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CHAPTER 3 INDUSTRY ANALYSIS: THE FUNDAMENTALS

Introduction and Objectives

In this chapter and the next we explore the external environment of the firm. In Chapter 1we observed that profound understanding of the competitive environment is a criticalingredient of a successful strategy. We further noted that business strategy is essentiallya quest for profit. The primary task for this chapter is to identify the sources of profit inthe external environment. The firm's proximate environment is its industry environment;hence the focus of our environmental analysis wi l l be industry analysis.

lndustry analysis is relevant both to corporate-level and business-level strategy.

Corporate strategy is concerned with deciding which industries the firm shouldbe engaged in and how i t should al locate i ts resources among them. Suchdecisions require assessment of the attractiveness of different industries interms of their profit potential. The main objective of this chapter is tounderstand how the competitive structure of an industry determines itsprofitability.

Business strategy is concerned with establishing competitive advantage.By analyzing customer needs and preferences and the ways in which firmscompete to serve customers, we identify the general sources of competitiveadvantage in an industry - what we call key success factors.

By the t ime you have completed this chapter you wi l l be able to:

r ldent i fy the main structural features of an industry that inf luence competi t ionand profitability.

o Use industry analysis to explain why in some industr ies competi t ion is moreintense and prof i tabi l i ty lower than in other industr ies.

c Use evidence on structural t rends within industr ies to forecast chanoes incompeti t ion and prof i tabi l i ty in the future.

il Develop strategies to influence industry structure in order to improve industryprofitability.

o Analyze competi t ion and customer requirements in order to ident i fyopportunities for competitive advantage within an industry (key successfactors).

a

o

PART I I THE TOOLS OF S

From Environrnental Analysis to Industry Analysis

The business environment of the firm consists of all the external influences that affectits decisions and performance. Given the vast number and range of external influences,how can managers hope to monitor, let alone analyze, environmental conditions?The starting point is some kind of system or framework for organizing information.For example, environmental influences can be classified by source - e.g. into polit ical,economic, social, and technological factors ("PEST analysis") - or by proximity - the"micro-environment" or "task environment" can be distinguished from the widerinf luences that form the "mecro-envi ronment" . rThough systemet ic , cont inuous scan-ning of the whole range of external influences might seem desirable, such extensiveenvironmental analysis is unlikely to be cost effective and creates information overload.

Tlre prerecluisite for effective environmental analysis is to distinguish the vital fromthe merely important. To do tl-ris, let's return to first principles. For the firm to makeprofit i t must create value for customers. Hence, it nrust understand its customers.Second, in creatir-rg value, the firm acquires goods and services frorn suppliers. Hence,it must understand its suppliers and rnanage relationships with them. Third, the abil-ity to generate profitabil ity depends on the intensity of competit ion among firrns thatvie for the same value-creating opportunities. Hence, the firrn must understand com-petit ion. Thus, the core of the firm's business environment is formed by its relation-ships wi th three sets of p layers: customers, suppl iers, and cornpet i tors. This is i tsi r - rdustry envi ronment .

This is not to say thlt macro-level factors such as general economic trends, changesin cler.nographic structure, or social and polit ical trends are unimportant to strategyanalysis. Tl'rese factors n-ray be crit ical deterrninants of the threats and <>pportunitiesa courpany wil l face in the future. The key issue is how these more general environ-mental factors affect the firm's industry environment (Figure 3.1). Consider the threatof global warr.ning. For most companies dris is not arr irnportarrt strategic issue (atleast, not for the next hundrecl years). However, for the proclucers of :trtomobiles,global warnring is a vital issue. But, to analyze the strategic inrplications of globalwarnring, thc automobile manufacturers need to trace its implications for their indus-try environment. F-or example, what wil l be the impact on dernar.rd - wil l consumersswi tch to more fuel -ef i ic ient cars? Wi l l they abandorr thei r cars in favor of publ ic

F I (i I I I i It ; i I Fronr envirorrrnental analysis to industry analysis

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If the purpose of strategy is to help a company to survive ar-rd make money, the start-ing point for industry analysis is a simple question: what detennines the level of profitin an industry?

As already noted, business is about the creation of value for the customer, eitherby production (transforming inputs into outputs) or commerce (arbitrage). Value iscreated wherr the price the customer is wil l ing to pay for a product exceeds the costsincurred by the firnr. Br.rt value creatior.r does not translate directly into profit. Thesurplus of va lue over cost is d is t r ibutec l between customers and producers by theforces of conrpetit ion. Tl-re stronger is competit ion among producers, the more oftl.re surplus is received by customers in consumer surplus (the difference between theprice they actually pay and the maximum'r price they would l.rave been wil l ing to pay)ancl the less is the surplus received by producers (as prodwcer surplus or economicrcnt). A single supplier of bottled water at an all-night rave can charge a price thatfully exploits the dancers' thirst. If there lre many suppliers of bottled water, then, inthe absence of collusion, corxpetit ion ci. lr.rscs the price of bottled water to fall towardt l t e cos t o f supp l y i ug i t .

The sr-rrplus earnecl by proclucers over and abclve the minimum costs of productionis not ent i re ly captured in prof i ts . Where an industry l ras powerfu l suppl iers -

nronopolistic suppliers of cornponents or erlployees united by a strong labor union -

a substantial part of t lre surplus may be appropriated by these suppliers (the profits ofsuppliers or premiurn wages clf union r.rrembers).

The profits earnecl by the firms in an industry are thus deterrnined by three factors:

The valr-re of the product to customers.

The intcrrs i ty of cornpet i t ior r .

The bargaining power of the proclucers relative to their suppliers.

Indr"rstry analysis brings all thrcc fr.rctors into a single analytic framework.

Table 3.1 sl.rows the profitabil ity of different US industries. Some industries (such astobacco ancl pharrnaceuticals) consistently earn high rates of profit; <>thers (airl ines,paper, anc'l food production) fail to cover tl-reir cost of capital. The basic premise thatunderlies inclustry analysis is that the level of industry profitabil ity is neither randomnor the result of entirely industry-specific influences - it is determined by the system-atic influences of the industry's structure. The US pharmaceutical industry and theUS food production industry r-rot only supply very different products, they also havevery different structures, which nrake one highly profitable and the other a nightmareof price competit ion and weak r.nargins. The pharmaceutical industry produces highly

THE TOOLS OF STRATEGY ANALYSIS

The profitability of US industries,1999-2005

Household and Personal Products

Pha rmaceut ica lsTobaccoFood Consumer ProductsSecu rit iesDivers i f ied Financia lsBeveragesMining, Crude Oi l Product ionPetroleum RefiningMedical Products and EquipmentCommercia l BanksFood ServicesScient i f ic , Photographic, and

Contro l EquipmentApparelComputer SoftwarePubl ish ing, Pr int inglT ServicesHealthca reElectronics, Electr ica l EquipmentSpecialty RetailersChemicalsEngineer ing, Construct ionTrucking, Truck LeasingAerospace and DefenseComputers, Office EquipmentFu rnitu reAutomotive Retail ing and ServtcesWholesalers: Food and GroceryGeneral MerchandtsersPipel inesIndustr ia l and Farm EquiPmentOi l and Gas Equipment and Serv icesUt i l i t ies: Gas and Electr icEnergy Product ionFood and Drug StoresMotor Vehicles and PartsHotels, Casinos, Resortslnsurance: L l fe and Heal thPackaging and Conta inersReal EstateInsurance: Property and Casual tY

2 2 . 7

2 2 . 321 .619.61 8 . 91 8 . 31 7 . 51 7 . B1 7 . 31 7 . 21 5 51 5 . 31 5 . 0

14.41 3 . 91 3 . 51 3 . 513 .11 3 . 01 3 . 012.912.01 1 . 81 1 . 71 1 . 71 1 . 61 1 . 31 1 . 31 ' 1 . 01 1 . 01 0 . 810.710.41 0 . 61 0 . 09 . 89 .78 .68 . 68 . 58 .3

Procter & Gamble, Kimberley-Clark, Colgate-Palmol ive

Pf izer , Johnson & Johnson, MerckAltria, Reynolds American, UniversalPepsiCo, Sara Lee, ConagraMorgan Stanley, Merr i l l Lynch, Goldman Sachs

General Electric, American ExpressCoca-Cola, Anheuser-BuschOccidental Petroleum, Devon EnergyExxonMobi l , Chevron, ConocoPhi l l ipsMedtronic, Baxter In ternat ionalCi t igroup, Bank of Amer icaMcDonald 's , Yum BrandsEastman Kodak, Danaher, Al igent

Nike, VE Jones ApparelMicrosoft, Oracle, CAR. R. Donnel ley & Sons, Gannet tED5, Computer Sciences, Science Appl icat ions Int l

Uni ted Heal th Group, Wel lpoint , HCA, Medco

Emerson Electr ic , Whir lpoolHome Depot, Costco, Lowe'sDow Chemical, Du PontFlou r , Jacobs Engineer ingYRC Worldwide, Ryder SystemBoeing, United Technologies, Lockheed Martin

I BM, Hewlett-Packard, Dell ComputerLeggett & Platt, SteelcaseAutoNat ion, Uni ted Auto GroupSysco, Supervalu, CHSWal-Mart , Target , Sears Hold ingsPla ins Al l -Amer ican Pipel ine, Enterpr ise Products

Caterpil lar, Deere, l l l inois Tool WorksHal l ibur ton, Baker HughesDuke Energy, Dominion ResourcesConste l la t ion Energy, ONEOKKroger, Walgreen, Albertson'sGM, Ford, Johnson Contro lsMarr io t t In ternat ional , Harrah 's Enter ta inment

Metlife, New York LifeSmu rfit-Stone Container, Owens-l l l inois

Cendant, Host Marriott, Simon Property Group

Amer ican Int l . Group, Berkshi re Hathaway

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1 999 -2 00 s .

differentiated products with price-insensitive consumers and each new product re-ceives monopoly privileges in the form of 17-year patents. The food industry pro-duces commodity products wirh slow-growing demand and overcapacity, and issqueezed by powerful retail customers.

These industry patterns tend to be fairly consistent across countries. Figure 3.2shows return on capital for a number of global industries.

Particularly high rates of profit often result from industry segments dominated bya single firm. These niche markets provide attractive havens from the rigors of fiercecompetit ion. Strategy Capsule 3.1 offers some examples.

The underlying theory of how industry structure drives competitive behavior anddetermines industry profitabil ity is provided by industrial organization (Io) eco-nomics. The two reference points are the tbeory of monopoly and the theory ofperfect competit ion which form end points of the spectrum of industry structures.Monopoly exists where an industry comprises a single firm protected by high barriersto entry. The monopolist can appropriate in profit the full amount of the value itcreates. At the other extreme,perfect competition exists where there are many firmssupplying an identical product with no restrictions on entry or exit. Here, rhe rate ofprofit falls to a level that just covers firms' cost of capital. In the real world, industriesfall between these two extremes. The US market for chewing tobacco is close to beinga monopoly; the Chicago grain markets are close to being perfectly competitive. Mosrmanufacturing industries and many service industries tend to be oligopolie.s: they aredominated by a small number of major companies. Table 3.2 identifies some key pointson the spectrum. By examining the principal structural features and their interactionsfor any particular industry, it is possible to predict the type of competitive behaviorlikely to emerge and the resulting level of profitability.

PART II THE TOOLS OF STRATEGY ANALYSIS

Fl GIIRIT i i.2 Profitabil ity of global industries

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Retai l ing

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Food retai l ing

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Automobiles and components

Technology hardware and equipment

Hotels, restaurants, leisure

Food, beverages, tobacco

Healthcare equipment and services

Semiconductors

Commercial services

Media

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Household and personal products

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UST Inc. (formerly U5 Tobacco) has been themost profitable company in the S&P500 over thepast 10 years. Dur ing 2003*5 UST earned anROIC (operating profit as percentage of totalassets less current l iabil i t ies) of 680/o. What'sthe secret of UST's success? lt controls 78o/o ofthe U5 market for "smokeless tobacco" (chew-

ing tobacco and snuf f ) , wi th brands such asSkoal , Copenhagen, Long Cut , and Red Seal .Despite its association with a bygone era ofcowboys and farm workers, chewing tobaccohas been a growth market over the past twodecades wi th a surpr is ingly large number ofyoung consumers. UST's long-established brands,i ts d is t r ibut ion through tens of thousands ofsmal l reta i l out le ts , and the unwi l l ingness ofmajor tobacco companies to enter this market(due to the poor image and socia l unaccept-abil ity of the product) have made UST's marketposition unassailable. Restrictions on advertisingof smokeless tobacco products have further but-tressed UST's market dominance by making itmore diff icult for would-be entrants to establishtheir brands.

Devro plc, based in the Scottish vil lage ofMoodiesburn, is the wor ld 's leading suppl ier

CHAPTER 3 INDUSTRYANALYSIS: THE FUNDAMENTALS

of collagen sausage skins ("casings"). "From theBrit ish 'Banger'to the Chinese Lap Cheong, fromthe French Merguez to the South AmericanChourizo, Devro has a casing to suit all product

types." lts overall world market share is around600/o, rising to 94o/o in the UK market and 83% inAustralia. In recent years its ROIC has averaged'1 8% and its return on equity 30%.

International Game Technology (lcT) based inReno, Nevada, is the wor ld 's dominant manu-facturer of slot machines for casinos and otherestabl ishments that a l low gambl ing machines.With a continuous flow of new gaming machines* 2005 saw 172 new products launched, includ-ing Megabucks, Persian Princess, and LuckyLarry's Lobstermania - IGT has over 70o/o olthe US market share and market leadershio inseveral European countr ies, inc luding the UK.With heavy investment in R&D, new product

saturation, t ight control over distribution andservicing, and a policy of leasing rather than sell-ing machines, IGT's market leadership appearswell-entrenched. During 2004-6,lGT earned anaverage ROE of 25%.

sources: www. ustinc.com, www.devro.com, www.igt.com

Porter's Iriue Forces of Co'wypetitiott Frowrcwork,

Table 3.2 identifies four structural variables influencing competition and profitability.In practice, there are many features of an industry that determine the intensityof competition and the level of profitability. A helpful, widely used frameworkfor classifying and analyzing these factors was developed by Michael Porter ofHarvard Business School.2 Porter's five forces of competition framework views theprofitability of an industry (as indicated by its rate of return on capital relative to itscost of capital) as determined by five sources of competitive pressure. These five forcesof competition include three sources of "horizontal" competition: competition fromsubstitutes, competition from entrants, and competition from established rivals; and

PART I I THE TOOLS OF STRATEGY ANALYSIS

The spectrum of industry structures

Perfect Oligopoly Duopoly MonopolyCompetition

Concentration Many firms A few firms Two firms One flrm

Entry and Exit Barriers No barriers significant barriers High barriers

Product f lomogeneous Potential for product differentiationDifferentiation product (Commodity)

lnformation No impediments lmperfect availabil ity of informationAvaihbil ity to information flow

two sources of "vertical" competit ion: the power(see Figure 3.3).

The strength of each of these competit ive forcesstructural variables, as shown in Figure 3.4.

of suppl iers and power of buyers

is determined by a number of key

The price customers are wil l ing to pay for a product depends, in part, on the avail-abil ity of substitute products. The absence of close substitutes for a producr, as in rhecase of gasoline or cigarettes, means that consunrers Jre comperrtively insensitive to

Porter's f ive forces of competit ion framework

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BUYER POWER

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differentiation o Buyers, information. Competit ion . Buyers, abi l i ty to

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price (i.e., demand is inelastic with respect to price). The existence of close substi-tutes means that customers will switch to substitutes in response to price increases forthe product (i.e., demand is elastic with respect to price). The internet has provideda new source of substitute competition that has proved devastating for a number ofestablished industries. Tiavel agencies, newspapers, and telecommunication providershave all suffered devastating competition from internet-based substitutes.

The extent to which substitutes depress prices and profits depends on the propen-sity of buyers to substitute between alternatives. This, in turn, is dependent ontheir price-performance characteristics. If city-center to city-center travel between\Tashington and New York is 50 minutes quicker by air than by train and the averagetraveler values time at $30 an hour, the implication is that the train will be competi-tive at fares of $25 below those charged by the airlines. The more complex the prod-uct and the more difficult it is to discern performance differences, the lower the extentof substitution by customers on the basis of price differences. The failure of low-pricedimitations of leading perfumes to establish significant market share reflects consumers'difficulty in recognizing the performance characteristics of different fragrances.

See

Highlight


If an industry earns a return on capital in excess of its cost of capital, it wil l act as amagnet to firms clutside the industry. If the entry of new firms is unrestricted, the rateof profit wil l fall toward its competit ive level. The US bagel industry faced a flood ofnew entrants in the late 1990s that caused a sharp decline in profitabil ity. ' Why is itthat my wife, a psychotherapist, earns much less than our niece, a recently qualif iedmedical doctor? Barriers to entry are one factor. In psychotherapy there are multipleaccrediting bodies and limitecl state l icensir.rg, helrce the entry barriers to psychother-apy are much lower than in medicine.

Threat of entry rather then actual entry rnay be sufl icient to enslrre that establishedfirms constrain their prices to the competit ive level. Only American Airl ines offers adirect service between Dallas-Fort \Worth and Sar.rta Barbara, California, for example.Yet, American may be unwill ing to exploit its rr.ronopoly power to the full i f Southwestor another airl ine car.r easily extend its routes to cover the same two cit ies. An indus-t ry where no barr iers to entry or ex i t ex is t is cctntestable: pr ices and prof i ts tendtowards the competit ive level, regardless of the number of f irms within the industry.aContestabi l i ty depends on the absence of sr . rnk costs - investments whose valuecannot be recovered on exit. An absence of sunk cclsts nrakes an industry vulnerableto "hit-and-run" entry whenever establishec'l l inrs raise their prices above the com-pet i t ive level .

In most irrdustries, however, new entrants carlnot enter on equal ternrs with thoseof establishecl f irn.rs. A barricr to entry is any advantage that establishecl f irnrs haveover entrants. The height of a b:rrrier to entry is usurlly nrelsurecl as the unit costdisadvautage facecl by would-be entrxllts. The prirrcipll sources of brrricrs to eutry rrecliscussed below.

The capital costs of getting established in an industry canbe so large as to discourage all but the largest cor.npanies. TI-re duopoly of Boeing andAirbus in Iarge passenger jets is protectecl by tl-re l-ruge capital costs of establishingR&D, product ion, and serv ice fac i l i t ies for sr . rpply i r rg these p lanes. Simi lar ly wi th thebusiness of launching commercial satell i tes: the costs of developing rockets ar-rd launchfacil it ies make new er-rtry highly unlikely. In other industries, entry costs can be mod-est. One reason why the e-commerce boon-r of the late 1990s ended in fir-rancial dis-aster for most participants is that the init ial setup costs of new internet-based ventureswere typically very low. Across the service sector more generally, startup costs tend tobe low. For example, startLlp costs for a franchised pizza outlet begin at $141,000 fora Domino's , $250,000 for a Papa John's, and $1.1 n-r i l l ion for a Pizza Hur. '

. In industries that are capital or research or advertising in-tensive, efficiency requires large-scale operation. The problem for new entrants is thatthey are faced with the choice of either entering on a srrall scale and accepting highunit costs, or entering on a large scale and bearing the costs of underuti l ized capa-city. ln automobiles, cost efficiency means producing at least drree mill ion vehicles ayear. As a result, the only recent entrants into volume car production have been state-supported companies (e.g., Proton of Malaysia and Maruti of India). The main sourceof scale economies is new product development costs. Thus, developing and launch-ing a new model of car typ ical ly costs over $1.5 b i l l ion. Ai rbus 's A380 super jumbocost about $15 bil l ion to develop and must sell over 300 planes to break even. Once

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Abr;o.{uttl {,]{rs!,, ' \ttvi ln' i,a*es Established firms may have a unit cosr advantageover entrants irrespective of scale. Absolute cost advantages often result from theacquisition of low-cost sources of raw materials. Saudi Aramco's access to the world'sbiggest and most accessible oil reserves give it an unassailable cost advantage overShell, Exxon Mobil, and BP, whose costs per barrel are at least three times those ofSaudi Aramco. Absolute cost advantages may also result from economies of learning.Sharp's cost advantage in LCD flat screen TVs results from its early entry into LCDsand its speed in moving down the learning curve.

t 't utiucl Uii i i tr 'clrl. i i l l , ton In an industry where products are differentiated,established firms possess the advantages of brand recognition and customer loyalty.The percentage of US consumers loyal to a single brand varies from under 300/o inbatteries, canned vegetables, and garbage bags, up to 610/o in toothpaste, 650/o inmayonnaise, and7I0/o in cigarettes.6New entrants to such markets must spend dis-proportionately heavily on advertising and promotion to gain levels of brand aware-ness and brand goodwill similar to that of established companies. One study foundthat, compared to early entrants, late entrants into consumer goods markets incurredadditional advertising and promotional costs amounting to 2.120/o of sales revenue.t

- / t t r : rss to ( lhant ' re ls o l I ) is t r i l tu t , io t r For many new suppl iers of consumergoods, the principal barrier to entry is l ikely to be gaining distribution. Limitedcapacity within distribution channels (e.g., shelf space), risk aversion by retailers, andthe fixed costs associated with carrying an additional product result in retailers beingreluctant to carry a new manufacturer's product. The battle for supermarket shelfspace between the major food processors (typically involving "slotting fees" to re-serve shelf space) further disadvantages new entrants. One of the most important eco-nomic impacts of the internet has been allowing new businesses to circumvent barriersto distribution.

(ittverurnental antl Legal l larricrs Economists from the Chicago School claimthat the only effective barriers to entry are those created by government. In taxicabs,banking, telecommunications, and broadcasting, entry usually requires the granting ofa license by a public authority. From medieval times to the present day, companiesand favored individuals have benefitted from governments granting them an exclusiveright to ply a particular trade or offer a particular service. In knowledge-intensiveindustries, patents, copyrights, and other legally protected forms of intellectual prop-erty are major barriers to entry. Xerox Corporation's monopolization of the plain-paper copier industry unti l the late 1970s was protected by a wall of over 2,000patents relating to its xerography process. Regulatory requirements and environ-mental and safety standards often put new entrants at a disadvantage to establishedfirms because compliance costs tend to weigh more heavily on newcomers.

Itetaliation Barriers to entry also depend on the entrants' expectations as to pos-sible retaliation by established firms. Retaliation against a new entrant may take theform of aggressive price-cutting, increased advertising, sales promotion, or l i t iga-tion. The major airlines have a long history of retaliation against low-cost entrants.

PART I I THE TOOLS OI 'STRATEGY ANALYSIS

Southwest and other budget airlines have alleged that selective price cuts by Americanand other major airl ines amounted to predatory pricing designed to prevent its entryinto new routes.t To avoid retaliation by incumbents, new entrants may seek init ialsmall-scale entry into less visible market segments. \When Toyota, Nissan, and Hondafirst entered the US auto market, they targeted the small car segments, partly becausethis was a segment that had been written off by the Detroit Big Three as inherentlyunorofitable.'

Emoirical research shows industries oro-tected by high entry harriers tend to earn cbove ,u.irg. retes of pro6t.ru Capital require-ments and advertisir-rg appear to be particularly effective impediments to entry.tr

The effectiveness of barriers to entry depends on the resources and capabil it ies thatpotential entrants possess. Barriers that are effective against new companies may beineffective agair.rst established firrns that are diversifying from other industries. GeorgeYip found no evidence that entry barriers deterred new entry.' ' Some entrants pos-sessed resources that allowed them to surrnount barriers and compete against incum-bent firms usir.rg sirnilar strategies. Thus, Mars used its strong position in confectioneryto enter the ice cream market, while Virgin has used its brand name to enter a widerar-rge of inclustries from airl ir.res to telecommunications.

For most industries, the major determinant of the overall state of competit ion andthe general level of profitabil ity is competit ion among the firms within the industry.In some industries, f irms compete aggressively - sometimes to the extent that pricesare pushed below the level of costs and industry-wide losses are incurred. In otherindustries, price competit icln is rnuted and rivalry focuses on advertising, innovation,and other nonprice dimensions. The intensity of competit ion between establishedfirms is the result of interactions between six factors. Let us look at each of them.

Seller concentration refers to the number and size distribution offirms cornpeting within a market. It is most commonly rneasured by the concentrationratio: the cornbir-red nrarket share of the leading producers. For example, the four-firm concentration ratio (CR4) is t l-re rnarket share of the four largest producers. Inmarkets dominated by a single firn-r (e.g., Microsoft in PC operating systems, or USTin the US smokeless tobacc<-l market). the dominant f irm can exercise considerablediscretion over the prices it charges. \Where a market is dominated by a small groupof leading companies (an oligopoly), price competit ion may also be restrained, eitherby outright collusion, or more commonly through "parallelism" of pricing decisions.rrThus, in rnarkets dorninated by twcl companies, such as alkaline batteries (Duracelland Energizer), color f i lm (Kodak and Fuji), and soft drinks (Coke and Pepsi), pricestend to be similar and competit ion focuses on advertising, promotion, and productdevelopment. As the number of f irn.rs supplying a market increases, coordinationof prices becomes more diff icult, and the l ikelihood that one firm wil l init iate price-cutting increases. However, despite the common observation that the elimination ofa competitor reduces price competit ion, while the entry of a new competitor stimu-lates it, systematic evidence of the impact of seller concentration on profitability is sur-prisingly weak. Richard Schrnalensee concluded that: "The relation, if any, betweenseller concentration and profitability is weak statistically and the estimated effect isusual ly smal l . " ra

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The extent to which a group of firms can avoid pricecompetition in favor of collusive pricing practices depends on how similar they arein their origins, objectives, costs, and strategies. The cozy atmosphere of the US autoindustry prior to the advent of import competition was greatly assisted by the sim-ilarities of the companies in terms of cost structures, strategies, and top managementmindsets. The intense competition that affects the car markets of Europe and NorthAmerica today is partly due to the different national origins, costs, strategies, andmanagement styles of the competing firms. Similarly, the key challenge faced by OPECis agreeing and enforcing output quotas among member countries that are sharplydifferent in terms of objectives, production costs, politics, and religion.

The more similar the offerings among rival firms, themore willing customers are to substitute and the greater the incentive for firms to cutprices to increase sales.

'Where the products of rival firms are virtually indistinguish-

able, the product is a commodity and price is the sole basis for competition. Com-modity industries such as agriculture, mining, and petrochemicals tend to be plaguedby price wars and low profits. By contrast, in industries where products are highlydifferentiated (perfumes, pharmaceuticals, restaurants, management consulting services),price competition tends to be weak, even though there may be many firms competing.

\fhy does industry profitability tend tofall so drastically during periods of recession? The key is the balance between demandand capacity. Unused capacity encourages firms to offer price cuts to attract new busi-ness in order to spread fixed costs over a gteater sales volume. Excess capacity maybe cyclical (e.g. the boom-bust cycle in the semiconductor industry); it may also bepart of a structural problem resulting from overinvestment and declining demand. Inthese latter situations, the key issue is whether excess capacity will leave the industry.Barriers to exit are costs associated with capacity leaving an industry.

'Where resources

are durable and specialized, and where employees are entit led to job protection,barriers to exit may be substantial.ri In the European and North American autoindustry excess capacity together with high exit barriers have devastated industryprofitability. Conversely, rapid demand growth creates capacity shortages that boostmargins. Between 2001 and 2005, bulk cargo shipping rates increased sevenfold asa result of increased world demand for commodities.'t 'On average, companies ingrowing industries earn higher profits than companies in slow growing or decliningindustries (see Figure 3.5).

\fhen excess capacity causes price competit ion, how low wil l prices go? Thekey factor is cost structure.

