Chapter 3

External Analysis: Industry Structure, Competitive Forces, and Strategic Groups

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The AFI Strategy Framework

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The Firm within Its External Environment, Industry, and Strategic Group, Subject to PESTEL Factors

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The PESTEL Framework

Framework to scan, monitor, and evaluate important external factors/trends (opportunities and threats) impacting a firm in its quest for competitive advantage.

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Analyzing the General Environment

Consider the relevance of each of the six factors in the context of the particular business

Identify and categorize the information that applies to the relevant factors (identify opportunities and threats)

Analyze the data and draw conclusions – which O/T need to be acted on and when (short term vs. long term)?

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MACRO

MICRO

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EXTERNAL ANALYSIS

INDUSTRY ANALYSIS

Five Forces Model

COMPETITOR ANALYSIS

Strategic Group Mapping

PESTEL Framework

Definitions

Industry

A group of (**incumbent**) firms that face the same set of suppliers and buyers

Industry Analysis

Identifies the industry’s profit potential

Derive implications for a firm’s strategic position within an industry

Strategic Position

A firm’s ability to create value (V) for customers while containing costs (C)

Competitive Advantage = a large value gap (V – C)

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Instructors:

The digital companion to this book McGraw-Hill Connect has an brief case exercise on this section of the textbook. It builds student confidence on the PESTEL tool (LO 3-1).

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Michael Porter’s 5 Forces Model

A framework for identifying the five forces that determine industry profit potential and help shape firm competitive strategy

This model intersects:

Theory: industrial organization economics with

Practice: hundreds of case studies

Managers can predict industry profit potential and position their firms for sustainable competitive advantage.

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For example, hotel chains and resort owners have challenged Airbnb in courts and lobbied local governments, some of which passed regulations to limit or prohibit short-term rentals. Local residents in New York, San Francisco, Berlin, Paris, and many other cities are also pressuring local governments to enact more aggressive rules banning short-term rentals because they argue that companies such as Airbnb contribute to a shortage of affordable housing by turning entire apartment complexes into hotels or transforming quiet family neighborhoods into all-night, every-night party hot spots. 

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Strategy Video

Michael Porter on Five Forces

Interview with Michael Porter, Professor at Harvard University

http://www.youtube.com/watch?v=mYF2_FBCvXw

13:12 Minutes

Topics: Five Forces Model; Competitive Strategy

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Occasionally, boom periods can overheat and lead to speculative asset bubbles. In the early 2000s, the United States experienced an asset bubble in real estate.4 Easy credit, made possible by the availability of subprime mortgages and other financial innovations, fueled an unprecedented demand in housing. Real estate, rather than stocks, became the investment vehicle of choice for many Americans, propelled by the common belief that house prices could only go up. When the housing bubble burst, the deep economic recession of 2008–2009 began, impacting in some way nearly all businesses in the United States and worldwide.

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Porter’s Five Forces Model

Exhibit 3.3

Source: Porter, M. E. (2008, Jan.). “The five competitive forces that shape strategy,” Harvard Business Review.

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Porter derived two key insights that form the basis of his seminal five forces model:

Rather than defining competition narrowly as the firm’s closest competitors to explain and predict a firm’s performance, competition must be viewed more broadly, to also encompass the other forces in an industry: buyers, suppliers, potential new entry of other firms, and the threat of substitutes.

The profit potential of an industry is neither random nor entirely determined by industry-specific factors. Rather, it is a function of the five forces that shape competition: threat of entry, power of suppliers, power of buyers, threat of substitutes, and rivalry among existing firms.

As a rule of thumb, the stronger the five forces, the lower the industry’s profit potential—making the industry less attractive for competitors. The reverse is also true: the weaker the five forces, the greater the industry’s profit potential—making the industry more attractive.

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INDUSTRY FORCES IMPACT FIRM PROFITABILITY

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Instructors:

End of Chapter Discussion Question 2 covers this point.

How do the five competitive forces in Porter’s five forces model affect the profitability of the industry?

For example, in what way might strong forces increase industry profits, and in what way do strong forces reduce industry profits?

Identify an industry in which many of the competitors seem to be having financial performance problems. Which of the five forces seem to be strongest?

Weaker five forces equal greater industry profit potential, emphasizing attractiveness. However, the greater the five forces are, the lesser the industry profit potential, reducing the

attractiveness to competitors.

