Industry Analysis: The Fundamentals

Chapter 3

Objectives From Environmental Analysis to Industry Analysis Value Creation and Profitability Determinants of Industry Profit Porters Five Forces of Competition - Unit Costs and Economies
(volume, scale, scope, learning)

Applying Industry Analysis Boundaries of the Industry Identifying Key Success Factors

Objectives

To understand how industry structure

drives competition, which determines the level of industry profitability.

Corporate Strategy: Which industries should we be in?

To assess industry attractiveness To use evidence on changes in industry

structure to forecast future profitability

To formulate strategies to change industry

structure to improve industry profitability

Business Strategy: How should we compete in this industry?

To identify key success factors

From Environmental Analysis to Industry Analysis

The industry environment is rooted in the macro-environment The macro-environment affects the firm through its influence on the industry environment

Natural Environment Demographic Structure Suppliers Nationaland International Economy

Customers Suppliers Competitors

Potential Entrants

Industry Competitors

Substitutes

Buyers (Customers) Government andPolitics Social Structure

Technology

Value creation and profitability:

transaction between producers and end-users
Value is created through transformation: - Production (physical transformation) - Trade (transformation in space/time)

Value creation and profitability:

more transformation phases before final sale

Determinants of Industry Profitability

1. Value of the product to customers 2. Intensity of competition 3. Relative bargaining power at different levels within the value chain

Determinants of Industry Profitability:

Industry Structure

Perfect Competition Concentration Entry and exit barriers Product differentiation Information avaliability
Many firms

Oligopoly
A few firms

Duopoly
Two firms

Monopoly
One firm

No barriers Homogeneous product (commodity) Perfect availability

Significant barriers

High barriers

Potential for product differentiation

Imperfect availability of information

Determinants of Industry Profitability:

Porter Five Forces of Competition
3 horizontal forces: Potential Entrants Industry competitors Substitutes 2 vertical forces: Suppliers Buyers

SUPPLIERS
Bargaining power of suppliers

INDUSTRY COMPETITORS
Threat of new entrants Rivalry among existing firms Threat of substitutes

POTENTIAL ENTRANTS

SUBSTITUTES

Bargaining power of buyers

BUYERS

Determinants of Industry Profitability:

Porter Five Forces of Competition

SUPPLIER POWER
Buyers price sensitivity Relative bargaining power

THREAT OF ENTRY
Capital requirements Economies of scale Absolute cost advantage Product differentiation Access to distribution channels Legal/regulatory barriers Retaliation

INDUSTRY RIVALRY
Concentration Diversity of competitors Product differentiation Excess capacity & exit barriers Cost conditions

SUBSTITUTE COMPETITION
Buyers propensity to substitute Relative prices & performance of substitutes

BUYER POWER
Buyers price sensitivity Relative bargaining power

Porter Five Forces of Competition:

Threat of Substitutes

Competitive pressure from producers of substitutes depends on Buyers propensity to substitute, which in turn depends on The price-performance characteristics of substitutes
In so far that propensity is high, and the price-performance characteristics of the substitutes are similar to the industry product - The greater decrease of demand may be caused by a lower price of the substitutes - The less freedom the industry producers enjoy in setting their own market prices

If the product is complex and assessing its performance difficult, it is less likely that customers consider substitution on the basis of price differences

Porter Five Forces of Competition:

Threat of New Entrants

The fact that an industry shows a good rate of return on employed capital attracts new investments from the outside. These entries cause an increase of supply and competition, and this pushes prices and profits toward the competitive level. The possibility for an industry to maintain high average profitability depends on the existence of entry barriers that make new entries difficult and costly Barriers to entry are obstacles to the entry of other firms in the industry. They may be also regarded as advantages enjoyed by the existing firms in the industry

(e.g.: specific resources owned only by the firms that already operate in the industry, and not easily available to new entrants).

Porter Five Forces of Competition:

Threat of New Entrants and Barriers to Entry

Capital requirements Economies of scale Absolute cost advantages Product differentiation Access to channels of distribution Governmental and legal barriers Retaliation However the effectiveness of these barriers depends on the endowment of resources of new potential entrants (size, liquidity, brand, product range etc.)