'S7here fixed costs are high relative to variable costs, firms

will take on marginal business at any price that covers variable costs. The con-sequences for profitability can be disastrous. Between 200L and 2003, the total lossesof the US airline industry exceeded the cumulative profits earned during the entire pre-vious history of the industry. The willingness of airlines to offer heavily discountedtickets on flights with low bookings reflects the very low variable costs of filling emptyseats. Similarly, the devastating impact of excess capacity on profitability in tires,hotels, and semiconductors is a result of high fixed costs in these businesses and thewillingness of firms to accept additional business at any price that covers variable costs.

Scale economies may also encourage companies to compete aggressively on pricein order to gain the cost benefits of greater volume. If scale efficiency in the auto

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industry melrns producing four mill ion cars a year, a level that is achieved by only sixof t l.re nineteen international auto companies, the outcclme is a battle for market shareas eacl.r f irm tries to achieve crit ical mass.

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Tl-re firms in an industry ()perate in two rypes of markets: in the markets for inputs andthe rnarkets for outputs. In input markets firms purchase raw materials, components,and financial and labor services. In the markets for outputs firms sell their goods andservices to customers (who may be distributors, consumers, or other manufacturers).In both markets the transactions create value for both buyers and sellers. How thisvalue is shared between them in terms of profitabil ity depends on their relative eco-nomic power. Let us cleal f irst with output markets. The strength of buying powerthat f irms face from their customers depends on two sets of factors: buyers' pricesensitivity and relative bargaining power.

l i f r v * t ' ' r l ' ! r ' , r " ! u r r c i t i r , i l r r T h e e x t e n t t o w h i c h b u y e r s a r e s e n s i t i v e t o t h e p r i c e scharged by the firms in an industry depends on four main factors:

:" The greater the importance of an item as a proportion of total cost, the moresensitive buyers will be about tl-re price they pay. Beverage manufacturers arehighly sensitive to the costs of aluminum cans because this is one of theirlargest single cost items. Conversely, most cornpanies are not sensitive to thefees charged by their auditors, since auditing costs are such a small proportionof overall company expenses.

tr The less differentiated the products of the supplying industry, the morewill ing the buyer is to switch suppliers on the basis of price. Themanufacturers of T-shirts and light bulbs have much more to fear from'Wal-Mart's

buying power than have the suppliers of perfumes.

C The more intense the competit ion among buyers, the greater their eagernessfor price reductions from their sellers. As competition in the worldautomobile industry has intensified, so component suppliers face greaterDressures for lower Dnces.

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* The more critical an industry's product to the quality of the buyer's productor service, the less sensitive are buyers to the prices they are charged. Thebuying power of personal computer manufacturers relative to themanufacturers of microprocessors (Intel and AMD) is limited by the vitalimportance of these components to the functionality of PCs.

li.claiivo ilargelini*g floltrttr Bargaining power rests, ultimately, on refusal to dealwith the other party. The balance of power between the two parties to a transactiondepends on the credibility and effectiveness with which each makes this threat. Thekey issue is the relative cost that each party sustains as a result of the transaction notbeing consummated. A second issue is each party's expertise in managing its position.Several factors influence the bargaining power of buyers relative to that of sellers:

:t Size and concentration of bwyers relatiue to swppliers. The smaller the numberof buyers and the bigger their purchases, the greater the cost of losing one.Because of their size, health maintenance organizations (HMOs) can purchasehealthcare from hospitals and doctors at much lower cost than can individualpatients. Several empirical studies show that buyer concentration lowersprices and profits in the supplying industry.rT

,''o Bttyers' information. The better informed buyers are about suppliers and theirprices and costs, the better they are able to bargain. Doctors and lawyers do notnormally display the prices they charge, nor do traders in the bazaars of Thngierand Istanbul. Keeping customers ignorant of relative prices is an effectiveconstraint on their buying power. But knowing prices is of l i tt le value if thequality of the product is unknown. In the markets for haircuts, interior design,and management consulting, the abil ity of buyers to bargain over price islimited by uncertainty over the precise attributes of the product they are buying.

* Ability to integrate uertically.In refusing to deal with the other party thealternative to finding another supplier or buyer is to do it yourself. Largefood-processing companies such as Heinz and Campbell Soup have reducedtheir dependence on the manufacturers of metal cans by manufacturing theirown. The leading retail chains have increasingly displaced their suppliers'brands with their own-brand products. Backward integration need notnecessarily occur - a credible threat may suffice.

Analysis of the determinants of relative power between the producers in an industryand their suppliers is precisely analogous to analysis of the relationship between pro-ducers and their buyers. The only difference is that it is now the firms in the industrythat are the buyers and the producers of inputs that are the suppliers. The key issuesare the ease with which the firms in the industry can switch between different inputsuppliers and the relative bargaining power of each party.

Because raw materials, semi-finished products, and components are often com-modities supplied by small companies to large manufacturing companies, their sup-pliers usually lack bargaining power. Hence, commodity suppliers often seek to boosttheir bargaining power through cartelization (e.g., OPEC, the International CoffeeOrganization, and farmers' marketing cooperatives). A similar logic explains laborunions. Conversely, the suppliers of complex, technically sophisticated componentsmay be able to exert considerable bargaining power. The dismal profitability of the

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PART I I THI . ] TOOLS OF STRATE( iY ANALYSIS

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personal corxputer industry rnay be attributed to thc pclwer exercised by the suppliersof key c()nlponents (processors, clisk clrives, LCD screens) and the dominant supplierof operating systenrs (Microsoft).

Labor unions irre irnportlurt sources of supplier power. Where an industry has ahigh percentege of its employees unionized - as in steel, airl ir-res, and automobiles -

prof i tabi l i ty is rec luced (sec Figure 3.5) .

Once we understand how industry structure drives competit ion, which, in turn, deter-tnines industry profitabil ity, wc can apply this analysis, f irst to forecasting industryprofitabil ity ir.r t lre future, ancl sec<lncl to dcvising strategies for changing industrystructu re.

The 6rst stagc of industry analysis is to iclentify the key elements of t l-re industry'sstructure. Irr principle, this is a sirnple task. It reqr.rires identifying who are the mainplayers - the proclucers, the cllstomers, the suppliers, ar-rd the producers of substitutegoocls - ther-r exanrining some of the key structural characteristics of each of thesegrollps that wil l cleterrnine competit ion ancl bargaining power.

In rnost rnanufacturir-rg industrics the identity of the different groups of playersis usr-rally straightforwarcl, in clt lrer industries - particularly in service industries -

building a picture of t l.re ir.rdustry nray be more diff icult. Consider the supply of tele-vision prograrnming. There are a nurnber of different types of player and establishingwhich are buyers, which are sellers, and where the ir-rdustry bclundaries l ie is notsimple. In terms of industry clefinit ion, do we consider all forn-rs of TV distribution oridentify separate industries for broadcast T! cable T! and satell i te TV? In terms ofidentifying buyers and sellers, we see that there the industry has quite a cornplex valuechain with the producers of the individual shows, networks that put together pro-gram schedules, and local broadcasting and cable con-rpanies that undertake final

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distribution. For the distribution companies there are two buyers - viewers andadvertisers. Some companies are vertically integrated across several stages of the valuechain - thus, networks such as Fox and NBC not only create and distribute programschedules, they are also backward integrated into producing some TV shows and theyare forward integrated into local distribution through ownership of local TV stations.

Sorting out the different players and their relationships therefore involves somecritical issues of industry definition.

'$7hich activities within the value chain do we

include in the industry? 'Sfhat

are the horizontal boundaries of the industry in termsofboth products and geographical scope? Sfe shall return to some ofthese issues ofindustry definition in a subsequent section.

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can use industry analysis to understand why profitability has been low in someindustries and high in others but, ultimately, our interest in industry analysis is notto explain the past, but to predict the futwre.Investment decisions made today willcommit resources to an industry for a decade or more - hence, it is critical that we areable to predict what industry profitabil ity is l ikely to be in the future. Currenrprofitability tends to be a poor indicator of future profitability. However, if anindustry's profitability is determined by the srrucure of that industry, then we canuse observations of the structural trends in an industry to forecast the likely changesin competit ion and profitabil ity. Given that changes in industry structure tend tobe long term and are the result of fundamental shifts in customer buying behavior,technologg and firm strategies, we can use our current observations to identify emerg-ing structural trends.

To predict the future profitability of an industry, our analysis proceeds in three stages:

Examine how the industry's current and recent levels of competition andprofitability are a consequence of the industry's present structure.

Identify the trends that are changing the industry's structure. Is the industryconsolidating? Are new players seeking to enter? Are the industry's productsbecoming more differentiated or more commoditized? Does it look as thoughadditions to industry capacity will outstrip the industry's growth of demand?

i Identify how these structural changes will affect the five forces of competitionand resulting profitability of the industry. Compared with the present, does itseem as though the changes in industry structure will cause competition tointensify or to weaken? Rarely do all the structural changes move competitionin a consistent direction - typically, some factors wil l cause comperit ion toincreasel others wil l cause competit ion to moderate. Hence, determining theoverall impact on profitability is likely to be a matter of judgment.

Strategy Capsule 3.2 discusses the future profitability of the US casino industry.During the past 20 years industry profitabil ity has been undermined by two

major forces: increasing international competit ion and accelerating technologicalchange. Despite widespread optimism that the "TMT" (technology, media, andtelecommunication) boom of the late 1990s would usher in a new era of profitability,the reality was very different. Digital technologies and the internet both increasedcompetitive pressures through lowering entry barriers and causing industries to con-verge. (See Strategy Capsule 3.3.)

