Anda di halaman 1dari 32

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l ' r .r g e i r r i r r r : l.) o l l t ' t ' o I I l t rv t ' t ' s
l t r . r r g i l i n i n gl \ r t r c r o l S t t 1 r 1 1 1 1 r ' r ' t
l ; o r c c r t s t i t t gI n ( l l l s t r \ I t r o l i r r t l r r l i t r

CHAPTER 3

INDUSTRY ANALYSIS: THE FUNDAMENTALS

Introduction and Objectives


In thischapterandthe nextwe explorethe externalenvironment
of the firm. In Chapter1
we observedthat profoundunderstanding
of the competitiveenvironmentis a critical
ingredientof a successful
strategy.
We furthernotedthat business
strategyis essentially
a questfor profit.Theprimarytaskfor this chapteris to identifythe sourcesof profit in
the externalenvironment.
Thefirm'sproximateenvironment
is its industryenvironment;
hencethe focusof our environmental
analysis
will be industry
analysis.
lndustryanalysis
is relevantboth to corporate-level
and business-level
strategy.

a Corporatestrategyis concerned
with decidingwhich industries
the firm should
be engagedin and how it shouldallocate
its resources
amongthem.Such
decisions
requireassessment
of the attractiveness
of differentindustries
in
termsof their profit potential.Themainobjectiveof this chapteris to
understand
how the competitive
structureof an industrydetermines
its
profitability.

o Business
strategyis concerned
with establishing
competitive
advantage.
Byanalyzing
customerneedsand preferences
and the waysin whichfirms
competeto servecustomers,
we identifythe generalsources
of competitive
advantagein an industry- what we callkeysuccess
factors.

Bythe timeyou havecompleted


thischapteryouwill be ableto:
r ldentifythe mainstructural
features
of an industry
that influence
competition
and profitability.
o Useindustry
analysis
to explainwhy in someindustries
competition
is more
intense
and profitability
lowerthanin otherindustries.
c Useevidence
on structural
trendswithinindustries
to forecast
chanoes
in
profitability
competition
and
in the future.
il Developstrategies
to influenceindustrystructurein orderto improveindustry
profitability.
o Analyze
competition
andcustomer
requirements
in orderto identify
opportunities
for competitive
advantage
within an industry(keysuccess
factors).

PART II

THE TOOLS OF S

From Environrnental Analysis to Industry Analysis


The businessenvironment of the firm consistsof all the external influencesthat affect
its decisionsand performance.Given the vast number and range of external influences,
how can managershope to monitor, let alone analyze,environmental conditions?
The starting point is some kind of systemor framework for organizinginformation.
For example,environmentalinfluencescan be classifiedby source- e.g. into political,
economic,social,and technologicalfactors("PESTanalysis")- or by proximity - the
"micro-environment" or "task environment" can be distinguishedfrom the wider
i n f l u e n c e tsh a t f o r m t h e " m e c r o - e n v i r o n m e n t " . r T h o u gshy s t e m e t i cc,o n t i n u o u ss c a n ning of the whole range of external influencesmight seemdesirable,such extensive
environmental analysisis unlikely to be cost effectiveand createsinformation overload.
Tlre prerecluisitefor effective environmental analysisis to distinguish the vital from
the merely important. To do tl-ris,let's return to first principles.For the firm to make
profit it must create value for customers.Hence, it nrust understandits customers.
value,the firm acquiresgoodsand servicesfrorn suppliers.Hence,
Second,in creatir-rg
it must understandits suppliersand rnanagerelationshipswith them. Third, the ability to generateprofitability dependson the intensityof competition among firrnsthat
vie for the samevalue-creatingopportunities.Hence, the firrn must understandcompetition. Thus, the core of the firm's businessenvironment is formed by its relation. his is its
s h i p s w i t h t h r e e s e t so f p l a y e r s :c u s t o m e r s s, u p p l i e r s ,a n d c o r n p e t i t o r s T
i r - r d u s t reyn v i r o n m e n t .
This is not to saythlt macro-levelfactorssuchas generaleconomictrends,changes
in cler.nographic
structure,or social and political trends are unimportant to strategy
analysis.Tl'resefactorsn-raybe critical deterrninantsof the threatsand <>pportunities
a courpanywill face in the future. The key issueis how thesemore generalenvironmental factorsaffectthe firm's industryenvironment(Figure3.1). Considerthe threat
of global warr.ning.For most companiesdris is not arr irnportarrtstrategicissue(at
least,not for the next hundreclyears).However, for the proclucersof :trtomobiles,
global warnring is a vital issue.But, to analyzethe strategicinrplicationsof global
warnring,thc automobilemanufacturersneed to trace its implicationsfor their indus- will consumers
try environment. F-orexample,what will be the impact on dernar.rd
i
n
s w i t c h t o m o r e f u e l - e f i i c i e n ct a r s ?W i l l t h e y a b a n d o r rt h e i r c a r s f a v o r o f p u b l i c

c
i

f'

rl
n
r

a)
te

ft
tl
rh

:^

l5

m
af

SU

Inc
F I (i I I Ii It ;i I Fronr envirorrrnentalanalysisto industry analysis

A:
The national/

The natural
environment

Ti'ffi-fin-A" rH',ND,rsrRy
EN\/IRONMENT
. Suppliers

l.::::_"1:":.,,-.$@. Competitors

Demographic
structure

. Customers
Government
and politics

Socialstructure
'1":g!.,ft
r,--,,-,s,lffi#@

TaL
tob
pap
unc
nor
atic

US
ver)
ofp

CHAPTER 3

INDUSTRY

ANALYSIS:

THE FUNDAMENTALS

transportation?'Withregardto competition,will there be new entry by manufacturers


of electricvehiclesinto the car industry?Will increasedR&D costscausethe industrv to consolidate?
affect
ences,
tions?
ation.
litical,
/-the
wider
s scan:enslve
:rload.
rl from
r make
omers.
Hence,
re abilmsthat
d com:lationis is its
:hanges
strategy
'tunities
:nvironrethreat
issue(at
mobiles,
'f global
ir indLrsnsumers
rf public

" a."

If the purposeof strategyis to help a company to survivear-rdmake money,the starting point for industry analysisis a simplequestion:what detenninesthe level of profit
in an industry?
As alreadynoted, businessis about the creation of value for the customer,either
by production (transforminginputs into outputs) or commerce (arbitrage).Value is
createdwherr the price the customeris willing to pay for a product exceedsthe costs
incurred by the firnr. Br.rtvalue creatior.rdoes not translatedirectly into profit. The
s u r p l u so f v a l u e o v e r c o s t i s d i s t r i b u t e cbl e t w e e nc u s t o m e r sa n d p r o d u c e r sb y t h e
forcesof conrpetition. Tl-restronger is competition among producers,the more of
tl.resurplusis receivedby customersin consumersurplus (the differencebetweenthe
price they actuallypay and the maximum'rprice they would l.ravebeen willing to pay)
anclthe less is the surplus receivedby producers (as prodwcersurplus or economic
rcnt). A singlesupplier of bottled water at an all-night rave can charge a price that
fully exploitsthe dancers'thirst. If there lre many suppliersof bottled water, then, in
the absenceof collusion,corxpetitionci.lr.rscs
the price of bottled water to fall toward
t l t ec o s to f s u p p l y i u gi t .
The sr-rrplus
earneclby proclucersover and abclvethe minimum costsof production
i s n o t e n t i r e l y c a p t u r e d i n p r o f i t s . W h e r e a n i n d u s t r y l r a s p o w e r f u l s u p p l i e r snronopolisticsuppliersof cornponentsor erlployeesunited by a strong labor union a substantialpart of tlre surplusmay be appropriatedby thesesuppliers(the profits of
suppliersor premiurn wagesclf union r.rrembers).
The profitsearneclby the firms in an industry are thus deterrninedby three factors:
The valr-re
of the product to customers.
T h e i n t c r r s i t yo f c o r n p e t i t i o r r .
The bargainingpower of the proclucersrelativeto their suppliers.
Indr"rstry
analysisbrings all thrcc fr.rctors
into a singleanalytic framework.

Table3.1 sl.rowsthe profitability of different US industries.Some industries(such as


(airlines,
tobaccoanclpharrnaceuticals)
consistentlyearn high ratesof profit; <>thers
paper,anc'lfood production) fail to cover tl-reircost of capital.The basicpremisethat
underliesinclustryanalysisis that the level of industry profitability is neither random
nor the resultof entirely industry-specific
influences- it is determinedby the systematic influencesof the industry's structure.The US pharmaceuticalindustry and the
USfood production industry r-rotonly supply very different products,they also have
verydifferentstructures,which nrakeone highly profitableand the other a nightmare
of pricecompetitionand weak r.nargins.
The pharmaceuticalindustry produceshighly

T H E T O O L S O F S T R A T E G YA N A L Y S I S

The profitabilityof USindustries,1999-2005

Products
and Personal
Household

22.7

P h ar m a c e u t i lcsa
Tobacco
Products
FoodConsumer
rities
Secu
D i v e r s i f i eFdi n a n c i a l s
Beverages
M i n i n gC
, r u d eO i l P r o d u c t i o n
Refining
Petroleum
M e d i c aPl r o d u c tasn d E q u i p m e n t
C o m m e r c iB
a la n k s
FoodServices
i cn, d
S c i e n t i f iP
c ,h o t o g r a p h a
C o n t r oEl q u i p m e n t
Apparel
ComputerSoftware
P u b l i s h i nP
g ,r i n t i n g
lT Services
re
Healthca
aq
l uipment
E l e c t r o n i cEsl,e c t r i cE
Retailers
Specialty
Chemicals
E n g i n e e r i nCgo, n s t r u c t i o n
TruckLeasing
Trucking,
and Defense
Aerospace
OfficeEquipment
Computers,
Furniture
and Servtces
AutomotiveRetailing
Foodand Grocery
Wholesalers:
G e n e r aMl e r c h a n d t s e r s
Pipelines
I n d u s t r i a ln d F a r mE q u i P m e n t
O i la n dG a sE q u i p m e natn d S e r v i c e s
U t i l i t i e sG: a sa n d E l e c t r i c
E n e r gP
y roduction
Foodand DrugStores
and Parts
MotorVehicles
Resorts
Hotels,Casinos,
lnsurancL
e l: f ea n d H e a l t h
P a c k a g i nagn dC o n t a i n e r s
RealEstate
I n s u r a n cP
e :r o p e r tayn dC a s u a l t Y