Unit Costs and Economies:

Economies of Volume
Given a production capacity, when actual production fully exploits that capacity unit costs are lower, because the fixed costs of production facilities are distributed over a greater production volume (see the red curve below).
Fixedcosts Variable(unit)cost Fixed(total)costs Unitsofproduct 10 1 Fixed(unit)costs
12

FixedCosts
10

Variablecosts

Unitcosts

1 2 3 4 5 6 7 8 9 10

10 10 10 10 10 10 10 10 10 10

1 11.00 2 6.00 3 4.33 4 3.50 5 3.00 6 2.67 7 2.43 8 2.25 9 2.11 10 2.00

10.00 5.00 3.33 2.50 2.00 1.67 1.43 1.25 1.11 1.00

0 1 2 3 4 5 6 7 8 9 10

Unit Costs and Economies:

Economies of Scale
Lower unit costs are caused by larger production capacity (for constant rate of exploitation of that capacity), as a consequence of the higher efficiency of large production facilities. In economies of volume the production capacity is given and fixed, the variable is the rate of exploitation of the capacity, the higher it is the lower is the incidence of fixed costs for product unit. In economies of scale the production capacity itself is the variable and lower unit costs follow from: i. increase in the cost of a larger plant is less than proportional to the increase of capacity ii. variable unit costs are lower; for instance, less electrical power for product unit.

Long term unit cost

Short term unit cost for some alternative installed capacities (increasing from left to right)

The difference between economies of volume and economies of scale is parallel to the distinction between (unit) cost functions - Short term (x axis is the rate of exploitation of a given capacity) - Long term (x axis is the production capacity itself).

Units of output per period

Unit Costs and Economies:

Economies of Experience or Learning

Lower unit costs caused by the increase of cumulated production. This is the total production obtained since the first product was obtained, while production capacity is the production obtainable per time unit (e.g. year). The decrease of unit costs is consequence of: i. improvement of individual abilities of the workers (individual learning-by-doing) ii. improvement of organization of production (organizational learning).

In this case the production volume on the x axis - is NOT the quantity produced in a given period (a rate, e.g. the production per year) - but the entire production obtained across all the time elapsed since the production of the first unit of product (cumulated production). If we fix the rate of production (e.g. given quantity per year) we can consider the x axis as the time dimension. Time Cumulated production

2000
10.000

2001
20.000

2002
30,000

2003
40.000

2004
50.000

Unit Costs and Economies:

Economies of Scope
Lower unit costs are caused by the widening of the products range. This is the effect of the increased exploitation of resources that may be employed for further products without additional costs. For instance: - different types of products can be sold across the same distribution facilities (suppose they are not entirely exploited for a narrower range of products, and that they are not reducible) - an already established brand can be extended over further products without additional costs - the technical know-how developed in connection with a certain product might be valuable also for products of different type. Note that there may be ambiguity in labeling the types of economies. While the distinction between volume, scale and experience is clear-cut, the distinction of economies of scope from the economies of scale or volume is sometime not so straightforward. It helps to consider that the economies of scope are caused by the increased variety of the products range, while other economies are caused by the increased production of a given product. What is common to all cases is that it is always implied a higher level of activity inside the firm.

Porter Five Forces of Competition:

Rivalry Between Established Competitors
Within the industry, among the existing firms the nature of competition and its intensity, depend on

(on price or other dimensions, such as product innovation, advertising )

Concentration

number of firms, size of the firms (relative to the aggregated market demand)
for their cost conditions, objectives, interpretation of the competitive situation

Diversity of competitors Product differentiation

extent to which the offerings of different firms cannot be compared only on the basis of price

Excess capacity and exit barriers Cost conditions: economies of scale and ratio fixed costs/variable costs

Porter Five Forces of Competition:

Rivalry Between Established Competitors
(role of balance between capacity and demand)

ROI (%)

30

25

20

15

10

Return on sales

Return on investment

Cash flow/Investment

Annual rate of growth of market demand

< -5%

-5% to 0

0 to 5%

5% to 10%

> 10%

Porter Five Forces of Competition:

Bargaining Power of Buyers
1. Buyers price sensitivity
o Cost of purchases as % of buyers total cost o Differentiation of the purchased item o Intensity of competition between buyers o Importance of the purchased item for the quality of the buyers own output

2. Relative bargaining power

o Size and concentration of buyers relative to sellers o Buyers information o Potential of backward vertical integration of buyers

Porter Five Forces of Competition:

Bargaining Power of Suppliers

Here the industry firms find themselves in the reversed role of buyers, but the same factors apply again. With some remarks Raw materials, semi-finished goods and components are often commodities supplied by small companies to large manufacturers. Because of this commodity suppliers often seek to enhance their bargaining power through: Cartelization
(OPEC, International Coffee Organization ; similar is the unionization of workers)

Product differentiation Forward vertical integration into the buyers industry

Porter Five Forces of Competition:

Bargaining Power of Suppliers
(role of unionization of workers)
Profitability (%)
25