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THE TOOi ,S OF STRATI 'GY ANAI ,YSIS

The ear ly years o f the 21s t cen tury saw a con-

t inuat ion o f the US cas ino boom tha t had begun

dur ing the mid-1990s. Between 1991 and 2005,

the ins ta l led base o f gaming mach ines inc reased

f rom 184,000 to 829,000 mach ines , wh i le US

expend i tu re on gambl ing revenues rose f rom

$304 b i l l i on to $850 b i l l i on over the same

per iod . Desp i te the cos ts o f expans ion , the

two industry leaders continued to earn good

pro f i t s . Har rah 's Enter ta inment (Grand Cas ino ,

Caesar 's , Ba l l y ' s , Par is ) earned an average ROE

of 14 .8o /o dur ing 2003-5 , wh i le MGM Mi rage

(Bellagio, New York New York, Luxor, Excal ibur,

MGM Grand) earned an average ROE o f 12 .6%.

However, the bankruptcy of Trump Hotels and

Casinos at the end of 2OO4 had raised a question

mark over the industry. Was Trump's entry into

Chapter 1l an isolated case of bad management,

or did i t point to an industry future of intensify-

ing compet i t ion and dec l in ing marg ins?

The most v is ib le s ign o f expans ion was the

race to bui ld the "biggest and best" hotel-casino

complexes in Las Vegas. Between 1996 and

2000, the number o f ho te l rooms in Las

Vegas casinos more than doubled. New "mega-

cas inos" in Vegas inc luded the MGM Grand, the

Bellagio, New York New York, and the Venetian.

Competit ion between the casinos involved ever

more ambit ious dif ferentiat ion in terms of soec-

tacle, entertainment, theming, and sheer scale.

Pr ice compet i t ion was a lso ev ident in te rms

of subsidized travel packages, free rooms, and

other perks for "high rol lers."

However, by far the greater part of industry

expans ion was ou ts ide the t rad i t iona l cen ters

in Las Vegas and At lan t ic C i ty , NJ . The mun ic i -

pa l i t ies and s ta te governments saw gambl ing

as a new source o f tax revenue and a s t imu lus

to economic deve lopment . The resu l t was the

introduction of r iverboat casinos and the l icens-

ing o f cas inos in Miss iss ipp i and seven o ther

s ta tes . Most impor tan t was the open ing o f

new cas inos on Ind ian reserva t ions . By 2006

there were some 120 cas inos on Ind ian reser -

vations across 1 7 states. One of the biggest

was Foxwood's, owned by the Mashantucket

Pequot tr ibe in Ledyard, CT. At the end of 2005,

there were 287,000 gaming mach ines in cas inos

located on tr ibal lands compared with 459,000

in " t rad i t iona l " cas inos ( inc lud ing r i verboats and

cru ise sh ips) .

Dur ing 2006-7 , geograph ica l expans ion o f

gambl ing seemed se t to cont inue w i th severa l

new cas inos in lnd ian reserva t ions in Ca l i fo rn ia

and more permiss ive approaches to gambl ing

in Ca l i fo rn ia , Wash ing ton Sta te , F lo r ida , and

Ok lahoma.

A fu r ther source o f new compet i t ion was

the in te rne t " A l though i l lega l in the US, in te rne t

gambl ing (espec ia l l y poker ) th rough non-US

in terne t gambl ing compan ies grew mass ive ly

dur ing 2000-5 .

With the growth of casino capacity and new

gambl ing oppor tun i t ies fa r ou ts t r ipp ing growth

in demand, what wou ld the imp l ica t ions be

for competit ion and profi tabi l i ty? Much would

depend on how the lead ing cas ino compan ies

responded to the deteriorat ing competit ive situ-

at ion. During 2005, the industry had experienced

another merger wave. Former indus t ry leader

Park Place was acquired by Harrah's, while MGM

Mirage acqu i red the number 4 in the indus t ry ,

Mandalay Resorts. As a result, two companies,

Har rah 's and MGM Mi rage, dominated the

industry with the reconsti tuted Trump Entertain-

ment Resorts a distant third.

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The Internet: Value Creator or Value DeStroyer?

The d i f fus ion o f the in te rne t dur ing the la te

1990s and the creation of a host of businesses

that sought to exploit i ts economic potential

resulted in one of the most spectacular

stock market booms in history. Pets.com,

Webvan.com, Kozmo.com, and Boo.com a l l

burned th rough hundreds o f mi l l ions o f do l la rs

of venture capital and, in several cases, achieved

s tock marke t va lues over $1 b i l l i on be fore

descending into bankruptcy.

So what a re the t rue indus t r ia l economics

of e-business? What can Porter 's f ive forces

analysis tel l us about the l ikely prof i t potential of

new internet-based businesses?

C H A P T E R 3 I N D U S T R Y A N A L Y S I S THE FUNDAMENTALS

The f irst thing to note is that most new

elec t ron ic bus inesses were no t fundamenta l l y

new businesses. For the most part they used

a new d is t r ibu t ion channe l fo r ex is t ing goods

and services: books (Amazon), air l ine t ickets

(Expedia), groceries (Peapod), and securit ies

(E-Trade). As such, the main features of these

markets are: strong substi tute competit ion from

tradit ional retai l distr ibution, low entry barr iers(sett ing up a website costs l i t t le), and weak

product dif ferentiat ion. The principal structural

fea tures o f these "e- ta i l inq" bus inesses are

shown below:

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The imp l ica t ion is tha t most "e - ta i l ing"

markets - whether for books, securit ies, house-

hold goods, or hotel accommodation - wi l l tend

to be h igh ly compet i t i ve and, on average, w i l l

generate low margins and low rates of return

on capital. Wil l any e-businesses offer high

profi tabi l i ty? The key is the potential to reduce

rivalry and raise barr iers to entry through strat-

egies that exploit network effects, economies of

scale, or product dif ferentiat ion. For example,

eBay exploits network effects to dominate the

person-to-person auction business; in books,

Amazon rel ies on scale economies and oroduct

dif ferentiat ion through i ts range of customer

services; Google exploits scale economies and

differentiat ion based on rapid innovation to

dominate web search.

Sources: M. E. Porter, "Strategy and the Internet," Harvard

Business Review (March 2001): 63*77) "fhe E-Commerce

Winners," Business Week (August 3, 2001).

\ t i " r r l c r l i c s i o A l l r r I t r r t t t s l t ' t 1 S l t " t t r l t t ' r t ,

Understanding how the structural characteristics of an industry determine the inten-sity of competit ion and the level of profitabil ity provides a basis for identifyingopportunities for changing industry structure to alleviate competit ive pressures. Thefirst issue is to identify the key structural features of an industry that are responsiblefor depressing profitability. The second is to consider which of these structural featuresare amenable to change through appropriate strategic init iatives. For example:

The remarkable profit revival in the world steel industry since 2002 owesmuch to the rapid consolidation of the industry, led by Mittal Steel. ' '

Excess capacity was a major problem in the European petrochemicals industry.Through a series of bilateral plant exchanges, each company built a leadingposition within a particular product area.'o

In the US airl ine industrg the major airl ines have struggled to change anunfavorable industry structure. In the absence of significant productdifferentiation, the airl ines have used frequent-fl ier schemes to build customerloyalty. Through hub-and-spoke route systems, the companies have achieveddominance of particular airports: American at Dallas-Fort Worth, US Airwaysat Charlotte NC, and Northwest at Detroit and Memphis. Mergers andall iances have reduced the numbers of competitors on many routes.'"

Building entry barriers is a vital strategy for preserving high profitabil ity in thelong run. A primary goal of the American Medical Association has been tomaintain the incomes of its members by controll ing the numbers of doctorstrained in the United States and imposing barriers to the entry of doctors fromoverseas.

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In our earlier discussion of the structure of the television broadcasting industry,I noted that a key challenge in industry analysis is defining the relevant industry. TheStandard Industrial Classification (SIC) offers an official guide, but this provideslimited practical assistance. Suppose Jaguar, a subsidiary of Ford Motor Company, is

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assessing its future prospects. In forecasting the profitability of its industry, should

Jaguar consider itself part of the "motor vehicles and equipment" industry (SIC 371),the automobile industry (SIC37l2), or the luxury car industry? Should it view itsindustry as national (UK), regional (Europe), or global?

In,du,strie s and Mark ets

The first issue is clarifying what we mean by the term "industry." Economists definean industry as a group of firms that supplies a market. Hence, a close correspondenceexists between markets and industries. So, what's the difference betr,veen analyzingindustry structure and analyzing market structure? The principal difference is thatindustry analysis - notably five forces analysis - looks at industry profitability beingdetermined by competition in two markets: product markets and input markets.

Everyday usage makes a bigger distinction between industries and markets. Typi-cally, industry is identified with relatively broad sectors, while markets refer to specificproducts. Thus, the firms within the packaging industry compete in many distinctproduct markets - glass containers, steel cans, aluminum cans, paper cartons, plasticcontainers, and so on.

Similar issues arise in relation to geographical boundaries. From an economist'sviewpoint, the US automobile industry would denote all companies supplying the USauto market - irrespective of their location. In everyday usage, the term "US autoindustry" typically refers to auto manufacturers located within the US, and is oftenrestricted to US-owned automakers (which now includes primarily Ford and GeneralMotors).