22.3
21.6
19.6
18.9
18.3
1 7. 5
1 7. B
1 7. 3
1 7. 2
1 55
15 . 3
15.0

ColgateProcter& Gamble,Kimberley-Clark,
Palmolive
n J o h n s o nM, e r c k
P f i z e Jr ,o h n s o &
Universal
American,
Altria,Reynolds
SaraLee,Conagra
PepsiCo,
M o r g a nS t a n l e yM, e r r i lLl y n c hG, o l d m a nS a c h s
AmericanExpress
GeneralElectric,
Anheuser-Busch
Coca-Cola,
DevonEnergy
Petroleum,
Occidental
E x x o n M o bC
i l ,h e v r o nC, o n o c o P h i l l i p s
M e d t r o n i cB, a x t eIrn t e r n a t i o n a l
C i t i g r o u pB, a n ko f A m e r i c a
M c D o n a l d 'Y
s ,u mB r a n d s
, a n a h eAr ,l i g e n t
E a s t m aK
n o d a kD

B
t\
F
F
5
J.
lc

=
=
P

s pparel
N i k eV
, EJ o n e A
Oracle,CA
Microsoft,
, annett
R .R .D o n n e l l e&y S o n sG
E D 5C
, o m p u t eSr c i e n c eSsc, i e n cAep p l i c a t i o nI nst l
, e l l p o i n tH, C A ,M e d c o
U n i t e dH e a l t hG r o u pW
c,hirlpool
E m e r s oE
nl e c t r iW
HomeDepot,Costco,Lowe's
Du Pont
Dow Chemical,
F l o ur ,J a c o b E
s ngineering
YRCWorldwide,RyderSystem
Martin
Lockheed
Boeing,UnitedTechnologies,
DellComputer
IBM, Hewlett-Packard,
Leggett& Platt,Steelcase
A u t o N a t i o nU, n i t e dA u t oG r o u p
CHS
Supervalu,
Sysco,
s oldings
W a l - M a r tT, a r g e tS, e a r H
P l a i nAs l l - A m e r i c aPni p e l i n eE,n t e r p r i sPer o d u c t s
Deere,lllinoisToolWorks
Caterpillar,
r ughes
HalliburtoB
n ,a k eH
DominionResources
DukeEnergy,
C o n s t e l l a t iE
o n e r g yO, N E O K
Albertson's
Walgreen,
Kroger,
n ontrols
G M , F o r dJ, o h n s o C
M a r r i o tItn t e r n a t i o n aHla, r r a h 'Es n t e r t a i n m e n t
Metlife,NewYorkLife
llinois
Owens-l
Container,
Smurfit-Stone
Group
Cendant,HostMarriott,SimonProperty
, e r k s h i rHea t h a w a y
A m e r i c a Inn t l .G r o u p B

A/(
1
2

14.4
13.9
13.5
13.5
13.1
13.0
13.0
12.9
12.0
11 . 8
1 1. 7
1 1. 7
1 1. 6
11.3
11.3
1'1.0
11 . 0
10.8
10.7
10.4
10.6
10.0
9.8
9.7
8.6
8.6
8.5
8.3

N
E
Ai

CHAPTER 3

INDUSTRY

ANALYSIS:

THE FUNDAMENTALS

(cont'd)

-olgate-

n a nS a c h s

B u i l d i nM
g a t e r i a lG
s ,l a s s
Metals
FoodProduction
Forest
and PaperProducts
S e m i c o n d u c taonr sd E l e c t r o nC
i co m p o n e n t s
Telecommu
nications
N e t w o rakn dC o m m u n i c a t i oEn qs u i p m e n t
Entertainment
Airlines

8.3
8.0
7.2
6.6
5.9
4.6
1.2
0.4
(22.0)

O w e n sC o r n i n gU, S GA
, rmstronH
g oldings
A l c o aU
, SS t e e lN
, ucor
A r c h eD
r a n i e lM
s i d l a n dT, y s o nF o o d s
International
Paper,
Weyerhaeuser
I n t e lT
, e x alsn s t r u m e n tS
s ,a n m i n a - S C l
Verizon,AT&1,Sprint-Nextel
Motorola,CiscoSystems,
Lucent
TimeWarner,Walt Disney,
NewsCorp.
A M R ,U A L ,D e l t aA i r l i n e s

Nofes:
1 MedianROEfor eachindustry
averaged
across
the 7 years1999-2005.
2 Industries
with fiveor fewerfirmswereexcluded.
Alsoomittedwereindustries
that weresubstantially
redefined
during
19 9 9- 2 0 0s .

Intl
rplications
-A,Medco

reedMartin
ler

:riseProducts
K5

rtertarnment
linois
rpertyGrouP
athaway

differentiatedproducts with price-insensitiveconsumersand each new product receivesmonopoly privilegesin the form of 17-yearpatents.The food industry produces commodity products wirh slow-growing demand and overcapacity,and is
squeezedby powerful retail customers.
These industry patterns tend to be fairly consistentacrosscountries. Figure 3.2
shows return on capital for a number of global industries.
Particularly high rates of profit often result from industry segmentsdominated by
a single firm. These niche markets provide attractive havensfrom the rigors of fierce
competition.StrategyCapsule3.1 offers some examples.
The underlying theory of how industry structure drives competitive behavior and
determinesindustry profitability is provided by industrial organization (Io) economics. The two referencepoints are the tbeory of monopoly and the theory of
perfectcompetition which form end points of the spectrum of industry structures.
Monopoly exists where an industry comprisesa single firm protected by high barriers
to entry. The monopolist can appropriate in profit the full amount of the value it
creates.At the other extreme,perfect competition exists where there are many firms
supplying an identical product with no restrictions on entry or exit. Here, rhe rate of
profit falls to a level that just covers firms' cost of capital. In the real world, industries
fall betweenthesetwo extremes.The US market for chewing tobacco is close to being
a monopoly; the Chicago grain markets are closeto being perfectly competitive. Mosr
manufacturing industries and many serviceindustries tend to be oligopolie.s:they are
dominatedby a small number of major companies.Table3.2 identifiessome key points
on the spectrum. By examining the principal structural featuresand their interactions
for any particular industry, it is possible to predict the type of competitive behavior
likely to emerge and the resulting level of profitability.

PART II

THE TOOLS OF STRATEGY ANALYSIS

Fl GIIRIT ii.2 Profitabilityof global industries

Utilities
Telecomservices
Transportation
Energy
Materials

Overall average
Retailing
Consumerdurablesand apparel
Foodretailing

e
f

Capitalgoods
Automobilesand components

*
e

Technology
hardwareand equipment
Hotels,restaurants,
leisure

:P

Food,beverages,tobacco

::

Healthcare
equipmentand services
Semiconductors

=i

Commercial
services
Media

f>

=5

Computersoftwareand services
Householdand personalproducts

EP
=R

Pharmaceuticals

Fi

t
t
i

D
C

h
d
y<
it:
sn
m
(d

ab
po

of
tre
m(
thr

De
Mc

CHAPTER3

USTInc. (formerlyU5 Tobacco)has beenthe


mostprofitable
companyin the S&P500
overthe
p a s t1 0 y e a r s D
. u r i n g2 0 0 3 * 5U S Te a r n e da n
ROIC(operatingprofit as percentage
of total
assetslesscurrent liabilities)of 680/o.
What's
the secretof UST'ssuccess?
lt controls78o/o
of
the U5 marketfor "smokeless
tobacco"(chew3
G
n

\
e
6
S

=
=x

::
:=
- d

S>

:=

r>

=F

> N

i n g t o b a c c oa n d s n u f f ) ,w i t h b r a n d ss u c ha s
S k o a lC
, o p e n h a g e nL ,o n gC u t , a n d R e dS e a l .
Despiteits association
with a bygoneera of
cowboysand farm workers,chewingtobacco
hasbeena growth marketoverthe pasttwo
d e c a d ew
s i t h a s u r p r i s i n g l ya r g en u m b e ro f
youngconsumers.
UST's
long-established
brands,
i t s d i s t r i b u t i otnh r o u g ht e n s o f t h o u s a n d os f
s m a l lr e t a i lo u t l e t s a
, n d t h e u n w i l l i n g n e sosf
majortobaccocompanies
to enterthis market
( d u et o t h e p o o r i m a g ea n d s o c i a u
l nacceptabilityof the product)havemadeUST'smarket
position
unassailable.
Restrictions
on advertising
of smokeless
tobaccoproductshavefurtherbuttressedUST'smarketdominanceby makingit
moredifficultfor would-beentrantsto establish
theirbrands.