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ATTRACTIVE INDUSTRY

Sustainable Competitive Advantage Easier

UNATTRACTIVE INDUSTRY

Sustainable Competitive Advantage Harder

High profit potential (higher than economy will provide)

The weaker the five forces

The stronger the five forces

Low profit potential

Why these 5 Forces?

Price X Units Sold

Costs

Power of Buyers –

Power of Suppliers –

Threat of New Entrants –

Threat of Substitutes –

Rivalry –

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As discussed in the Chapter Case, Airbnb launched a radical process innovation of offering and renting rooms based on a business model leveraging the sharing economy. If one thing seems certain, technological progress is relentless and seems to be picking up speed.

Strategy Highlight 3.1 details how BlackBerry fell victim by not paying sufficient attention to the PESTEL factors.

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Threat of Entry

The risk that potential competitors will enter an industry:

Lowers industry profit potential.

Increases spending among incumbent firms.

Entry barriers:

Economies of scale.

Network effects.

Customer switching costs.

Capital requirements.

Advantages independent of size.

Government policy.

Credible threat of retaliation.

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The threat of entry is high when:

✓The minimum efficient scale to compete in an industry is low.

✓Network effects are not present.

✓Customer switching costs are low.

✓Capital requirements are low.

✓Incumbents do not possess:

Brand loyalty.

Proprietary technology.

Preferential access to raw materials.

Preferential access to distribution channels.

Favorable geographic locations.

Cumulative learning and experience effects.

✓Restrictive government regulations do not exist.

✓New entrants expect that incumbents will not or cannot retaliate.

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The Power of Suppliers

POWERFUL SUPPLIERS

Can demand higher prices for their inputs.

Capture part (sometimes a large part) of the economic value created.

Signs of Strong Suppliers

Suppliers industry is concentrated.

They don’t depend heavily on the incumbent’s industry.

Incumbent firms face high switching costs.

Suppliers’ products are differentiated.

Limited substitutes.

Suppliers have credible forward integration threats.

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Instructors:

A physically engaging exercise suggestion from the IM:

To illustrate the supplier and buyer impacts on industry attractiveness you can use a tug of war exercise.

One rope connects the suppliers to the industry rivals. Another rope connects the buyers to the industry rivals. A knot in the center of the buyer rope illustrates the industry sales price and a knot is the supplier rope illustrates the industry COGS paid to suppliers. The supplier rope will be manned by supplier sales reps on one side and industry rival purchasing agents on the other.

 Similarly, the buyer rope will be manned by the buyer purchasing agents and the industry sales reps. Have the industry sales reps and purchasing agents stand on opposite sides of the room and the suppliers and buyers in the center. Draw a line with masking tape in the center to represent a zero margin for the industry. Draw a line on the industry purchasing agent side to represent the suppliers COGS (zero margin for suppliers) and a line on the sales rep side to represent the buyers value for the product (zero benefit for the buyers).

Start with the knots centered between their respective lines. The closer the two knots get to the center the smaller the industry margin becomes. Choose the stronger students to represent supplier, buyer, and industry power associated and switch the power to show the difference between soft drinks and airlines.

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Power of Buyers (Customers)

Lowers industry profit potential if:

Buyers obtain price discounts, which reduces revenue.

Buyers demand higher quality / service, which raises production costs.

Situations when buyers are price sensitive:

The buyer’s purchase represents a significant portion of its procurement budget.

Buyers earn low profits or are strapped for cash.

The quality (cost) of the buyers’ products and services is not affected much by the quality (cost) of their inputs.

Buyers are the customers of an industry.

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The power of buyers is high when:

✓There are a few buyers and each buyer purchases large quantities relative to the size of a single seller.

✓The industry’s products are standardized or undifferentiated commodities.

✓Buyers face low or no switching costs.

✓Buyers can credibly threaten to backwardly integrate into the industry.

The retail giant Walmart provides perhaps the most potent example of tremendous buyer power. Walmart is not only the largest retailer worldwide (with over 12,000 stores and 2 million employees), but it is also one of the largest companies in the world (with $530 billion in revenues in 2019). Walmart is one of the few large big-box global retail chains and frequently purchases large quantities from its suppliers.

 Walmart leverages its buyer power by exerting tremendous pressure on its suppliers to lower prices and to increase quality or risk losing access to shelf space at the largest retailer in the world. Walmart’s buyer power is so strong that many suppliers co-locate offices directly next to Walmart’s headquarters in Bentonville, Arkansas, because such proximity enables Walmart’s managers to test the supplier’s latest products and negotiate prices.