For the purposes of industry analysis, we need to adopt the economist's approachto identifying and defining industries. Thus, our starting point is the market - whichare the groups of firms that compete to supply a particular service? The result may bethat, for the purposes of industry analysis, we may wish to disregard conventionalconcepts of industry. For example, if we are examining competit ion within thebanking industry, it is likely that we would want to regard banking as comprisinga number of industries - banks supply a number of distinct services and competitionin each product market comprises different sets of firms. Most basic is the distinctionbetrveen retail banking and investment banking. Even within retail banking we can dis-tinguish different product groups. For example, credit cards and consumer lending areclosely related products, but they involve distinct product offerings and differentgroups of competing firms.

Given the conventional view of industries as broad economic sectors, it can berevealing to focus on competit ion using a micro-level approach that begins withcustomers choosing between rival offerings (see Strategy Capsule 3.4).

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I have argued that the key to defining industry boundaries is identifying the relevantmarket. By focusing on the relevant market, we do not lose sight of the critical rela-tionship among firms within an industry: competition. But how do we define markets?

A market's boundaries are defined by swbstitwtability.There are two dimensions tothis - substitutability on the demand side and the supply side. Let us consider oncemore the market within which Jaguar competes. Starting with the demand side, if cus-tomers are unwilling to substitute trucks for cars on the basis of price differences,

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Analyzing Competition in Markets for Offerings

THE TOOLS OF STRATI ]GY ANALYSIS

Mathur and Kenyon argue that our conventional

concept of industry is fundamental ly f lawed. In

order to ana lyze compet i t ion , we must beg in

with customer choice. Customers do not choose

a product or a company, their unit of choice is

the single offering. Competit ive strategy is the

"pos i t ion ing o f a s ing le o f fe r ing v is - i -v is a

unique set of potential customers and com-

peti tors." To analyze competit ion, i t makes no

sense to talk about the "watch market" or the

"watch industry" * the Patek Phil ippe Sky Moon

Tourbi l lon that sel ls at about half a mil l ion dol lars

does no t compete w i th the $35 T imex Spor t

Watch. Similarly, a $1,400 Swatch Lustrous Bl iss

Sapphire Watch is not a close competitor to

Swatch 's $39.95 Pampas R ider . Each mode l by

each watch maker is a separate offering and

each offering forms a dist inct market where

competitors can be ranked according to how

closely they compete with the focal offering.

Thus, i f we consider the Seiko Men's Steel Watch

($81), we can view the Cit izen Men's Steel Watch

($78) and f imexT29771 ($60) as close competi-

tors; the Bulova Inf inity ($150) and Swatch Once

Again ($45) are more distant competitors.

This micro approach to analyzing competit ion

focuses on cus tomer cho ices and cont ras ts

sharp ly w i th Por te r ' s indus t ry ana lys is tha t

examines compet i t ion a t a much h iger leve l o f

aggregat ion .

Shou ld we abandon our more aggregated in -

dustry analysis in favor of the meticulously micro

analysis advocated by Mathur and Kenyon? The

crit ical consideration is the type of question that

we want our compet i t i ve ana lys is to answer .

For decisions relat ing to marketing strategy -

inc lud ing produc t des ign , p r ic ing , adver t i s ing ,

distr ibution, and entry into specif ic market

segments - analysis of competit ion between

narrowly defined offerings in relat ion to specif ic

cus tomers and cus tomer g roups is l i ke ly to be

part icularly revealing.

For unders tand ing and pred ic t ing med ium-

term profi t trends, the conventional f ive forces

ana lys is o f fa i r l y b road ly de f ined indus t r ies

has two v i r tues . F i rs t , i t a l lows us to cons ider

compet i t ion in two marke ts s imu l taneous ly -

the market for outputs and markets for inputs.

Second, i t takes account o f supp ly -s ide sub-

st i tut ion. Thus, dif ferent Swatch models are

produced a t the same p lan ts us ing many o f

the same components . Indeed, the parent

company - Swatch Group - owns 16 brands ,

inc lud ing Swatch , Omega, Long ines , and T isso t .

Even between brands there is scope for real lo-

cating resources. Hence, for analyzing broad

quest ions o f p ro f i tab i l i t y and compet i t i ve

advantage, i t i s use fu l to cons ider the g loba l

watch indus t ry - though probab ly exc lud ing

the luxury watch segment, which in terms of

demand cond i t ions and produc t ion is c loser

to the jewelry industry than to the watch

i nd ustry.

Based on: Shiv Mathur and Alfred Kenyon, Winning Business

Strategles (Oxford: Butterworth-Heinemann. 2007).

Jaguar's market should be viewed as auton-robiles rather than all motor vehicles. Again,if customers are only wil l ing to substitute between Jaguars and other makes of luxurycars, then Jaguar's relevant market is lurury cars rather than the automobile marketas a whole.

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But this fails to take account of substitutability on the supply side. If manufacturersfind it easy to switch their production from luxury cars to family sedans ro sporrs carsand the like, such supply-side substitutability would suggesr that Jaguar is competingwithin the broader automobile market. The ability of Toyota, Nissan, and Honda topenetrate the luxury car market suggests that supply-side substitutability betweenmass-market autos and specialty autos is moderately high. Similarly, the automobileindustry is frequently defined to include vans and light trucks, since these can bemanufactured at the same plants as automobiles (often using the same platforms andengines). So too with "major appliance" manufacturers. They tend to be classified asa single industry, not because consumers are willing to substitute between refrigera-tors and dishwashers, but because the manufacturers can use the same manufacturingplants and distribution channels for different appliances.

The same considerations apply to the geographical boundaries of markets. ShouldJaguar view itself as competing in a single global market or in a series of separatenational or regional markets? The criterion here again is substitutability. If cusromersare willing and able to substitute cars available on different national markets, or ifmanufacturers are willing and able to divert their output among different countriesto take account of differences in margins, then a market is global. The key test of thegeographical boundaries of a market is price: if price differences for the same prod-uct between different locations tend to be eroded by demand-side and supply-sidesubstitution, then these locations lie within a single market.

In practice, drawing the boundaries of markets and industries is a matter of judg-ment that depends on the purposes and context of the analysis. If Ford is consideringthe pricing and market positioning of its Jaguar cars, it must take a micro-levelapproach that defines markets around each model, in each country, and in relation todifferent categories of customer (e.g., distinguishing between sales to car rental com-panies and sales to individual consumers). In considering decisions over investmentsin fuel cell technology, the location of engine plants, and which new products todevelop over the next five years, Ford will view Jaguar as one part of its auto andlight truck business and will define its market as global and extending across its fullrange of models. The longer term the decisions are that it is considering, the morebroadly it will wish to consider its markers, since substitutability is higher in the longrun than in the short term.

Second, the precise delineation of the boundaries of a market or industry isseldom critical to the outcome of our analysis so long as we remain wary of externalinfluences. The market in which an offering competes is a continuum rather than abounded space. Thus, we may view the competitive market of Disneyland, Anaheimas a set of concentric circles. Closest is Universal Studios Tour. Slightly more distantcompetitors are Sea \World and Six Flags. Further still might be a trip to Las Vegas, ora skiing weekend. Beyond these would be the broader entertainmenr market thatmight include cinemas, the beach, or playing video games.

For the purposes of applying the five forces framework, industry definition is notcritical.

'We define an industry "box" within which industry rivals compete, bur

because we include competitive forces outside the industry box - notably entrantsand substitutes - the precise boundaries of the industry box are not greatly important.'Whether

we view Harley-Davidson as competing in the "retro" segment of the heavy-weight motorcycle industry, in rhe heavyweight motorcycle industry, or in the motor-cycle industry as a whole is not critical to the outcome of our analysis. Even if wedefine Harley's market narrowly, we can still take into account competition from

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Tiiumph and Ducati as substitute competit ion. Indeed, we might want to considercompetit ion from more distant substitutes - sports cars, motorized water craft, andpart ic ipat ion in "ext reme sporrs." t '

The five forces framework allows us to determine an industry's potential for profit.But how is industry profit shared between the different f irms competing in thatindustry? As we have noted in our discussion of industry dynamics, comperirionbetween industry participants is ultimately a battle for competitive advar-rtage in whichfirms rival one another to attract customers and rnaneuver for positional advantage.Let us look explicit ly at the sources of competit ive advantage within an industry.In subsequent chapters we develop a more comprehensive analysis of competit iveadvantage. Our goal here is to identify those factors within the firm's market envir-onment that determine the firm's abil ity to survive and prosper - its key success

factors.z2 In Strategy Capsule 3.5, Kenichi Ohmae of McKinsey's Tokyo office dis-cusses key success factors in forestry and their link with srrategy.

Like Ohmae, our approach to identifying key success factors is straightforward andcolnmonsense. To survive arrd prosper in an industrS a firm must meet two criteria:first, it must supply what customers want to buy; second, it must survive competit ion.Hence, we may start by asking two questions:

'What do our customers want?

What does the firm need to do to survive competit ion?

To answer the first question we need to look more closely at customers of theindustry and to view them not so muclt as a source of bargaining power, and hence asa threat to profitabil ity, but more as the basic rationale for the existence of the indus-try and as the underlying source of profit. This irnplies that the firm must identify whoits customers are, what are their needs, and how they choose between competingofferings. Once we have identified the basis of custorners' preference, this is merely thestarting point for a chain of ar-ralysis. F'or example, if consumers' choice of supermar-kets is based primarily on which charges the lowest prices and if the abil ity to chargelow prices depends on low costs, the key issues concern the deterrninants of costsamong supermarkets.

The second question requires that the firm examines the basis of competit ion in theindustry. How intense is competit ion and what are its key dimensions? Thus, in theluxury car market, consumers select primarily on the basis of prestige, design, qual-ity, and exclusiveness. However, these qualit ies are an insufficient basis for success.In this intensely competit ive market, survival requires a strong financial position(to finance new product development) and costs that are sufficiently low to allow acompany to cover its cost of capital.