_ o

! r

8=

Devro plc, based in the Scottishvillageof


M o o d i e s b u r ins, t h e w o r l d ' sl e a d i n gs u p p l i e r

INDUSTRYANALYSIS: THE FUNDAMENTALS

"Fromthe
of collagensausage
skins("casings").
'Banger'to
British
the Chinese
LapCheong,
from
the FrenchMerguezto the South American
Chourizo,
Devrohasa casingto suitall product
types."lts overallworld marketshareis around
600/o,
risingto 94o/o
in the UKmarketand 83%in
Australia.
In recentyearsits ROIChasaveraged
'1
8% and its returnon equity30%.
InternationalGameTechnology(lcT)basedin
RenoN
, e v a d ai ,s t h e w o r l d ' sd o m i n a n tm a n u facturerof slot machines
for casinosand other
e s t a b l i s h m e nt ht sa t a l l o wg a m b l i n gm a c h i n e s .
Witha continuous
flow of newgamingmachines
* 2005saw172new productslaunched,
including Megabucks,PersianPrincess,
and Lucky
- IGT has over 70o/ool
Larry'sLobstermania
t h e U Sm a r k e ts h a r ea n d m a r k e tl e a d e r s h iion
s e v e r aEl u r o p e a cno u n t r i e si ,n c l u d i n gt h e U K .
With heavyinvestmentin R&D,new product
saturation,tight controlover distributionand
servicing,
anda policyof leasingratherthanselling machines,
IGT'smarketleadership
appears
well-entrenched.
During2004-6,lGTearnedan
averageROEof 25%.
sources: www. ustinc.com,www.devro.com, www.igt.com

Porter's Iriue Forcesof Co'wypetitiott


Frowrcwork,
Table3.2 identifies four structural variablesinfluencing competition and profitability.
In practice, there are many features of an industry that determine the intensity
of competition and the level of profitability. A helpful, widely used framework
for classifying and analyzing these factors was developed by Michael Porter of
Harvard BusinessSchool.2Porter's five forces of competition framework views the
profitability of an industry (as indicated by its rate of return on capital relative to its
cost of capital) as determined by five sourcesof competitive pressure.These five forces
of competition include three sourcesof "horizontal" competition: competition from
substitutes,competition from entrants, and competition from establishedrivals; and

PART II

THE TOOLS OF STRATEGY ANALYSIS

The spectrumof industry structures


Perfect
Competition

Oligopoly

Duopoly

Monopoly

Concentration

Manyfirms

A few firms

Twofirms

Oneflrm

Entryand ExitBarriers

No barriers

Product
Differentiation
lnformation
Avaihbility

significant
barriers

Highbarriers

flomogeneous
product(Commodity)

Potential
for productdifferentiation

No impediments
to information
flow

lmperfectavailability
of information

two sourcesof "vertical" competition: the power o f s u p p l i e r sa n d p o w e r o f b u y e r s


(seeFigure 3.3).
The strengthof eachof thesecompetitiveforcesis determinedby a number of key
structuralvariables,as shown in Figure 3.4.

The price customersare willing to pay for a product depends,in part, on the availability of substituteproducts.The absenceof closesubstitutesfor a producr, as in rhe
caseof gasolineor cigarettes,meansthat consunrersJre comperrtively insensitiveto
Porter'sfive forcesof competition framework

Bargainingpower

INDUSTRY
COMPETITORS
Threatof
substitutes
Rivalryamong
existingfirms

t-".
I

power
Bargaining
buyers
lof

ffi

SUBSTITUTES

CHAPTER 3

INDUSTRYANALYSIS: THE FUNDAMENTALS

1'{ G [r ll F] 3 ..[ The structural determinants of the five forces of competition

SUPPLIER
POWER
Factorsdeterminingpower of suppliers
relativeto producers;sameas those
determiningpower of producersrelative
to buyers- see"BuyerPower" box

ntr
)ni

)n

yers
'key

vailr the
/e to

THREAT
OF ENTRY
o Capitalrequirements
a Economies
of scale
. Absolutecost
advantages
. Productdifferentiation
o Accessto distribution
channels
a Governmentand legal
barriers
o Retaliation
by
producers
established

INDUSTRY
RIVALRY
r
o
o
a

Concentration
Diversityof competitors
Productdifferentiation
Excesscapacityand
exit barriers
a Costconditions

THREAT
OF
SUBSTITUTES
a Buyerpropensityto
substitute
o Relativepricesand
performanceof
substitutes

BUYERPOWER
PriceSensitivity
o Costof product
relativeto total cost
o Product
differentiation
. Competition
betweenbuyers

Bargaining Power
I Sizeand concentration
of buyersrelativeto producers
o Buyers'switching
costs
o Buyers,information
. Buyers,
abilityto
backwardinteorate

price (i.e., demand is inelastic with respect to price). The existence of close substitutes meansthat customerswill switch to substitutesin responseto price increasesfor
the product (i.e., demand is elasticwith respect to price). The internet has provided
a new source of substitute competition that has proved devastatingfor a number of
establishedindustries.Tiavel agencies,newspapers,and telecommunication providers
have all suffered devastatingcompetition from internet-basedsubstitutes.
The extent to which substitutesdepressprices and profits depends on the propensity of buyers to substitute between alternatives. This, in turn, is dependent on
their price-performance characteristics.If city-center to city-center travel between
\Tashingtonand New York is 50 minutes quicker by air than by train and the average
traveler values time at $30 an hour, the implication is that the train will be competitive at fares of $25 below those charged by the airlines. The more complex the product and the more difficult it is to discern performance differences,the lower the extent
of substitutionby customerson the basisof price differences.The failure of low-priced
imitations of leading perfumesto establishsignificantmarket sharereflectsconsumers'
difficulty in recognizing the performance characteristicsof different fragrances.

T H E T O O L S O F S T R A T E G YA N A L Y S I S

If an industry earnsa return on capital in excessof its cost of capital, it will act as a
magnetto firms clutsidethe industry.If the entry of new firms is unrestricted,the rate
of profit will fall toward its competitivelevel.The US bagelindustry faced a flood of
new entrantsin the late 1990s that causeda sharp decline in profitability.' Why is it
that my wife, a psychotherapist,earnsmuch lessthan our niece,a recentlyqualified
medical doctor? Barriersto entry are one factor.In psychotherapythere are multiple
accreditingbodiesand limiteclstatelicensir.rg,
helrcethe entry barriersto psychotherapy are much lower than in medicine.
Threat of entry rather then actualentry rnaybe suflicientto enslrrethat established
firms constraintheir pricesto the competitive level. Only American Airlines offers a
direct servicebetweenDallas-Fort\Worthand Sar.rta
Barbara,California, for example.
Yet, Americanmay be unwilling to exploit its rr.ronopoly
power to the full if Southwest
or another airline car.reasilyextend its routesto cover the sametwo cities.An indust r y w h e r e n o b a r r i e r st o e n t r y o r e x i t e x i s t i s c c t n t e s t a b l ep:r i c e sa n d p r o f i t s t e n d
towards the competitivelevel, regardlessof the number of firms within the industry.a
C o n t e s t a b i l i t yd e p e n d so n t h e a b s e n c eo f s r . r n kc o s t s- i n v e s t m e n t sw h o s e v a l u e
cannot be recoveredon exit. An absenceof sunk cclstsnrakesan industry vulnerable
to "hit-and-run" entry wheneverestablishec'l
linrs raisetheir prices above the comp e t i t i v el e v e l .
In most irrdustries,however,new entrantscarlnot enter on equal ternrswith those
of establishecl
firn.rs.A barricr to entry is any advantagethat establishecl
firnrs have
over entrants.The height of a b:rrrier to entry is usurlly nrelsureclas the unit cost
disadvautage
faceclby would-beentrxllts.The prirrcipll sourcesof brrricrs to eutry rre
cliscussed
below.
The capitalcostsof getting establishedin an industry can
be so largeas to discourageall but the largestcor.npanies.
TI-reduopoly of Boeingand
Airbus in Iarge passengerjets is protecteclby tl-rel-rugecapital costs of establishing
. i m i l a r l yw i t h t h e
R & D , p r o d u c t i o n ,a n d s e r v i c ef a c i l i t i e sf o r s r . r p p l y i r trhge s ep l a n e s S
businessof launchingcommercialsatellites:the costsof developingrocketsar-rdlaunch
facilitiesmake new er-rtryhighly unlikely.In other industries,entry costscan be modest. One reasonwhy the e-commerceboon-rof the late 1990s ended in fir-rancial
disasterfor most participantsis that the initial setupcostsof new internet-based
ventures
were typically very low. Acrossthe servicesectormore generally,startupcoststend to
be low. For example,startLlpcostsfor a franchisedpizzaoutlet begin at $141,000 for
a D o m i n o ' s ,$ 2 5 0 , 0 0 0f o r a P a p aJ o h n ' s ,a n d $ 1 . 1 n - r i l l i o nf o r a P i z z aH u r . '
.

In industriesthat are capital or researchor advertisingintensive,efficiencyrequireslarge-scale


operation.The problem for new entrantsis that
they are faced with the choice of either entering on a srrall scaleand acceptinghigh
unit costs,or entering on a large scaleand bearing the costsof underutilized capacity. ln automobiles,cost efficiencymeansproducing at leastdrree million vehiclesa
year.As a result,the only recententrantsinto volume car production have beenstatesupportedcompanies(e.g.,Proton of Malaysiaand Maruti of India).The main source
of scaleeconomiesis new product developmentcosts.Thus, developingand launchi n g a n e w m o d e l o f c a r t y p i c a l l yc o s t so v e r $ 1 . 5 b i l l i o n . A i r b u s ' sA 3 8 0 s u p e r j u m b o
cost about $15 billion to developand must sell over 300 planesto break even. Once

CHAPTER 3

INDUSTRY ANALYSIS: THE FUNDAMENTALS

Airbus had committed to the project, then Boeing was effectively excluded from the
superjumbo segment of the market.
SA

ate

of
sit
ied
ple
.erred
lie.
/est
Lus:nd
fy.
LIue
rble
)m-

Abr;o.{uttl {,]{rs!,,'\ttviln'i,a*es Establishedfirms may have a unit cosr advantage


over entrants irrespectiveof scale.Absolute cost advantagesoften result from the
acquisition of low-cost sourcesof raw materials.SaudiAramco's accessto the world's
biggestand most accessibleoil reservesgive it an unassailablecost advantageover
Shell, Exxon Mobil, and BP,whose costs per barrel are at least three times those of
SaudiAramco. Absolute cost advantagesmay also result from economiesof learning.
Sharp'scost advantagein LCD flat screenTVs results from its early entry into LCDs
and its speedin moving down the learning curve.
t't utiucl Uiiiitr'clrl.iill,ton In an industry where products are differentiated,
establishedfirms possessthe advantagesof brand recognition and customer loyalty.
The percentage of US consumers loyal to a single brand varies from under 300/oin
batteries,canned vegetables,and garbagebags, up to 610/oin toothpaste, 650/oin
mayonnaise,and7I0/o in cigarettes.6Newentrantsto such markets must spend disproportionately heavily on advertising and promotion to gain levels of brand awarenessand brand goodwill similar to that of establishedcompanies. One study found
that, compared to early entrants, late entrants into consumer goods markets incurred
additionaladvertisingand promotional costsamounting to 2.120/oof salesrevenue.t