Threat of Substitutes

Meet the same basic customer need:

In a different way.

Available from outside the given industry.

Examples:

Software vs. professional services.

Energy drinks vs. coffee.

Videoconferencing vs. business travel.

Wireless phone services vs. internet-based services (Skype).

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The threat of substitutes is high when:

✓The substitute offers an attractive price-performance trade-off.

✓The buyer’s cost of switching to the substitute is low.

Examples: many software products are substitutes to professional services, at least at the lower end. Tax preparation software such as Intuit’s TurboTax is a substitute for professional services offered by H&R Block and others. LegalZoom, an online legal documentation service, is a threat to professional law firms. Other examples of substitutes are energy drinks versus coffee, videoconferencing versus business travel, e-mail versus express mail, gasoline versus biofuel, and wireless telephone services versus Voice over Internet Protocol (VoIP), offered by Skype or Vonage.

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Rivalry Among Competitors

The intensity with which companies in the same industry jockey for market share and profitability.

Can range from genteel to cut-throat.

The other forces in the model pressure this rivalry.

The stronger the forces, the stronger the competitive intensity.

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The rivalry among existing competitors is high when:

✓There are many competitors in the industry.

✓The competitors are roughly of equal size.

✓Industry growth is slow, zero, or even negative.

✓Exit barriers are high.

✓Incumbent firms are highly committed to the business.

✓Incumbent firms cannot read or understand each other’s strategies well.

✓Products and services are direct substitutes.

✓Fixed costs are high and marginal costs are low.

✓Excess capacity exists in the industry.

✓The product or service is perishable.

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Industry Competitive Structures along the Continuum from Fragmented to Consolidated

Exhibit 3.4

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Perfect competition: Many Internet entrepreneurs learned the hard way that it is difficult to beat the forces of perfect competition. Fueled by eager venture capitalists, about 100 online pet supply stores such as pets.com, petopia.com, and pet-store.com had sprung up by 1999, at the height of the Internet bubble. Cut-throat competition ensued, with online retailers selling products below cost. When there are many small firms offering a commodity product in an industry that is easy to enter, no one is able to increase prices and generate profits. Besanko, D., E. Dranove, M. Hanley, and S. Schaefer (2010), The Economics of Strategy, 5th ed. (Hoboken, NJ: John Wiley).

Examples of monopolistic competition: The computer hardware industry provides one example of monopolistic competition. Many firms compete in this industry, and even the largest of them (Apple, ASUS, Dell, HP, or Lenovo) have less than 20 percent market share. Moreover, while products between competitors tend to be similar, they are by no means identical.

Examples of oligopoly: The express-delivery industry is an example of an oligopoly. The main competitors in this space are FedEx and UPS. Any strategic decision made by FedEx (e.g., to expand delivery services to ground delivery of larger-size packages) directly affects UPS; likewise, any decision made by UPS (e.g., to guarantee next-day delivery before 8:00 a.m.) directly affects FedEx. Other examples of oligopolies include the soft drink industry (Coca-Cola vs, Pepsi), airframe manufacturing business (Boeing vs. Airbus), home-improvement retailing (The Home Depot vs. Lowe’s), toys and games (Hasbro vs. Mattel), and detergents (P&G vs. Unilever). When there are only two main competitors, it’s called a duopoly and is a special case of oligopoly.

Examples of monopoly: Examples: Georgia Power is the only supplier of electricity for some 2.5 million customers in the southeastern United States. Philadelphia Gas Works is the only supplier of natural gas in the city of Philadelphia, Pennsylvania, serving some 500,000 customers.

Important Things to Remember!

This is an industry level analysis

This analysis is always conducted from the perspective of incumbents (those already in the industry)

There is not a direct relationship between buyers and suppliers

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Consider how several European countries and the European Union (EU) apply political and legal pressure on U.S. tech companies. European targets include Apple, Amazon, Facebook, Google, and Microsoft—the five largest U.S. tech companies—but also startups such as Uber, the taxi-hailing mobile app. Europe’s policy makers seek to retain control over important industries ranging from transportation to the internet to ensure that profits earned in Europe by Silicon Valley firms are taxed locally. The EU parliament even proposed legislation to break up “digital monopolies” such as Google. This proposal would require Google to offer search services independently as a standalone company from its other online services.

Suppliers, Buyers, and the Industry

Suppliers Industry Buyers

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Power of Suppliers

Suppliers Industry Buyers

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Power of Buyers

Suppliers Industry Buyers

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Threat of New Entrants is Low When: