of com-
panies are known as strategic groups.12
Normally, the basic differences between the strategies that companies in different
strategic groups use can be captured by a relatively small number of strategic fac-
tors. For example, in the pharmaceutical industry, two main strategic groups stand
out (see Figure 3.2).13 One group, which includes such companies as Merck, Eli Lilly,
and Pfizer, is characterized by a business model based on heavy R&D spending and
a focus on developing new, proprietary, blockbuster drugs. The companies in this
proprietary strategic group are pursuing a high-risk, high-return strategy. It is a high-
risk strategy because basic drug research is difficult and expensive. Bringing a new
Strategic Groups drug to market can cost up to $800 million in R&D money and a decade of research
Groups of companies and clinical trials. The risks are high because the failure rate in new drug develop-
in which each company ment is very high: only one out of every five drugs entering clinical trials is ultimately
follows a strategy approved by the U.S. Food and Drug Administration. However, the strategy is also
that is similar to that a high-return one because a single successful drug can be patented, giving the in-
pursued by other novator a 20-year monopoly on its production and sale. This lets these proprietary
companies in the companies charge a high price for the patented drug, allowing them to earn millions,
group, but different if not billions, of dollars over the lifetime of the patent.
from the strategies The second strategic group might be characterized as the generic drug strate-
followed by companies gic group. This group of companies, which includes Forest Labs, Mylan Labs and
in other groups. Watson Pharmaceuticals focuses on the manufacture of generic drugs: low-cost