IOSC

30st
are

can
and
11ng
Lthe

rnch
roddisures
Ldto
) for

g lnthat
high
'.^pa'
:lesa
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Lnchrmbo
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- / t t r : r s s t o ( l h a n t ' r e l s o l I ) i s t r i l t u t , i o t r F o r m a n y n e w s u p p l i e r so f c o n s u m e r
goods, the principal barrier to entry is likely to be gaining distribution. Limited
capacitywithin distribution channels(e.g.,shelfspace),risk aversionby retailers,and
the fixed costsassociatedwith carrying an additional product result in retailers being
reluctant to carry a new manufacturer'sproduct. The battle for supermarketshelf
spacebetween the major food processors(typically involving "slotting fees" to reserveshelf space)further disadvantagesnew entrants. One of the most important economic impacts of the internet has been allowing new businessesto circumvent barriers
to distribution.
(ittverurnental

antl Legal llarricrs


Economistsfrom the ChicagoSchoolclaim
that the only effective barriers to entry are those created by government. In taxicabs,
banking, telecommunications,and broadcasting,entry usually requires the granting of
a license by a public authority. From medieval times to the present day, companies
and favored individuals have benefitted from governmentsgranting them an exclusive
right to ply a particular trade or offer a particular service. In knowledge-intensive
industries,patents, copyrights, and other legally protected forms of intellectual property are major barriers to entry. Xerox Corporation's monopolization of the plainpaper copier industry until the late 1970s was protected by a wall of over 2,000
patentsrelating to its xerography process.Regulatory requirements and environmental and safety standards often put new entrants at a disadvantageto established
firms becausecompliance costs tend to weigh more heavily on newcomers.
Itetaliation Barriersto entry also depend on the entrants'expectationsas to possible retaliation by establishedfirms. Retaliation against a new entrant may take the
form of aggressiveprice-cutting, increasedadvertising,salespromotion, or litigation. The major airlines have a long history of retaliation against low-cost entrants.

PART II

THE TOOLSOI'STRATEGY ANALYSIS

Southwestand other budget airlines have allegedthat selectiveprice cuts by American


and other major airlinesamounted to predatory pricing designedto prevent its entry
into new routes.t To avoid retaliation by incumbents,new entrantsmay seek initial
small-scaleentry into lessvisiblemarket segments.\WhenToyota,Nissan,and Honda
first entered the US auto market, they targeted the small car segments,partly because
this was a segmentthat had been written off by the Detroit Big Three as inherently
unorofitable.'
Emoirical researchshowsindustriesorotectedby high entry harrierstend to earncbove,u.irg. retesof pro6t.ruCapitalrequirements and advertisir-rg
appearto be particularlyeffectiveimpedimentsto entry.tr
The effectiveness
of barriersto entry dependson the resourcesand capabilitiesthat
potential entrantspossess.Barriersthat are effectiveagainstnew companiesmay be
ineffective agair.rst
establishedfirrns that are diversifying from other industries.George
Yip found no evidencethat entry barriersdeterred new entry.'' Some entrants possessedresourcesthat allowed them to surrnountbarriersand competeagainstincumbent firms usir.rgsirnilar strategies.Thus, Mars used its strong position in confectionery
to enter the ice cream market, while Virgin has used its brand name to enter a wide
rar-rge
to telecommunications.
of inclustriesfrom airlir.res

For most industries,the major determinant of the overall state of competition and
the generallevel of profitability is competition among the firms within the industry.
- sometimesto the extent that prices
In some industries,firms compete aggressively
are pushed below the level of costsand industry-widelossesare incurred. In other
industries,price competiticlnis rnutedand rivalry focuseson advertising,innovation,
and other nonprice dimensions.The intensity of competition between established
firms is the result of interactionsbetweensix factors.Let us look at each of them.

t
Sellerconcentrationrefersto the number and size distribution of
firms cornpeting within a market. It is most commonly rneasuredby the concentration
ratio: the cornbir-red
nrarket share of the leading producers.For example, the fourfirm concentrationratio (CR4) is tl-rernarket shareof the four largestproducers.In
marketsdominated by a singlefirn-r(e.g.,Microsoft in PC operatingsystems,or UST
in the US smokelesstobacc<-l
market). the dominant firm can exerciseconsiderable
discretionover the prices it charges.\Wherea market is dominated by a small group
of leadingcompanies(an oligopoly), price competition may also be restrained,either
by outright collusion,or more commonly through "parallelism"of pricing decisions.rr
Thus, in rnarkets dorninated by twcl companies, such as alkaline batteries (Duracell
and Energizer),color film (Kodak and Fuji), and soft drinks (Coke and Pepsi),prices
tend to be similar and competition focuseson advertising,promotion, and product
development. As the number of firn.rssupplying a market increases,coordination
of pricesbecomesmore difficult, and the likelihood that one firm will initiate pricecutting increases.However, despitethe common observationthat the elimination of
a competitor reducesprice competition, while the entry of a new competitor stimulatesit, systematicevidenceof the impact of seller concentration on profitability is surprisingly weak. Richard Schrnalensee
concludedthat: "The relation, if any, between
profitability
is weak statistically and the estimated effect is
seller concentration and
u s u a l l ys m a l l . " r a

i
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v
S

c
v
tr
s'
h
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CHAPTER 3

an
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UST
able
'oup

INDUSTRYANALYSIS:

THE FUNDAMENTALS

The extent to which a group of firms can avoid price


competition in favor of collusive pricing practices depends on how similar they are
in their origins, objectives,costs,and strategies.The cozy atmosphere of the US auto
industry prior to the advent of import competition was greatly assistedby the similarities of the companiesin terms of cost structures,strategies,and top management
mindsets. The intense competition that affects the car markets of Europe and North
America today is partly due to the different national origins, costs, strategies,and
managementstylesof the competing firms. Similarly,the key challengefaced by OPEC
is agreeingand enforcing output quotas among member countries that are sharply
different in terms of objectives,production costs,politics, and religion.
The more similar the offerings among rival firms, the
more willing customersare to substituteand the greater the incentive for firms to cut
'Where
prices to increasesales.
the products of rival firms are virtually indistinguishable, the product is a commodity and price is the sole basis for competition. Commodity industries such as agriculture, mining, and petrochemicalstend to be plagued
by price wars and low profits. By contrast, in industries where products are highly
differentiated(perfumes,pharmaceuticals,
restaurants,managementconsultingservices),
price competition tends to be weak, even though there may be many firms competing.
\fhy does industry profitability tend to
fall so drastically during periods of recession?The key is the balancebetween demand
and capacity.Unused capacity encouragesfirms to offer price cuts to attract new businessin order to spread fixed costs over a gteater salesvolume. Excesscapacity may
be cyclical (e.g.the boom-bust cycle in the semiconductorindustry); it may also be
part of a structural problem resulting from overinvestment and declining demand. In
theselatter situations, the key issueis whether excesscapacity will leave the industry.
'Where
Barriersto exit are costsassociatedwith capacity leaving an industry.
resources
are durable and specialized,and where employeesare entitled to job protection,
barriers to exit may be substantial.riIn the European and North American auto
industry excesscapacity together with high exit barriers have devastatedindustry
profitability. Conversely,rapid demand growth createscapacity shortagesthat boost
margins. Between 2001 and 2005, bulk cargo shipping rates increased sevenfold as
a result of increasedworld demand for commodities.'t'On average,companiesin
growing industries earn higher profits than companies in slow growing or declining
industries(seeFigure 3.5).

ther
ns,tj

acell
flces
duct
Ltion
flcern of
lmu-

; sur,veen
:ct is

\fhen excesscapacitycausesprice competition,how low will pricesgo? The


'S7here
key factor is cost structure.
fixed costsare high relative to variable costs,firms
will take on marginal businessat any price that covers variable costs. The consequencesfor profitability can be disastrous.Between 200L and 2003, the total losses
of the US airline industry exceededthe cumulative profits earnedduring the entire previous history of the industry. The willingness of airlines to offer heavily discounted
ticketson flights with low bookings reflectsthe very low variable costsof filling empty
seats.Similarly, the devastating impact of excesscapacity on profitability in tires,
hotels, and semiconductorsis a result of high fixed costs in these businessesand the
willingnessof firms to acceptadditional businessat any price that coversvariable costs.
Scaleeconomiesmay also encouragecompanies to compete aggressivelyon price
in order to gain the cost benefitsof greater volume. If scaleefficiencyin the auto

T H E T O O L S O F S T R A T E G YA N A L Y S I S

T h e i m p a c to f g r o w r h o n p r o f i t a b i l i t y

T<.

ir
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r;
ta
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=t
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=3
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Returnon sales
M a r k e -t .
.,
;;il!Lessthan-570

Returnon investment

tr*5%to0

Cashflow/investment

t r 0 t o 5 o / ol f 5 o / o t o 1 0 % f ] O v e r 1 0 %

-s?
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industry melrnsproducing four million carsa year,a level that is achievedby only six
of tl.renineteeninternationalauto companies,the outcclmeis a battle for market share
as eacl.rfirm tries to achievecritical mass.
rl

Tl-refirms in an industry()peratein two rypesof markets:in the marketsfor inputs and


the rnarketsfor outputs. In input marketsfirms purchaseraw materials,components,
and financialand labor services.In the marketsfor outputs firms sell their goods and
servicesto customers(who may be distributors,consumers,or other manufacturers).
In both markets the transactionscreatevalue for both buyers and sellers.How this
value is sharedbetweenthem in terms of profitability dependson their relative economic power. Let us clealfirst with output markets.The strength of buying power
that firms face from their customersdependson two sets of factors: buyers' price
sensitivityand relativebargainingpower.
l i f r v * t ' ' r l ' ! r ' ,r " ! u r r c i t i r , i l r rT 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 s
chargedby the firms in an industry dependson four main factors:
:" The greaterthe importanceof an item as a proportion of total cost, the more
sensitivebuyers will be about tl-reprice they pay. Beveragemanufacturers are
highly sensitiveto the costsof aluminum cansbecausethis is one of their
largestsinglecost items. Conversely,most cornpaniesare not sensitiveto the
feeschargedby their auditors,sinceauditing costsare such a small proportion
of overall company expenses.
tr The lessdifferentiated the products of the supplying industry, the more
willing the buyer is to switch supplierson the basisof price. The
manufacturers 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 intensethe competition among buyers,the greatertheir eagerness
for price reductions from their sellers.As competition in the world
automobile industry has intensified, so component suppliers face greater
Dressures
for lower Dnces.

