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Lecture 2

Business Strategy Analysis

Slide 2
Key Concepts

• The importance of industry-level analysis

• Porter’s five forces framework for industry


analysis

• Competitive strategy analysis of the firm

• Corporate strategy analysis for multi-business


organizations

Slide 3
The Importance of Strategy Analysis

• Strategy drives the actions of an organization.

• Studying a firm’s strategy provides:


– An understanding of what drives risks, profitability,
and competitive advantages

– A basis for future performance to be forecasted

– An idea of how to measure the success of a firm’s


actions

Slide 4
Industry Analysis
Short term profitability is determined by demand and supply factors
whereas long term profitability is determined by industry structure.

Degree of Actual Potential Competition:

- The profits in an industry are function of the maximum price that


customers are wiling to pay for the industry’s product or service.

- One of the key determinants of the price is the degree to which


there is competition among suppliers of the same or similar
products

- If there is keen/perfect competition, difficult to earn super profit

Slide 5
The Importance of Industry-Level Analysis

• A firms strategy is heavily influenced by the


industry it belongs to.
• Understanding the environment and competitive
forces within an industry helps in assessing the
key success factor and business risk of the
company.
• Porter’s five forces model created a useful
framework to evaluate the competitive forces at
work in an industry.

Slide 6
Degree of Actual Potential Competition

Five forces of “competition” developed by


Porter - potential sources of competition in
the industry (competitive force)

1. Rivalry among existing firms


2. Threat of New Entrants
3. Threat of Substitute Products
4. Bargaining Power of Buyers
5. Bargaining Power of Suppliers
Slide 7
Industry
Structure and
Profitability

Slide 8
Competitive Force 1:
Rivalry Among Existing Firms

• Higher degrees of competition among firms:

– Push prices towards the marginal cost of production.

– Make non-price dimensions of products or services


more important.

Slide 9
Degree of Actual Potential Competition

Five factors determine the intensity of


competition:
1. Industry growth rate
2. Concentration and balance of competitors
3. Degree of differentiation and switching costs
4. Scale/ learning economies and the ratio of fixed
to variable costs
5. Excess capacity and exit barriers

Slide 10
Degree of Actual Potential Competition

Competitive Force 1:
• Rivalry among existing firms: to determine the
intensity of competition between existing players
in an industry
(1) Industry growth rate:
• Existing firms in growing industry
• Existing firms can grow by taking share
away from other players in a mature
industries (price war is common)
Slide 11
Degree of Actual Potential Competition

• Rivalry among existing firms (cont’d):


(2) Concentration and balance of competitors
• Number of firms and their relative sizes
determine the degree of concentration in an
industry

• Degree of concentration influences the


extent to which firms in an industry can
coordinate their pricing and other
competitive moves

Slide 12
Degree of Actual Potential Competition

• Rivalry among existing firms (cont’d):


(3) Degree of differentiation and switching costs

• The extent to which firms in an industry


can avoid head-on competition depends
on the extent to which they can
differentiate their products and services
• Switching costs also determine
customers’ willingness to move from
one product to another
Slide 13
Degree of Actual Potential Competition

• Rivalry among existing firms (cont’d):


(4) Scale of economies and the ratio of fixed to variable
costs
• Size of the firm may affect scale of
economies and in turn, may affect the
level of competition that the company is
facing.
• If ratio of fixed to variable costs is high,
firms have an incentive to reduce prices
to utilize the capacity
Slide 14
Degree of Actual Potential Competition
• Rivalry among existing firms (cont’d):
(5) Excess capacity and exit barriers
• If capacity in an industry > customer demand,
there is a strong incentive for firms to cut prices
to fill capacity
• Exit barriers are high when the assets are
specialized or if there are regulations which
make exit costly
• The problem of excess capacity is more
serious if there are significant barriers for firms
to exit the industry
Slide 15
Competitive Force 2:
Threat of New Entrants
• The potential of earning abnormal profits will
attract new entrants to an industry. The ease to
which new firms can enter an industry is a key
determinant of its profitability.

• Factors affecting the barriers to entry are:


– Economies of scale
– First mover advantage
– Relationships with suppliers and customers
– Legal barriers

Slide 16
Degree of Actual Potential Competition
Competitive Force 2: Threat of New Entrants:
(1) Economies of scale:
- Economies of scale might arise from large
investments in physical plant and equipment.
– New entrants face the choice of having either to
invest in a large capacity which might not be utilized
right away or to enter with less than the optimum
capacity.
– New entrants will suffer from a cost disadvantage in
competing with existing firms.

Slide 17
Degree of Actual Potential Competition

• Threat of New Entrants (cont’d):


(2) First Mover Advantage (early entrants)
– By setting standards or enter into exclusive
arrangements with suppliers of cheap raw materials
– Acquire scarce government licenses to operate in
regulated industries
– Require significant switching costs for customers
once they start using existing products
– e.g. switching costs faced by the users of
Microsoft’s Window System make it difficult for
software companies to market a new operating
system
Slide 18
Degree of Actual Potential Competition
• Threat of New Entrants (cont’d):
(3 ) Access channels of distribution and relationships

- Limited capacity in the existing distribution channels and


high costs of developing new channels can act as powerful
barriers to entry

- Existing relationships between firms and customers in an


industry is important

(4) Legal barriers


– Patents and copyrights e.g. research-intensive industry
– Licensing regulations e.g. telecommunication industry
Slide 19
Competitive Force 3:

Threat of Substitute Products


• The degree to which substitute products exist
affects the industry’s bargaining power with
customers, and ultimately profitability.

• The degree to which substitutes exist depends


upon the relative price and performance of
competing products or services, and the
willingness of customers to accept substitutes.

Slide 20
Competitive Force 4:

Bargaining Power of Buyers


• Factors that can affect this bargaining power are:

– Buyer price sensitivity to product

– Relative bargaining power of buyers

Buyer bargaining power can exert downward


pressure on prices when buyers are price
sensitive and there are plenty of substitute
products.
Slide 21
Degree of Actual Potential Competition

Competitive Force 4:
Bargaining Power of Buyers

(1) Price sensitivity: extent to which buyers


care to bargain on price

– Price sensitive: product is undifferentiated and there


are few switching costs

– Depends on the importance of the product to their


own cost structure

Slide 22
Degree of Actual Potential Competition

• Bargaining Power of Buyers

(2) Relative bargaining power: extent to which


they will succeed in forcing the price down

It is determined by:
- the number of buyers relative to the number of
suppliers,
- volume of purchases by a single buyer,
- number of alternative products available to the buyer,
- buyers’ costs of switching from one product to another

Slide 23
Competitive Force 5:

Bargaining Power of Suppliers

• A mirror image of the bargaining power of


buyers.

– Suppliers have bargaining power when there are few


substitutes and/or few suppliers relative to the
number of customers demanding a product or service.

Slide 24
Degree of Actual Potential Competition

Competitive Force 5:
• Bargaining Power of Suppliers
- Powerful when there are only a few companies and
few substitutes available to their customers
- Powerful over buyers when suppliers’ product or
service is critical to buyers’ business

Slide 25
Industry Analysis

Limitations of industry analysis :

The assumption that industries have clear


boundaries but in reality, it is often not easy
to clearly demarcate industry boundaries due
to diversification.

Slide 26
Competitive Strategy Analysis

• The profitability of a firm is influenced not only by its


industry structure but also by the strategic choices it
makes to positioning itself in the industry
• Individual firms must choose appropriate strategies to
succeed within their industry segment.
• Two basic competitive strategies are:
– Cost leadership
– Product / service differentiation
Both allow a firm to build a sustainable competitive
advantage

Slide27
Strategies
for Creating
Competitive
Advantage

Slide 28
Achieving and Sustaining
Competitive Advantage
• Choice of strategy is an important first step for a firm.
The likelihood of achieving and sustaining
competitive advantage must be evaluated.

• Factors to evaluate include:


– Strategic positioning: whether the firm’s activities are
consistent with its competitive strategy.

– Unique core competencies : resources and


capabilities to implement strategies.

– A system of activities that fits with the strategy and


potentially reinforce each other
Slide 29
Competitive Strategy Analysis
Sources of Competitive Advantage
1. Cost Leadership (for product not professional
services)

– Ways to achieve cost leadership:


• Economies of scale
• Efficient production
• Simpler product design
• Lower input costs
• Efficient organizational processes

Slide 30
Competitive Strategy Analysis
Sources of Competitive Advantage
• Cost Leadership (Cont’d)
– Cost leaders can earn above-average profitability and force its
competitors to cut prices and accept lower returns or exit the
industry

– Cost leaders often have tight cost controls


• Investments in efficient scale plants
• Focus on product designs that reduce manufacturing costs
• Minimize overheads
• Make little investment on risky research and development
• Have organizational structures and control system that
focus on cost control
Slide 31
Competitive Strategy Analysis
Sources of Competitive Advantage
2. Differentiation
– It needs to identify one or more attributes of a
product or service that customers value