20

15 ROI (%) ROS (%) 10

0%

1%-35%

36%-60%

61%-75%

over 75%

Percentage of employees unionized

Applying Industry Analysis

Describing industry structure Forecasting industry profitability Changing industry structure

Applying Industry Analysis:

Describing Industry Structure
Identify the main players

Producers, customers, suppliers, producers of substitute goods, potential entrants not always these are all important, at the same time it might be the case that other types of actors are important (i.e. complementors)

Examine their characteristics that determine competition and bargaining power it may be difficult!
Television programming in the USA: there are a number of different types of player and it is not simple to establish (i) the industry boundaries and (ii) which actors are buyers and which are sellers. i. Industry boundaries: do we consider all forms of TV distribution or indentify separate industries for broadcast TV, cable TV and satellite TV?

ii. Buyers and sellers: the industry has quite a complex value chain with the producers of the individual shows, networks that put together program schedules, and local broadcasting and cable companies that undertake final distribution. For the distribution companies there are two buyers: viewers and advertisers. Some comapnies are vertically integrated across several stages of the value chain thus networks such as FOX and NBC not only create and distribute program schedules, they are also backward integrated into producing some TV shows and forward integrated into local distribution through ownership of local TV stations.

Vertical boundaries: Which activities of the value chain to include in the industry? Horizontal boundaries: Which products and geographical areas to include in the industry?

Applying Industry Analysis:

Forecasting Industry Profitability
Industry analysis may explain the profitability of the industry in the past, however what is really important is predicting future profitability. Strategic decisions are essentially investment decisions that commit resources to an industry for a long time. Forecasting is of critical importance. Current or past profitability may not be a reliable index of future profitability.

1. Examine how current and recent levels of competition and profitability are a consequence of its present structure 2. Identify the trends that are changing the industrys structure 3. Identify how these structural changes will affect the five forces of competition and resulting profitability of the industry Different structural changes may have different direction, some will increase competition, some will moderate it. Establishing their net effect is a matter of judgment.

Applying Industry Analysis:

Changing Industry Structure
Industry structure may be changed through appropriate strategic initiatives. 1. Which are the important structural features of the industry? 2. On which is it possible to intervene, and how? Individually? Collectively through inter-firm agreements?
Steel industry: good profitability between 2002 and 2008 was result of growing demand, but also supported by the rapid consolidation of the industry, led by Mittal Steel. European petrochemicals: excess capacity was a major problem. Through a series of bilateral plant exchanges, each company built a leading position within a particular product area. U.S. airline industry: frequent flyer schemes built customer loyalty in the absence of product differentiation; through hub-and-spoke route systems companies have achieved dominance of particular airports. Mergers and alliances have reduced the number of competitors on many routes. Professional associations: impose barriers to entry by controlling training, and especially accreditation, of professionals.

Boundaries of the Industry

Industries and Markets
Suppose Jaguar is assessing its future prospects. In forecasting industry profitability
Which product scope should be considered? Segment of luxury cars (SIC 3712) automobile industry (SIC 371) motor vehicles and equipment Which geographic scope? National (UK) Regional (Europe) Global

Definition: Economists define an industry as a group of firms that supply a market.

Is there a one-to-one correspondence between industry and market? What if the same firms supply different and heterogeneous markets? it happens! What if heterogeneous firms serve the same market? it happens!

Current usage: industry is broad definition (i.e. packaging), and may be subdivided in several markets (glass containers, metal cans, paper boxes ).
Confusing! lets try to make order

Industry: group of firms

Supply side; based on which similarities among firms is the group identified? Demand side; based on which similarities among products? Are these similarities in production or consumption?

Market: group of products

Industry structure, industry analysis: referred to producers, supply side. Market structure, market analysis: types of customers, demand side.

Boundaries of the Industry

Interdependencies between different products (and producers) Substitution in Demand and Supply
Suppose Jaguar is assessing its future prospects. In forecasting industry profitability
Which product scope should be considered? Segment of luxury cars (SIC 3712) automobile industry (SIC 371) motor vehicles and equipment Which geographic scope? National (UK) Regional (Europe) Global

Interdependencies: Which actors in Jaguars economic environment may influence its profitability? Whose behaviors may make a difference for the attainment of its goals?

Demand-side substitution:

Do Jaguar customers consider as a potential alternative the purchase of a truck, based on the comparison of price and performance? No, producers of trucks may be excluded, even if they produced fast and cheap trucks they would not take customers from Jaguar in the same fashion the producers of economy cars may be excluded too. Are economy cars or truck producers able to convert their production to luxury cars? If yes their behaviors are relevant, and must be included in the analysis if conversion takes time, inclusion or not in the industry depends on the temporal scope of the analysis, which in turn depends on the duration of the investments that are considered. The longer term are the decision that a firm is considering, the more broadly it will wish to consider its markets.

Supply-side substitution:

Boundaries of the Industry

Interdependencies between different geographical locations Substitution in Demand and Supply

Suppose Jaguar is assessing its future prospects. In forecasting industry profitability
Which product scope should be considered? Segment of luxury cars (SIC 3712) automobile industry (SIC 371) motor vehicles and equipment Which geographic scope? National (UK) Regional (Europe) Global

Interdependencies: If price differences for the same product between different locations tend to be eroded by demand-side and supply-side substitution, then these locations lie within a single market.

Demand-side substitution: Supply-side substitution:

May Jaguars customers consider as an alternative the purchase of a German or Italian car (Europe)? What about an US or Japanese car (global)? Are German or Italian producers able to supply the UK market? What about the US or Japanese? Is Jaguar able to supply German, Italian, US or Japanese markets?

If Japanese produced luxury cars perceived by customers as an alternative to Jaguar cars, and sold them at lower prices in the same geographical markets, then Jaguar would experience a loss of customers that would put pressure toward either (i) effectively distinguish its cars from the Japanese (differentiation); (ii) lower its cars prices (likely also by cutting costs)

Key Success Factors

How to create value What do customers want?

How to appropriate the rent How to deal with competiton?

ANALYSIS OF DEMAND o Who are our customers? o What do they want?

ANALYSIS OF COMPETITION o What factors drive competition? o What are the main dimensions of competition? o How intense is competition? o How can we obtain a superior competitive position?

KEY SUCCESS FACTORS

Key Success Factors

Examples of Steel, Fashion Clothing and Supermarkets (Table 3.3)

WHAT DO CUSTOMERS WANT? (Analysis of demand) HOW DO FIRMS SURVIVE COMPETITION? (Analysis of competition)

KEY SUCCESS FACTORS

Steel

Low price Product consistency Reliability of supply Specific technical specifications for special steels.

Strong price competition and Main sources of cost efficiency include: cyclical profitability necessitates large-scale plants, low-cost location, cost efficiency and strong rapid adjustment of capacity to output. financial resources Alternatively, hi-tech minimills can achieve low costs through flexibility and high productivity. Differentiation through product and service quality possible.

Fashion clothing

Fragmented demand (segmented by garment type, style, quality, color). Customers willing to pay price premium for brand, style, exclusivity, and quality. Mass market highly price sensitive.

Intensely competitive due to low entry barriers, low seller concentration, and strong retail buying power Differentiation can yield substantial price premium, but imitation rapid.

Combine effective differentiation with low-costs Key differentiation variables are speed of response to changing fashion, style, reputation and quality. Cost efficiency requires manufacture in low wage countries.

Supermarkets

Low prices. Convenient location. Wide range of products adapted to local preferences. Fresh/quality produce, good service, ease of parking, pleasant ambience.

Markets localized Intensity of price competition depends on number and proximity of competitors. Bargaining power a critical determinant of cost of boughtin goods.

Low-cost operation requires operational efficiency, scale-efficient stores, strong buying power, low wage costs. Differentiation requires wide product range (hence, large stores), convenient location, easy parking.

Key Success Factors

Identifying key success factors by analyzing profit drivers Example of Retailing (Figure 3.7)

Sales mix of products

Return on Sales

Avoiding markdowns through tight inventory control Maximize buying power to minimize cost of goods purchased

ROCE Maximize sales/square foot through: * location *product mix * customer service *quality control Maximize inventory turnover through electronic data interchange, close vendor relationships, fast delivery Minimize capital deployment through outsourcing & leasing

Sales/Capital Employed

Key Success Factors

Identifying key success factors by modeling profitability The Airline Industry (Box 3.6)

Profitability

Yield

Load factor

Unit cost

Income ASMs

Revenue RPMs

RPMs ASMs

Expenses ASMs

Strength of competition on routes. Responsiveness to changing market conditions % business travelers Achieving differentiation advantage

Price competitiveness. Efficiency of route planning. Flexibility and responsiveness. Customer loyalty. Meeting customer requirements.

Wage rates. Fuel efficiency of planes. Employee productivity. Load factors. Administrative overhead.

ASM = Available Seat Miles (number of seats available for sale x distance traveled in miles) RPM = Revenue Passenger Miles (number of paying passengers x distance traveled in miles)