I
A
a
d
tl
a.
SI

II

rr
C
ui
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CHAPTER 3

FF
3H
6:.

ti

INDUSTRY ANALYSIS: THE FUNDAMENTALS

* The more critical an industry's product to the quality of the buyer's product
or service,the lesssensitiveare buyers to the prices they are charged. The
buying power of personal computer manufacturers relative to the
manufacturers of microprocessors(Intel and AMD) is limited by the vital
importance of these components to the functionality of PCs.

EX

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li.claiivo ilargelini*g floltrttr Bargainingpower rests,ultimately, on refusalto deal


with the other party. The balance of power between the two parties to a transaction
depends on the credibility and effectivenesswith which each makes this threat. The
key issueis the relative cost that each party sustainsas a result of the transaction not
being consummated.A secondissueis eachparty's expertisein managingits position.
Severalfactors influence the bargaining power of buyers relative to that of sellers:
:t Sizeand concentration of bwyersrelatiue to swppliers.The smaller the number
of buyers and the bigger their purchases,the greater the cost of losing one.
Becauseof their size,health maintenanceorganizations(HMOs) can purchase
healthcare from hospitals and doctors at much lower cost than can individual
patients.Severalempirical studiesshow that buyer concentrationlowers
prices and profits in the supplying industry.rT
,''oBttyers' information. The better informed buyers are about suppliers and their
prices and costs,the better they are able to bargain. Doctors and lawyers do not
normally display the prices they charge,nor do traders in the bazaarsof Thngier
and Istanbul.Keepingcustomersignorant of relativepricesis an effective
constrainton their buying power. But knowing pricesis of little value if the
quality of the product is unknown. In the markets for haircuts, interior design,
and managementconsulting,the ability of buyersto bargainover price is
limited by uncertainty over the preciseattributes of the product they are buying.
* Ability to integrate uertically.In refusing to deal with the other party the
alternative to finding another supplier or buyer is to do it yourself. Large
food-processingcompaniessuch as Heinz and Campbell Soup have reduced
their dependenceon the manufacturers of metal cans by manufacturing their
own. The leadingretail chainshave increasinglydisplacedtheir suppliers'
brands with their own-brand products. Backward integration need not
necessarilyoccur - a credible threat may suffice.

)re
rfe

ne
uon

Analysisof the determinants of relative power between the producers in an industry


and their suppliers is preciselyanalogousto analysisof the relationship between producersand their buyers. The only difference is that it is now the firms in the industry
that are the buyersand the producersof inputs that are the suppliers.The key issues
are the easewith which the firms in the industry can switch between different input
suppliersand the relative bargaining power of each party.
Becauseraw materials,semi-finishedproducts, and components are often commodities supplied by small companies to large manufacturing companies, their suppliers usually lack bargaining power. Hence, commodity suppliers often seekto boost
their bargaining power through cartelization (e.g., OPEC, the International Coffee
Organization,and farmers' marketing cooperatives).A similar logic explains labor
unions. Conversely,the suppliers of complex, technically sophisticated components
may be able to exert considerablebargaining power. The dismal profitability of the

PART II

THI.] TOOLS OF STRATE(iY ANALYSIS

The impact of unionization on profitability

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personalcorxputerindustry rnaybe attributedto thc pclwerexercisedby the suppliers


of key c()nlponents(processors,
cliskclrives,LCD screens)and the dominant supplier
of operatingsystenrs(Microsoft).
Labor unions irre irnportlurt sourcesof supplier power. Where an industry has a
high percentegeof its employeesunionized - as in steel,airlir-res,
and automobilesp r o f i t a b i l i t yi s r e c l u c e d( s e cF i g u r e3 . 5 ) .

t-

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ir
Once we understandhow industrystructuredrivescompetition,which, in turn, detertnines industry profitability, wc can apply this analysis,first to forecastingindustry
profitability ir.rtlre future, ancl sec<lncl
to dcvising strategiesfor changing industry
structure.

The 6rst stagc of industry analysisis to iclentify the key elementsof tl-reindustry's
structure. Irr principle, this is a sirnpletask. It reqr.rires
identifying who are the main
players- the proclucers,the cllstomers,the suppliers,ar-rdthe producersof substitute
goocls- ther-rexanriningsome of the key structural characteristicsof each of these
grollps that will cleterrninecompetition anclbargainingpower.
In rnost rnanufacturir-rg
industricsthe identity of the different groups of players
is usr-rallystraightforwarcl,in cltlrer industries- particularly in service industriesbuilding a picture of tl.reir.rdustrynray be more difficult. Considerthe supply of television prograrnming.There are a nurnberof different typesof player and establishing
which are buyers, which are sellers,and where the ir-rdustrybclundarieslie is not
simple.In terms of industry clefinition,do we considerall forn-rsof TV distribution or
identify separateindustriesfor broadcastT! cableT! and satelliteTV? In terms of
identifyingbuyersand sellers,we seethat there the industryhasquite a cornplexvalue
chain with the producers of the individual shows, networks that put together program schedules,and local broadcastingand cable con-rpanies
that undertake final

m
cl
te

rh
cc
ve

CHAPTER 3

distribution. For the distribution companies there are two buyers - viewers and
advertisers.Some companiesare vertically integrated acrossseveralstagesof 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 they
are forward integrated into local distribution through ownership of local TV stations.
Sorting out the different players and their relationships therefore involves some
'$7hich
critical issuesof industry definition.
activities within the value chain do we
'Sfhat
include in the industry?
are the horizontal boundaries of the industry in terms
ofboth products and geographicalscope?Sfe shall return to some ofthese issuesof
industry definition in a subsequentsection.

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INDUSTRYANALYSIS: THE FUNDAMENTALS

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'We

can use industry analysisto understand why profitability has been low in some
industries and high in others but, ultimately, our interest in industry analysis is not
to explain the past, but to predict the futwre.Investment decisions made today will
commit resourcesto an industry for a decadeor more - hence, it is critical that we are
able to predict what industry profitability is likely to be in the future. Currenr
profitability tends to be a poor indicator of future profitability. However, if an
industry's profitability is determined by the srrucure of that industry, then we can
use observationsof the structural trends in an industry to forecast the likely changes
in competition and profitability. Given that changesin industry structure tend to
be long term and are the result of fundamental shifts in customer buying behavior,
technologg and firm strategies,we can use our current observationsto identify emerging structural trends.
To predict the future profitability of an industry,our analysisproceedsin three stages:
Examine how the industry's current and recent levels of competition and
profitability are a consequenceof the industry's present structure.
Identify the trends that are changing the industry's structure. Is the industry
consolidating?Are new playersseekingto enter?Are the industry's products
becomingmore differentiatedor more commoditized?Does it look as though
additions to industry capacity will outstrip the industry's growth of demand?
i Identify how these structural changeswill affect the five forces of competition
and resulting profitability of the industry. Compared with the present, does it
seem as though the changesin industry structure will causecompetition to
intensify or to weaken? Rarely do all the structural changesmove competition
in a consistentdirection - typically,some factorswill causecomperition to
increaselothers will causecompetition to moderate.Hence, determiningthe
overall impact on profitability is likely to be a matter of judgment.
StrategyCapsule 3.2 discussesthe future profitability of the US casino industry.
During the past 20 years industry profitability has been undermined by two
major forces: increasinginternational competition and acceleratingtechnological
change.Despite widespread optimism that the "TMT" (technology,media, and
telecommunication)boom of the late 1990s would usher in a new era of profitability,
the reality was very different. Digital technologies and the internet both increased
competitive pressuresthrough lowering entry barriers and causing industries to converge.(SeeStrategyCapsule3.3.)

THE TOOi,S OF STRATI'GY ANAI,YSIS

Prospectsfor the US CasinoIndustry


T h e e a r l yy e a r so f t h e 2 1 s t c e n t u r ys a w a c o n -

t o e c o n o m i cd e v e l o p m e n t T
. h e r e s u l tw a s t h e

t i n u a t i o no f t h e U Sc a s i n ob o o m t h a t h a d b e g u n

introductionof riverboatcasinosand the licens-

19

. e t w e e n1 9 9 1a n d 2 0 0 5 ,
d u r i n g t h e m i d - 1 9 9 0 sB

i n g o f c a s i n o si n M i s s i s s i p pai n d s e v e n o t h e r

tha

t h e i n s t a l l e db a s eo f g a m i n gm a c h i n e si n c r e a s e d

states.Most important was the opening of

res

f r o m 1 8 4 , 0 0 0 t o 8 2 9 , 0 0 0 m a c h i n e s ,w h i l e U S

n e w c a s i n o so n I n d i a n r e s e r v a t i o n sB. y 2 0 0 6

stol

e x p e n d i t u r eo n g a m b l i n g r e v e n u e sr o s e f r o m

t h e r e w e r e s o m e 1 2 0 c a s i n o so n I n d i a n r e s e r -

Wel

$304 billion to $850 billion over the same


p e r i o d . D e s p i t e t h e c o s t s o f e x p a n s i o n ,t h e

vations across 17 states. One of the biggest

bun

was Foxwood's, owned by the Mashantucket

ofv

two industry leaders continued to earn good


p r o f i t s .H a r r a h ' sE n t e r t a i n m e n(t G r a n dC a s i n o ,

Pequottribe in Ledyard,CT.At the end of 2005,

stoc

t h e r ew e r e 2 8 7 , 0 0 0g a m i n gm a c h i n e si n c a s i n o s

des<

C a e s a r ' sB
, a l l y ' s ,P a r i s )e a r n e da n a v e r a g eR O E
ou r i n g 2 0 0 3 - 5 , w h i l e M G M M i r a g e
o f 1 4 . 8 o /d
(Bellagio,New York New York, Luxor,Excalibur,
M G M G r a n d )e a r n e da n a v e r a g eR O Eo f 1 2 . 6 % .

ofe

c r u i s es h i p s ) .

anal

D u r i n g 2 0 0 6 - 7 , g e o g r a p h i c a el x p a n s i o no f
g a m b l i n g s e e m e ds e t t o c o n t i n u ew i t h s e v e r a l

mark over the industry.Was Trump's entry into

a n d m o r e p e r m i s s i v ea p p r o a c h e st o g a m b l i n g
i n C a l i f o r n i a ,W a s h i n g t o n S t a t e , F l o r i d a ,a n d

or did it point to an industryfuture of intensify-

Oklahoma.

raceto build the "biggest and best" hotel-casino

new

n e w c a s i n o si n l n d i a n r e s e r v a t i o nisn C a l i f o r n i a

Chapter1l an isolatedcaseof bad management,

T h e m o s t v i s i b l es i g n o f e x p a n s i o nw a s t h e

located on tribal lands compared with 459,000


snd
i n " t r a d i t i o n a l "c a s i n o s( i n c l u d i n gr i v e r b o a t a

However,the bankruptcy of Trump Hotels and


Casinosat the end of 2OO4had raiseda question

i n g c o m p e t i t i o na n d d e c l i n i n gm a r g i n s ?

Thr

A f u r t h e r s o u r c eo f n e w c o m p e t i t i o nw a s
the internetA
" l t h o u g hi l l e g a li n t h e U S ,i n t e r n e t
g a m b l i n g ( e s p e c i a l l yp o k e r ) t h r o u g h n o n - U S

c o m p l e x e si n L a s V e g a s . B e t w e e n 1 9 9 6 a n d

i n t e r n e t g a m b l i n g c o m p a n i e sg r e w m a s s i v e l y

2000, the number of hotel rooms in Las

d u r i n g2 0 0 0 - 5 .

Vegascasinosmore than doubled. New "mega-

With the growth of casinocapacityand new

c a s i n o s "i n V e g a si n c l u d e dt h e M G M G r a n d ,t h e

g a m b l i n go p p o r t u n i t i e fsa r o u t s t r i p p i n gg r o w t h

Bellagio,New York New York, and the Venetian.

i n d e m a n d , w h a t w o u l d t h e i m p l i c a t i o n sb e

Competition between the casinosinvolvedever

for competition and profitability?Much would

more ambitious differentiationin terms of soec-

d e p e n d o n h o w t h e l e a d i n gc a s i n oc o m p a n i e s

tacle, entertainment,theming, and sheer scale.

respondedto the deterioratingcompetitivesitu-

P r i c ec o m p e t i t i o n w a s a l s o e v i d e n t i n t e r m s

ation. During2005,the industryhad experienced

of subsidizedtravel packages,free rooms, and


other perksfor "high rollers."

a n o t h e r m e r g e r w a v e . F o r m e ri n d u s t r y l e a d e r

However,by far the greater part of industry

M i r a g e a c q u i r e dt h e n u m b e r 4 i n t h e i n d u s t r y ,

e x p a n s i o nw a s o u t s i d e t h e t r a d i t i o n a lc e n t e r s

Mandalay Resorts.As a result,two companies,

ParkPlacewas acquiredby Harrah's,while MGM

i n L a sV e g a sa n d A t l a n t i c C i t y ,N J .T h e m u n i c i -

Harrah'sand MGM Mirage, dominated the

p a l i t i e sa n d s t a t e g o v e r n m e n t ss a w g a m b l i n g

industrywith the reconstitutedTrump Entertain-

a s a n e w s o u r c eo f t a x r e v e n u ea n d a s t i m u l u s

ment Resortsa distant third.

.c

al
oBl
sl

CHAPTER3

INDUSTRYANALYSIS

THE FUNDAMENTALS

The Internet:ValueCreatoror ValueDeStroyer?


was the

The diffusionof the internetduring the late

The first thing to note is that most new

nelicens-

1990s and the creation of a host of businesses

en other

that sought to exploit its economic potential

new businesses.For the most part they used

ening of

resulted in one of the

By 2006

stock market booms in history. Pets.com,

a n e w d i s t r i b u t i o nc h a n n e lf o r e x i s t i n gg o o d s
and services:books (Amazon), airline tickets

e l e c t r o n i cb u s i n e s s e w
s ere not fundamentally

most spectacular

(Expedia), groceries (Peapod), and securities


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

an reser-

W e b v a n . c o m ,K o z m o . c o m , a n d B o o . c o m a l l

l biggest

b u r n e dt h r o u g h h u n d r e d so f m i l l i o n so f d o l l a r s

rantucket

of venturecapitaland, in severalcases,achieved

marketsare: strong substitutecompetitionfrom

I of 2005,

stock market values over $1 billion before


descendinginto bankruptcy.

traditional retail distribution, low entry barriers


(setting up a website costs little), and weak

i nc a s i n o s
r 459,000
boatsand
ansionof

of e-business?What can Porter's five forces

S o w h a t a r e t h e t r u e i n d u s t r i a le c o n o m i c s

product differentiation.The principalstructural


f e a t u r e s o f t h e s e " e - t a i l i n q " b u s i n e s s e sa r e

analysis
tell us about the likelyprofit potentialof

shown below:

new internet-basedbusinesses?

th several
California
gambling

..:.tJ
['f""r..lLll:'

rrida,and

t Suppliers
of web
software;ownersof
main portalshave
s i g n i f i c a nbta r g a i n i n g
power

iition was
S,internet
h non-US
massivelY

I I'i:i

y ano new
ng growth
:ations be
u c hw o u l d
companies
etitivesitu-

Capitalcostsof entry
arelow
B r a n d as n d
reputationnot
significant
barriers

ir' Easeof entrymeansmany


competitors
rr,Marketslackgeographical
boundaries
$ Low productdifferentiation
( e . 9 .E x p e d i aO, r b i t z a, n d
Travelocity
are near-identical)

rxperienced
stry leader
rvhileMGM
re industry,
:ompanles,
inated the
c Entertain-

: 1 1l l

r Pricetransparency
and
low searchcostsallow
verylow switchingcost
and high buyerprice
sensitivity

"Bricksand
mortar"
distribution
c h a n n e las r e
ctose
substitutes

T H E T O O L S O F S T R A T E G YA N A L Y S I S

The implication is that most "e-tailing"


markets- whether for books, securities,household goods, or hotel accommodation- will tend

Amazon relieson scaleeconomiesand oroduct

t o b e h i g h l y c o m p e t i t i v ea n d , o n a v e r a g e ,w i l l

differentiation through its range of customer

generate low margins and low rates of return

services;Google exploits scale economies and

on capital. Will any e-businessesoffer high

differentiation based on rapid innovation to

profitability?The key is the potential to reduce

dominate web search.

rivalryand raisebarriersto entry through strat-

eBay exploits network effects to dominate the


person-to-personauction business; in books,

egiesthat exploit network effects,economiesof

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


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

scale, or product differentiation. For example,

Winners," BusinessWeek (August 3, 2001).

\t i"rrlcrlicsio Allrr

I t r r t t t s l t ' t 1S l t " t t r l t t ' r t ,

Understanding how the structural characteristicsof an industry determine the intensity of competition and the level of profitability provides a basis for identifying
opportunitiesfor changingindustry structureto alleviatecompetitivepressures.The
first issueis to identify the key structuralfeaturesof an industry that are responsible
for depressingprofitability. The secondis to considerwhich of thesestructural features
are amenableto changethrough appropriatestrategicinitiatives.For example:
The remarkableprofit revival in the world steelindustry since2002 owes
much to the rapid consolidationof the industry,led by Mittal Steel.''

t
a
t.

Excesscapacitywas a major problem in the Europeanpetrochemicalsindustry.


Through a seriesof bilateralplant exchanges,eachcompany built a leading
position within a particular product area.'o
In the US airline industrg the major airlineshave struggledto changean
unfavorable industry structure. In the absenceof significant product
differentiation,the airlineshave usedfrequent-flierschemesto build customer
loyalty.Through hub-and-spokeroute systems,the companieshave achieved
dominanceof particular airports: American at Dallas-FortWorth, US Airways
at Charlotte NC, and Northwest at Detroit and Memphis. Mergers and
allianceshave reducedthe numbersof competitorson many routes.'"
Building entry barriersis a vital strategyfor preservinghigh profitability in the
long run. A primary goal of the American Medical Associationhas been to
maintain the incomesof its membersby controlling the numbersof doctors
trained in the United Statesand imposing barriers to the entry of doctors from
overseas.

, l,.rl ;irr; nil &n rlu si,l"iu:s:[\il-tt:l'r' l,rt[] rarv thc Prountlarics
In our earlier discussionof the structure of the television broadcastingindustry,
I noted that a key challengein industry analysisis defining the relevant industry. The
Standard Industrial Classification(SIC) offers an official guide, but this provides
limited practicalassistance.
SupposeJaguar,a subsidiaryof Ford Motor Company,is

b
a

ir
b
ti
^l

gr

r(
ct

n
I]
m
ti(
th
m
to

CHAPTER3

I the
roKs,
duct
)mer
ano
nto

arvard
merce

Lo

.e
)S

INDUSTRY ANALYSIS: THE FUNDAMENTALS

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


Jaguarconsideritself part of the "motor vehiclesand equipment" industry (SIC 371),
the automobile industry (SIC37l2), or the luxury car industry? Should it view its
industry as national (UK), regional (Europe), or global?

In,du,stries and Mark ets


The first issueis clarifying what we mean by the term "industry." Economists define
an industry as a group of firms that suppliesa market. Hence, a close correspondence
exists between markets and industries. So, what's the difference betr,veenanalyzing
industry structure and analyzing market structure? The principal difference is that
industry analysis- notably five forces analysis- looks at industry profitability being
determined by competition in two markets: product markets and input markets.
Everyday usagemakes a bigger distinction between industries and markets. Typically,industry is identified with relatively broad sectors,while markets refer to specific
products. Thus, the firms within the packaging industry compete in many distinct
product markets - glasscontainers, steel cans, aluminum cans, paper cartons, plastic
containers,and so on.
Similar issuesarise in relation to geographicalboundaries.From an economist's
viewpoint, the US automobile industry would denote all companiessupplying the US
auto market - irrespective of their location. In everyday usage, the term "US auto
industry" typically refers to auto manufacturers located within the US, and is often
restricted to US-owned automakers (which now includes primarily Ford and General
Motors).
For the purposesof industry analysis,we need to adopt the economist'sapproach
to identifying and defining industries. Thus, our starting point is the market - which
are the groups of firms that compete to supply a particular service?The result may be
that, for the purposes of industry analysis,we may wish to disregard conventional
concepts of industry. For example, if we are examining competition within the
banking industry, it is likely that we would want to regard banking as comprising
a number of industries - banks supply a number of distinct servicesand competition
in eachproduct market comprisesdifferent setsof firms. Most basic is the distinction
betrveenretail banking and investmentbanking. Even within retail banking we can distinguish different product groups. For example,credit cards and consumerlending are
closelyrelated products, but they involve distinct product offerings and different
groups of competing firms.
Given the conventional view of industriesas broad economic sectors,it can be
revealingto focus on competition using a micro-level approach that begins with
customerschoosingbetweenrival offerings (seeStrategyCapsule3.4).

I)t:,ftnirtaMarkt:|;;: Sub.s/ifutfiott irr l)cw,umd,(ffld,Srrppllt

rY,
'he
les
tc

I have argued that the key to defining industry boundaries is identifying the relevant
market. By focusing on the relevant market, we do not lose sight of the critical relationship among firms within an industry: competition. But how do we define markets?
A market's boundariesare defined by swbstitwtability.There are two dimensionsto
this - substitutability on the demand side and the supply side. Let us consider once
more the market within which Jaguar competes.Starting with the demand side, if customers are unwilling to substitute trucks for cars on the basis of price differences,

THE TOOLS OF STRATI]GY ANALYSIS

Analyzing Competition in Markets for Offerings


Mathur and Kenyonarguethat our conventional

criticalconsiderationis the type of questionthat

concept of industry is fundamentallyflawed. In


o r d e r t o a n a l y z ec o m p e t i t i o n ,w e m u s t b e g i n

w e w a n t o u r c o m p e t i t i v ea n a l y s i st o a n s w e r .
For decisionsrelating to marketing strategy -

with customerchoice.Customersdo not choose

i n c l u d i n gp r o d u c t d e s i g n ,p r i c i n g ,a d v e r t i s i n g ,

a product or a company,their unit of choice is

distribution, and entry into specific market


segments - analysis of competition between

the single offering. Competitivestrategy is the


"positioning of a single offering vis-i-vis a

narrowlydefined offeringsin relationto specific

unique set of potential customers and com-

c u s t o m e r sa n d c u s t o m e rg r o u p s i s l i k e l yt o b e

petitors." To analyze competition, it makes no

particularlyrevealing.

senseto talk about the "watch market" or the


"watch industry" * the PatekPhilippeSky Moon

F o r u n d e r s t a n d i n ga n d p r e d i c t i n gm e d i u m term profit trends, the conventionalfive forces

Tourbillonthat sellsat about half a milliondollars

a n a l y s i so f f a i r l y b r o a d l y d e f i n e d i n d u s t r i e s

does not compete with the $35 Timex Sport


Watch. Similarly,a $1,400 Swatch LustrousBliss

h a s t w o v i r t u e s .F i r s t ,i t a l l o w s u s t o c o n s i d e r
c o m p e t i t i o n i n t w o m a r k e t s s i m u l t a n e o u s l y-

Sapphire Watch is not a close competitor to

the market for outputs and marketsfor inputs.

S w a t c h ' s$ 3 9 . 9 5 P a m p a sR i d e r .E a c hm o d e l b y

S e c o n d ,i t t a k e s a c c o u n t o f s u p p l y - s i d es u b -

each watch maker is a separate offering and

stitution. Thus, different Swatch models are

each offering forms a distinct market where

p r o d u c e da t t h e s a m e p l a n t s u s i n g m a n y o f

competitors can be ranked according to how

the same components. Indeed, the parent


c o m p a n y- S w a t c h G r o u p - o w n s 1 6 b r a n d s ,

closely they compete with the focal offering.


Thus,if we considerthe SeikoMen's SteelWatch
($81),we can view the CitizenMen's SteelWatch

i n c l u d i n gS w a t c h ,O m e g a ,L o n g i n e sa, n d T i s s o t .

($78) and fimexT29771 ($60) as closecompeti-

cating resources.Hence, for analyzing broad

tors; the BulovaInfinity($150)and SwatchOnce


Again ($45) are more distant competitors.

questions of

Thismicro approachto analyzingcompetition

Even between brands there is scope for realloprofitability and competitive

a d v a n t a g e ,i t i s u s e f u l t o c o n s i d e rt h e g l o b a l
watch industry- though probably excluding

focuses on customer choicesand contrasts

the luxury watch segment, which in terms of

s h a r p l y w i t h P o r t e r ' s i n d u s t r y a n a l y s i st h a t
e x a m i n e sc o m p e t i t i o na t a m u c h h i g e r l e v e lo f

d e m a n d c o n d i t i o n sa n d p r o d u c t i o n i s c l o s e r
to the jewelry industry than to the watch

aggregation.

i nd ustry.

S h o u l dw e a b a n d o no u r m o r e a g g r e g a t e di n dustry analysisin favor of the meticulouslymicro

Based on: Shiv Mathur and Alfred Kenyon, Winning Business

analysisadvocatedby Mathur and Kenyon?The

Strategles(Oxford: Butterworth-Heinemann.2007).

ratherthan all motor vehicles.Again,


Jaguar'smarket shouldbe viewedas auton-robiles
if customersare only willing to substitutebetweenJaguarsand other makesof luxury
cars,then Jaguar'srelevantmarket is lurury cars rather than the automobile market
as a whole.

CHAPTER 3

ffi#ilil
tionthat
answer.
:rategyrertising,
market
between
c specific
elyto be
mediumveforces
ndustries
consider
reously
)r inputs,
s i d es u b cdelsare
manyof
e parent
6 brands,
ndTissot.
forreallong broad
rmpetitive
heglobal
excluding
termsof
is closer
he watch

ningBusiness
7\.

Again,
uxury
narket

INDUSTRY ANALYSIS: THE FUNDAMENTALS

But this fails to take account of substitutability on the supply side. If manufacturers
find it easyto switch their production from luxury cars to family sedansro sporrs cars
and the like, such supply-sidesubstitutability would suggesrthat Jaguar is competing
within the broader automobile market. The ability of Toyota, Nissan, and Honda to
penetrate the luxury car market suggeststhat supply-side substitutability between
mass-marketautos and specialty autos is moderately high. Similarly, the automobile
industry is frequently defined to include vans and light trucks, since these can be
manufactured at the same plants as automobiles (often using the same platforms and
engines).So too with "major appliance" manufacturers.They tend to be classifiedas
a single industry, not becauseconsumersare willing to substitute between refrigerators and dishwashers,but becausethe manufacturerscan use the samemanufacturing
plants and distribution channelsfor different appliances.
The sameconsiderationsapply to the geographicalboundaries of markets. Should
Jaguarview itself as competing in a single global market or in a series of separate
national or regional markets?The criterion here again is substitutability.If cusromers
are willing and able to substitute cars available on different national markets, or if
manufacturers are willing and able to divert their output among different countries
to take account of differencesin margins, then a market is global. The key test of the
geographicalboundaries of a market is price: if price differencesfor the same product between different locations tend to be eroded by demand-sideand supply-side
substitution, then these locations lie within a single market.
In practice, drawing the boundaries of markets and industries is a matter of judgment that dependson the purposesand context of the analysis.If Ford is considering
the pricing and market positioning of its Jaguar cars, it must take a micro-level
approach that definesmarkets around each model, in each country, and in relation to
differentcategoriesof customer(e.g.,distinguishingbetweensalesto car rental companiesand salesto individual consumers).In considering decisionsover investments
in fuel cell technology,the location of engine plants, and which new products to
develop over the next five years, Ford will view Jaguar as one part of its auto and
light truck businessand will define its market as global and extending acrossits full
range of models. The longer term the decisions are that it is considering, the more
broadly it will wish to consider its markers, since substitutability is higher in the long
run than in the short term.
Second, the precise delineation of the boundaries of a market or industry is
seldom critical to the outcome of our analysisso long as we remain wary of external
influences.The market in which an offering competes is a continuum rather than a
bounded space.Thus, we may view the competitive market of Disneyland, Anaheim
as a set of concentric circles. Closest is Universal Studios Tour. Slightly more distant
competitors are Sea\World and Six Flags.Further still might be a trip to Las Vegas,or
a skiing weekend. Beyond these would be the broader entertainmenr market that
might include cinemas,the beach, or playing video games.
For the purposes of applying the five forces framework, industry definition is not
'We
critical.
define an industry "box" within which industry rivals compete, bur
becausewe include competitive forces outside the industry box - notably entrants
and substitutes- the preciseboundariesof the industry box are not greatly important.
'Whether
we view Harley-Davidson as competing in the "retro" segmentof the heavyweight motorcycle industry, in rhe heavyweight motorcycle industry, or in the motorcycle industry as a whole is not critical to the outcome of our analysis.Even if we
define Harley's market narrowly, we can still take into account competition from

PART II

T H E T O O L S O F S T R A T E G YA N A L Y S I S

Tiiumph and Ducati as substitutecompetition. Indeed, we might want to consider


competition from more distant substitutes- sports cars,motorized water craft, and
p a r t i c i p a t i o ni n " e x t r e m es p o r r s . " t '