A basic framework for identifying key success factors is presented in Figure 3.7.Application of the framework to identify key success factors in three industries isoutl ined in Thble 3.3.

Key success factors can also be identif ied through the direct modeling of profitabil-ity. In the same way that the five forces analysis models the determinants of industry-level profitabil ity, we can also artempr to model f irm-level profitabil ity in terms of

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Probing for Key Success Factors

As a consul tant faced wi th an unfami l iar busi -ness or industry, I make a point of f irst asking

the specia l is ts in the business, "What is thesecret of success in this industry?" Needless to

say, I seldom get an immediate answer, and so

I pursue the inqui ry by asking other quest ions

from a variety of angles in order to establish asquickly as possible some reasonable hypothesesas to key factors for success. In the courseof these interviews it usually becomes quite

obvious what analyses wil l be required in order

to prove or disprove these hypotheses. By first

identifying the probable key factors for successand then screening them by proof or disproof, itis often possible for the strategist to penetrate

very quickly to the core of a problem.

Traveling in the United States last year, I

found myself on one occasion sitt ing in a plane

next to a director of one of the biggest lumber

companies in the country. Thinking I might learn

something useful in the course of the five-hour

fl ight, I asked him. "What are the key factors forsuccess in the lumber industry?" To my surprise.his reply was immediate: "Owning large forests

and maximizing the yield from them." The first

of these key factors is a relatively simple matter:purchase of forest land. But his second point re-quired further explanation. Accordingly, my nextquestion was: "What variable or variables do you

control in order to maximize the vield from aqiven tract?"


He repl ied: "The rate of tree growth is the key

variable. As a rule, two factors promote growth:

the amount o f sunsh ine and the amount o f

water. Our company doesn't have many forests

with enough of both. In Arizona and Utah, for

example, we get more than enough sunshine but

too little water, and so tree growth is very low.

Now, i f we could give the trees in those states

enough water, they'd be ready in less than

fi f teen years instead of the thirty i t takes now.

The most important project we have in hand

at the moment is aimed at f indinq out how to

do th is . "

lmpressed that this director knew how to

work out a key factor strategy for his business,

I offered my own contr ibution: "Then under the

opposite condit ions, where there is plenty of

water but too l i t t le sunshine - for example,

around the lower reaches of the Columbia River- the key factors should be fert i l izers to speed up

the growth and the choice of tree variet ies that

don ' t need so much sunsh ine . "

Hav ing es tab l i shed in a few minutes the

general framework of what we were going to

talk about, I spent the rest of the long f l ight very

profi tably hearing from him in detai l how each

of these factors was being applied.

Source.'Kenichi Ohmae, Ihe Mind of the strategist

(Harmondswor th : Pengu in , '1982) :85 . @ 1982. Repr in ted by

permission of McGraw-Hill ComDanres.

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Identifying key success factors

Analysis of competitiono What drives competit ion?0 What are the main

dimensions of comoetit ion?r How intense is competit ion?e How can we obtain a superior

competit ive posit ion?

KEY SUCCESS FACTORS p

identifying the key factors that drive a firrn's relative profitabil ity within an industry.In Chapter 2, we made some progress on this front. By disaggregating a firm's returnon capital employed into individual operating factors and ratios, we can pinpoint themost important determinants of f irm success (see Figure 2.1).In many industries, theseprimary drivers of f irrn-level profitabil ity are well known and widely used as perform-ance targets. Strategy Capsule 3.6 begins with a well-known profitabil ity formula usedin the airline industry, then identifies the factors that drive this ratio. More generally,the approach introduced in Chapter 2 to disaggregate return on capital into its com-ponent ratios can be extended to identify the specific operational and strategic driversof superior profitabil ity. Figure 3.8 applies this ar-ralysis to identifying success factorsin retail ing.

The value of success factors in formulating strategy has been scorned by some strat-egy scholars. Pankaj Ghemawat observes th:rt the "whole idea of identifying a successfactor and then chasing it seems to have something in common with the i l l-consideredmedieval hunt for the philosopher's stone, a substance that would transmute every-thing it touched into gold."2r Our objective in identifying key success factors is lessambitious. There is no universal blueprint for a successful strategy and, even in indi-vidual industries, there is no "generic strategy" that can guarantee success. However,each market is different in terms of what motivates customers and how competit ionworks. Understanding these aspects of the industry environment is a prerequisite foran effective business strategy. Nevertheless, this does not imply that firms within anindustry adopt common strategies. Since every firm comprises a unique set of re-sources and capabil it ies, even when an industry is subject to comrnon success factors(e.g. low costs), f irms wil l select unique strategies to l ink their resources and capabil-it ies to industry success factors.

TAB

Steel

Fashioc loth in

Superm

Prereouisites for success

How does the f irmsurvive competit ion?

Analysis of demand: Who are our customers?": What do they want?


TAllLFl it. i | Identifying key success factors: steel, fashion clothing, and supermarkets

Steel

Fashioncloth ing

Superma rkets

WHAT DOCUSTOMERS WANT?(Analysis of demand)

I Low priceO Product consistencyo Rel iabi l i ty of supplyO Speci f ic technical

<nor i { i r : t innc {^ r

<nor ie l < tee l<

O Diversity of customernro fprpnrcc in fo rmc

of garment type,style, quality, color

a Customers wi l l ing topay premium forbrand, style,exclusivity, and quality

o Mass market h ighlyprice sensitive

O Low pricesO Convenient locationO Wide range of

products adapted tol n r r l n r o { o r o n r o <

O Fresh/quality produce;good service; ease ofpark ing; p leasantambience

HOW DO FIRMSSURVIVE COMPETITION?(Analysis of competit ion)

KEY SUCCESSFACTORS

O Cost efficiency requires:large-scale p lants, low-cost location, rapidcapacity adjustment

O Alternatively, hightechnology, small-scaleplants can achieve lowcosts through f lex ib i l i tyand h igh product iv i ty

O Di f ferent ia t ion throughtechnical specificationsand service quality

O Combining differentiationwith low costs

O Differentiation requiresspeed of response tochanging fashions, s ty le,reputat ion, and qual i ty

O Cost efficiency requiresmanufacture in low wagecou ntries

O Low costs requireoperational efficiency,scale-efficient stores, largeaggregate purchases, lowwage costs

O Differentiation requireslarge stores (to allowwide product range),convenient locat ion,fami l iar i ty wi th localcustomer preferences

o Commodity products,excess capacity, high fixedcosts, excess capactty, exttbarr iers, and subst i tu tecompet i t ion mean intenseprice competit ion and- , , - l : - - l ^ . ^ { ; + ^ 1 . ; l ; + , ,L y L i l L d r P r v r I r d u i l r L y

f - n < + o f f i r i a n n r : n d

f inancial strength essential

Low barriers to entry andexit, low sellerconcentrat ion, and buyingpower of retail chainsimply in tense compet i t ionDifferentiation can yieldsubstant ia l pr ice premium,but imi tat ion is rapid

Intensity of pricecompet i t ion depends onnumber and proximi ty ofcompetitorsBargain ing power a cr i t ica ldeterminant of cost ofh n r r n h + - i n n n n d c

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PART I I THE TOOLS OI ' STRATEGY ANALYSIS

Identifying Key Suecess Factors by Modeling Profltability:Airlines

Profi tabi l i ty, as measured by operating income

per avai lable seat-mile (ASM), is determined by

three factors: yield, which is total operating

revenues divided by the number of revenue

passenger miles (RPMs); load factor, which is

the rat io between RPMs and ASMs; and unit

cost, which is total operating expenses divided

by ASMs. Thus :

Income

ASMs

Revenue RPMs , Exoensest a c c -

RPMs ASMs ASMs

Some of the primary determinants of each of

these measures are the fol lowinq:

C Revenue/RPMs- Intensity of competit ion on routes f lown.- Ef{ective yield management to permit

quick price adjustment to changing

market condit ions.- Abi l i ty to attract business customers.- Superior customer service.

O Load factors- Competit iveness of prices.- Eff iciency of route planning (e,9.,

through hub-and-spoke systems).- Bu i ld ing cus tomer loya l ty th rough qua l i t y

of service, frequent-f l ier programs.

- Matching airplane size to demand for

ind iv idua l f l i gh ts .

its Expenses/ASMs- Wage rates and benefi t levels.- Fuel eff iciency of aircraft.- Productivi ty of employees (determined

part ly by their job f lexibi l i ty).- Load factors.- Level of administrat ive cost.

In their batt le for survival. the air l ines have

sought to optimize as many of these factors as

possible in order to improve their prof i tabi l i ty.

To enhance revenue, several air l ines have with-

drawn from their most intensely competit ive

routes; others have sought to achieve a fare

premium over the cu t -p r ice a i r l ines th rough

superior punctual i ty, convenience, comfort, and

services. To improve load factors, companies

have become more f lexible in their pricing and

in al locating dif ferent planes to dif ferent routes.