– It has to position itself to meet the chosen


customer’s need in a unique manner

– The firm has to achieve differentiation at a cost that


is lower than the price the customer is willing to pay
for the differentiated product or service

Slide 32
Competitive Strategy Analysis

Sources of Competitive Advantage


• Differentiation (Cont’d)
– Drivers of differentiation
• Providing superior intrinsic value via
– Product quality
– Product variety
– Bundled service
– Delivery timing
• Can also be achieved by investing in signals of
value such as brand image, product appearance
or reputation
Slide 33
Competitive Strategy Analysis
Sources of Competitive Advantage
• Differentiation (Cont’d)
– Drivers of differentiation
• Require investments in research and
development, engineering skills and marketing
capabilities
• Organizational structures and control system
need to foster creativity and innovation
• Firms that target differentiation still need to
focus on costs so that the differentiation can
be achieved at an acceptable cost.

Slide 34
Competitive Strategy Analysis
Applying Competitive Strategy Analysis to the IKEA group

• What was IKEA’s superior performance based on?

– Low-cost competitive strategy


– Global strategy
– Sourcing of production
– Economic designs
– Logistics
– Sales

Slide 35
Corporate Strategy Analysis
Sources of Value Creation at the Corporate Level
• Corporate strategy analysis involves examining whether a
company is able to create value by being in multiple
businesses at the same time.

• Value creation can be achieved by reduced costs or increases


revenues from running several businesses in one firm relative
to the same businesses operating independently and
transacting with each other in the marketplace.

• These cost savings or revenue increases come from


specialized resources that the firm has to exploit synergies
across these businesses.

Slide 36
Corporate Strategy Analysis
Sources of Value Creation at the Corporate Level
• It can create value through a multi-business organization only
when it is managed so that the transaction costs inside (in-
house) the organization are smaller than the market
transaction costs (out-sourcing).
• Transaction cost of performing a set of activities inside an
organization (in-house) may be less costly than market-based
transactions (out-sourcing more expensive).
• Transaction cost may arise if the production process involves
the specialized assets such as human capital skills or
proprietary technology that is not easily available in the
marketplace.
Slide 37
Corporate Strategy Analysis

Sources of Value Creation at the Corporate Level (Cont’d)

For companies with multiple business and centralized


organizational structure:

– Headquarters office can play a critical role in reducing


costs of enforcing agreements between organizational
subunits.

– Organizational subunits can share valuable non-tradable


assets (organizational skills such as Legal dept) or non-
divisible assets such as brand names & reputation.

Slide 38
Corporate Strategy Analysis

Sources of Value Creation at the Corporate Level (Cont’d)

• Top management of an organization may lack the specialized


information and skills necessary to manage business across
several different industries.
• This problem can be resolved by creating a decentralized
organization structure, hiring specialist managers to run each
business unit.
• However, with decentralized organization structure, it is difficult
to realize economies of scope, or reduce the operating cost of
the company.

Slide 39
Corporate Strategy Analysis
Sources of Value Creation at the Corporate Level
To assess whether an organization’s corporate strategy has
the potential to create value:
– Is there a good fit between the company’s specialized
resources and the portfolio of businesses in which the
company is operating?

– Does the company allocate decision rights between the


headquarters office and the business units optimally?

– Does the company have internal measurement, information


and incentive system to reduce agency costs and increase
coordination business units?
Slide 40
Corporate Strategy Analysis

Sources of Value Creation at the Corporate Level (Cont’d)


• Evidence suggests that creating value through a multi-
business corporate strategy is hard in practice:

– Managers’ decisions to diversify and expand are


frequently driven by a desire to maximize the size of
their organizations rather than to maximize
shareholders’ value

– Diversified companies often suffer from incentive


misalignment problems leading to suboptimal
investment decisions and poor operating performance
Slide 41
Corporate Strategy Analysis
Sources of Value Creation at the Corporate Level (Cont’d)

- Capital markets find it difficult to monitor and value multi-


business organizations because of inadequate disclosure
about the performance of individual business segments.

- In summary, while companies can theoretically create


value through corporate strategies, it is actually very hard
to achieve in practice.

Slide 42
Concluding Comments

• The industry analysis approach has notable


strengths and some limitations.

• Porters five forces framework is valuable in


evaluating the strategy and actions of firms
within an industry.

Slide 43