Most notably, companies have sought to cut

costs by increasing employee productivi ty, re-

ducing overhead, sharing services with other

air l ines, and reducing salaries and benefi ts.Sumn

In Chaptderstandcritical inchapteIproach tcin order tand to idage. Thefive forcethe strucintensityrealizes. ,petition

FIGURE 3.8 Identifying keycase of retailing

CHAPTER 3 INDUSTRY ANALYSIS THE FUNDAMENTALS

success factors through analyzing profit drivers: the

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Summarv

In Chapter 1, we establ ished that profound un-derstanding of the competitive environment is acritical ingredient of a successful strategy. In thischapter, we have developed a systematic ap-proach to analyzing a f i rm's industry environmentin order to evaluate that industry's profit potentialand to identify the sources of competitive advant-age. The centerpiece of our approach is Porter'sfiveforces of competition framework, which linksthe structure of an industry to the competi t iveintensity within it and to the profitability that itrealizes. Although every industry is unique, com-pet i t ion and prof i tabi l i ty are the result of the

Maximize buying power tominimize cost of goods

purchased

Maximize inventory turnoverthrough electronic data

interchange, close vendorrelat ionships, fast del ivery

systematic influences of the structure of thatindustry. The Porter framework provides a simple,yet powerful organizing framework for classifyingthe relevant features of an industry's structureand predict ing their impl icat ions for competi t ivebehavior. The framework is particularly useful forpredicting industry profitability and for identify-ing how the f i rm can inf luence industry structurein order to improve industry profitability.

,As with most of the tools for strategy analysisthat we shall consider in this book, the Porter fiveforces framework is easy to comprehend. Whi lei ts basis is a substant ial bodv of microeconomic

Sales mix of oroducts

Avoiding markdowns throughtight inventory control

a customer service o qual i ty control

Minimize capital deploymentthrough outsourcing and leasing


theory, the relationships it posits are straightfor-ward and consistent with commonsense. How-ever, the real learning about industry analysis, andabout the Porter framework in particular, derivesfrom its application.lt is only when we apply thePorter framework to analyzing competi t ion anddiagnosing the causes of high or low prof i tabi l i tyin an industry that we are forced to confront thecomplexi t ies and subt let ies of the model. Whatindustry (or industr ies) does a company competein? Where do the industry 's boundaries l ie? Howwide a range of substitutes do we consider? Howdo excess capacity, cost structures, and exitbarriers interact with one another?

I urge you to put the tools of industry analysisto work - not just in your strategic managementcoursework, but also in your interpretat ion of

everyday business events. What will be the impactof Linux, Apache, and other open-source softwareon Microsoft's hugely profitable sales of operat-ing systems and server software? What are theprospects for the fixed-line telecom providerscurrently battered by wireless and internet tele-phony? ls your cousin's plan to leave her lawfirm to take up the posit ion of legal counselwith a major air l ine a good idea given the di lferent competi t ive circumstances of the twoindustr ies?

Through pract ical appl icat ions of the Porterframework, we shall also become aware of itsl imitat ions. In the next chapter we shal l considersome of these l imitat ions and look to ways inwhich we can extend and augment our analysiswith additional concepts, tools, and frameworks,

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SelI ' -Study Questions

The major forces shaping the business environment of the fixed-line telecom industry aretechnology and government policy. The industry has been influenced by fiber-optics (greatlyincreasing transmission capacity), new modes of telecommunication (wireless and internettelephony), deregulation, and privatization. Using the five forces of competition framework, showhow each of these developments has influenced competition in the fixed-line telecom industry.

From Thble 3.1, select a high-profit industry and a low-profit industry. From what you knowof the structure of your selected industry, use the five forces framework to explain whyprofitabil ity has been either high or low

With reference to Strategy Capsule 3.1, use the five forces framework to explain why the USsmokeless tobacco industry is so profitable (as indicated by the profitability of its dominant firm).

Despite high fuel costs, profitabil ity in the world airl ine industry increased substantiallyduring 2005 and 2006 - even while fuel costs were rising sharply. \X/hy?

!7al-Mart (l ike Carrefour, Ahold, and Metro) competes in several countries of the world,yet most shoppers choose between retailers within a radius of a few miles. For the purposesof analyzing profitability and competitive strategy, should lfal-Mart consider the discountretail ing industry to be global, national, or local?

What do you think are key success factors in:

a) The delivered pizza industry?b) The investment banking industry?

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Notes

1 B. Eilert, "Ignite your Strategic Planning Process

with a PEST Analysis," Strategy Knowledge(http ://strategyknowhow.bnet.com/PEST_analysis_primer.html), September 2004.

2 M. E. Portet, Competitiue Strategy: Tbcbniques forAnalyzing Industries and Competitors (New York: FreePress, 1980): Chapter 1. For a summary, see his article,"How Competitive Forces Shape Strategy," HaruardBusiness Reuiew 57 (March-April 1979): 86-93.

3 "For Bagel Chains, Investment May Be Money in the

Hole," \Yall Street.lowrnal (December 30, 1997): B8.4 \il J. Baumol, J. C. Panzar, and R. D. IWillig, Contestable

Markets and the Theory of Industry Structure (New

York: Harcourt Brace Jovanovich, 1982). See alsoMichael Spence, "Contestable Markets and the Theory

of Industry Structure: A Review Article," Journal ofEconomic Li terature 21 (September 1983): 981-90.

5 'Annual Frarrchise 500," Entrepreneur (January 2006).6 "Brand Loyalty Is Rarely Blind Loyalty," \Yall Street

lournal (October 1.9, 1989): B1 .7 R. D. Buzzell and P \V Farris, "Marketing Costs in

Consumer Goods Industr ies," in H. Thorel l i (ed.) ,

Strategy + Strilcture = Perftirmance (Bloomington, IN:Indiarra University Press, 1977): 128-9.

8 ln October 1999, the Dept. ofJust ice al legecl thatAmerican Airlines was using unf:rir means in irttemptingto monopolize air tr:rffic out of Dallas-Fort Worth(http://www.aeroworldnet.com/1 tw05 I 79.htm).

9 M. Lieberman ("Excess Capacity as a Barrier to Entry,"

Journal of Industrial Economics 35, June 1987: 607-27)argues that, to be credible, the threat of retaliation needsto be supported by incumbents holding excess capacitygiving them the poter-rtial to flood the market.

10 See for example: J. S. Bain, Barriers to New Competition(Cambridge, MA: Harvard Univers i ty Press, 1956) andH. M. Mann, "Sel ler Concentrat ion, Entry Barr iers, ar . rdRates of Return in Thirty Industries," Reuieru of

Economics and Statistics 48 (1966\: 296-307.1 1 !( S. Cornanor and T. A. \/llson, Aduertising and Market

Power (Cambridge: H:rrvard University Press, 1974);

J. L. Siegfried and L. B. Ev:rns, "Empirical Stuclies ofEntry and Exit: A Survey of the Evidence," Reuiew ofIndustrial Organization 9 (1994): 121-5 5 .G. S. Yip. "Crteway' to Enrry," Haruard Busincss Rcui tw

60 (September-October 19ti2): t l5-93.13 F. M. Scl.rerer and D. R. Ross, lndustrial Market

Structure and Economic Performance.3rd edn (Boston:


Houghton Mifflin, 1990); R. M. Grant, "Pricing

Behavior in the UK \Jfholesale Market for Petrol. A'Structure-Conduct Analysis'," /o urnal of Industrial

Economics 30 (March 1982).

14 R. Schmalensee, "Inter-Industry Studies of Structure andPerformance," in R. Schn-ralensee and R. D. Willig,Handbook of Indwstrial Organization,2nd edn(Amsterdam: North Hol land, 1988): 976; M. A.Salir-rger, "The Concentration-Margins Relationship

Reconsidered, " Broo kings Pap er s : Microe conomic s(1990\: 287-335.

15 The problems caused by excess capacity and exit barrters

are discussed in C. Baden-Fuller (ed.), StrategicManagement of Excess Cctpdcity (Oxford: BasilBlackwel l , 1990).

.16 "Boom and Bust atSea," Economlsl (August 18, 2005).

17 S. H. Lustgarten, "The Impact of Buyer Concentrationin Manufacturir-rg L'rdustries," Reuiew of Economics and

Statistics 57 (L975): 125-32; T. Kelly and M. L.

Gosman, "lncreasecl Buyer Concentration andits Effects on Profitability in the Manufacturing Sector,"Reuien, of lndustrial Organization 17 (2000): 41-59.

1tl "Globafization or Concentration?" Business V/eek(November 8, 2004): 54; "Mi t ta l : Blood, Steel and

Empire Bu i ldi n g," Busine s s'V/ee k (F ebruary 1, 3, 200 6).19 J. Bower, Wben Markcts Quake (Boston: Harvard

Business School Press, 1986).20 M. Carnal l , S. Berry, and P Spi l ler , 'A i r l ine Hubbing,

Costs and Dernand," in D. Lee (ed.), Aduances in Airline

Economics vol . 1 (Elsevier , 2006).

21 For a concise discr,rssion of market definition see Officeof Fair Trading, Marl<et Definition (London: December2004), especia l ly pp. 7-17.

22 The term was coined by Chuck Hofer and Dan Schendel- Strdtegy Formulation: Analytical Concepts (St. Paul:

West Publ ishing, 1977): 77 - who def ined key successfactors irs "those variables that management caninfluence through its decisions and that can affectsignificantly the overall competitive positions of the

firrls in an industry . . . Vithin any particular industrythev are derived fronr the interaction of two sets of

variables, namely, the economic and technologicalchar:rcteristics of the industry . . . and the competitive

weapons on which the various firns in the industry have

built their strategies."23 P Glren-rawat, Commitment: The Dynamic of Strategy

(NewYork : F ree P ress , 1991 ) : 11 .

12

Documents

Grant - Chapter 3