The five forces framework allows us to determine an industry's potential for profit.
But how is industry profit shared between the different firms competing in that
industry? As we have noted in our discussionof industry dynamics, comperirion
between industry participantsis ultimately a battle for competitive advar-rtage
in which
firms rival one another to attract customersand rnaneuver for positional advantage.
Let us look explicitly at the sourcesof competitive advantagewithin an industry.
In subsequentchapterswe develop a more comprehensiveanalysisof competitive
advantage.Our goal here is to identify those factors within the firm's market environment that determine the firm's ability to survive and prosper - its key success
factors.z2In StrategyCapsule3.5, Kenichi Ohmae of McKinsey's Tokyo office discusseskey successfactors in forestry and their link with srrategy.
Like Ohmae, our approachto identifyingkey success
factorsis straightforwardand
colnmonsense.To survive arrd prosper in an industrS a firm must meet two criteria:
first, it must supply what customerswant to buy; second,it must survivecompetition.
Hence, we may start by askingtwo questions:
'What
do our customerswant?
What does the firm need to do to survivecompetition?
To answer the first question we need to look more closely at customersof the
industry and to view them not so muclt as a sourceof bargainingpower, and henceas
a threat to profitability,but more as the basicrationalefor the existenceof the industry and as the underlyingsourceof profit. This irnpliesthat the firm must identify who
its customersare, what are their needs,and how they choose between competing
offerings. Once we have identified the basisof custorners'preference,this is merely the
startingpoint for a chain of ar-ralysis.
F'orexample,if consumers'choice of supermarkets is basedprimarily on which chargesthe lowest pricesand if the ability to charge
low prices dependson low costs,the key issuesconcern the deterrninantsof costs
among supermarkets.
The secondquestionrequiresthat the firm examinesthe basisof competition in the
industry. How intenseis competition and what are its key dimensions?Thus, in the
luxury car market, consumersselectprimarily on the basisof prestige,design,quality, and exclusiveness.
However, thesequalitiesare an insufficientbasisfor success.
In this intensely competitive market, survival requires a strong financial position
(to financenew product development)and coststhat are sufficientlylow to allow a
company to cover its cost of capital.
A basic framework for identifying key successfactors is presentedin Figure 3.7.
Application of the framework to identify key successfactors in three industriesis
outlined in Thble 3.3.
Key successfactorscan also be identifiedthrough the direct modeling of profitability. In the sameway that the five forces analysismodels the determinants of industrylevel profitability, we can also artempr to model firm-level profitability in terms of

tl

S(

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qr
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CHAPTER 3

INDUSTRYANALYSIS:

THE FUNDAMENTALS

ider
and

Probingfor Key SuccessFactors

'ofit.
that
tion
hich
nge.
rstry.
itive
nvirccess
: disI and
.eria:
Ltion.

rf the
lce as
ndusrwho
reting
ly the
rmarharge
COSTS

in the
in the
qualtccess.
rsition
IIow a
."17
:riesis
fitabillustryrms of

A s a c o n s u l t a nf a
t c e dw i t h a n u n f a m i l i abr u s i nessor industry,I makea point of first asking
t h e s p e c i a l i s ti n
s t h e b u s i n e s s" ,W h a t i s t h e
secretof success
in this industry?"Needless
to
get
so
say,I seldom an immediateanswer,and
I p u r s u et h e i n q u i r yb y a s k i n go t h e rq u e s t i o n s
from a varietyof anglesin orderto establish
as
quicklyas possible
somereasonable
hypotheses
as to key factorsfor success.In the course
of these interviewsit usuallybecomesquite
obviouswhat analyses
will be requiredin order
By first
to proveor disprovethesehypotheses.
identifying
the probablekeyfactorsfor success
andthenscreening
them by proofor disproof,it
is oftenpossible
for the strategist
to penetrate
veryquicklyto the coreof a problem.
Travelingin the United Stateslast year,I
foundmyselfon one occasion
sittingin a plane
nextto a directorof one of the biggestlumber
companies
in the country.ThinkingI mightlearn
something
usefulin the courseof the five-hour
flight,I askedhim."Whatarethe keyfactorsfor
success
in the lumberindustry?"
Tomy surprise.
"Owninglargeforests
hisreplywas immediate:
andmaximizing
the yieldfrom them."Thefirst
of thesekeyfactorsis a relatively
simplematter:
purchase
of forestland.Buthissecondpointrequiredfurtherexplanation.
Accordingly,
my next
question
was:"Whatvariable
or variables
do you
controlin orderto maximizethe vieldfrom a
qiventract?"

He replied:"The rate of tree growth is the key


variable.As a rule, two factors promote growth:
t h e a m o u n t o f s u n s h i n ea n d t h e a m o u n t 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 sunshinebut
too little water, and so tree growth is very low.
Now, if we could give the trees in those states
enough water, they'd be ready in less than
fifteen years instead of the thirty it takes now.
The most important project we have in hand
at the moment is aimed at findinq out how to
do this."
lmpressed that this director knew how to
work out a key factor strategyfor his business,
I offered my own contribution:"Then under the
opposite conditions, where there is plenty of
water but too little sunshine - for example,
around the lower reachesof the Columbia River
- the keyfactorsshould be fertilizersto speedup
the growth and the choiceof tree varietiesthat
d o n ' t n e e ds o m u c h s u n s h i n e . "
H a v i n g e s t a b l i s h e di n a f e w m i n u t e s t h e
general framework of what we were going to
talk about, I spent the rest of the long flight very
profitably hearing from him in detail how each
of thesefactorswas being applied.

Source.'Kenichi

Ohmae,

Ihe

Mind

of

the

strategist

( H a r m o n d s w o r t h :P e n g u i n , ' 1 9 8 2 ) : 8 5 .@ 1 9 8 2 . R e p r i n t e db y
permissionof McGraw-Hill ComDanres.

PART II

THE TOOLS OF STRATEGY ANALYSIS

TAB

Identifying key successfactors

Prereouisites
for success

How doesthe firm


survivecompetition?

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

Stee

Analysisof competition
o What drivescompetition?
0 What arethe main
dimensionsof comoetition?
r How intenseis competition?
e How can we obtaina superior
competitiveposition?

KEYSUCCESS
FACTORSp

Fashi
clothi

identifying the key factorsthat drive a firrn's relativeprofitability within an industry.


In Chapter 2, we made some progresson this front. By disaggregating
a firm's return
on capital employedinto individual operatingfactorsand ratios,we can pinpoint the
(seeFigure2.1).In many industries,these
most important determinantsof firm success
primary driversof firrn-levelprofitabilityare well known and widely usedas performancetargets.StrategyCapsule3.6 beginswith a well-known profitabilityformula used
in the airline industry, then identifies the factors that drive this ratio. More generally,
return on capital into its comthe approachintroduced in Chapter 2 to disaggregate
ponent ratios can be extendedto identify the specificoperationaland strategicdrivers
to identifying successfactors
of superior profitability.Figure 3.8 appliesthis ar-ralysis
in retailing.
The value of successfactors in formulating strategyhas been scornedby some strategy scholars.PankajGhemawatobservesth:rt the "whole idea of identifying a success
factor and then chasingit seemsto havesomethingin common with the ill-considered
medievalhunt for the philosopher'sstone,a substancethat would transmuteeverything it touched into gold."2r Our objectivein identifying key successfactors is less
ambitious.There is no universalblueprint for a successfulstrategyand, even in indiHowever,
vidual industries,there is no "genericstrategy"that can guaranteesuccess.
each market is different in terms of what motivatescustomersand how competition
works. Understandingtheseaspectsof the industry environment is a prerequisitefor
an effective businessstrategy.Nevertheless,this does not imply that firms within an
industry adopt common strategies.Since every firm comprisesa unique set of resourcesand capabilities,even when an industry is subjectto comrnon successfactors
(e.g.low costs),firms will selectunique strategiesto link their resourcesand capabilities to industry successfactors.

Superm

CHAPTER 3

TAllLFl

INDUSTRY

Steel

I
O
o
O

Low price
Productconsistency
R e l i a b i l iot yf s u p p l y
S p e c i f itce c h n i c a l
<nori{ir:tinnc

H O WD OF I R M S
S U R V I VCEO M P E T I T I O N ?
(Analysis
of competition)

o Commodityproducts,
highfixed
excess
capacity,
capactty,
extt
costs,excess
barriera
s ,n ds u b s t i t u t e
c o m p e t i t i om
n e a ni n t e n s e
pricecompetition
and

{^r

<noriel <teel<

-,,-l:--l
^.^{;+^1.;l;+,,
LyLilLdr PrvrIrduilrLy

f-n<+ offiriannr:nd

financialstrengthessential

Fashion
clothing

t.

SE

ned
ly'
11-

lrs
)rs

O Diversity
of customer
nrofprpnrcc

3SS

'ed
ess
ul-'t

on
for
an
reors
ril-

in formc

of garmenttype,
style,quality,color
a C u s t o m ew
r si l l i n gt o
p a yp r e m i u mf o r
brand,style,
and quality
exclusivity,
o M a s sm a r k eht i g h l y
pricesensitive
Superma
rkets O Low prices
O Convenient
location
O W i d er a n g eo f
productsadaptedto
lnrrl

at-

THE FUNDAMENTALS

it.i| Identifying key successfactors:steel,fashion clothing, and supermarkets


WHATDO
WANT?
CUSTOMERS
(Analysis
of demand)

rn
ne

ANALYSIS:

nro{oronro<

produce;
O Fresh/quality
goodservice;
easeof
p a r k i n gp; l e a s a n t
ambience

o Lowbarriersto entryand
exit,low seller
c o n c e n t r a t i oann, d b u y i n g
powerof retailchains
i m p l yi n t e n s ceo m p e t i t i o n
O Differentiation
canyield
s u b s t a n t iparl i c ep r e m i u m ,
i sr a p i d
butimitation

o Intensityof price

c o m p e t i t i odne p e n dos n
n u m b ea
r n d p r o x i m i toyf
competitors
B a r g a i n i npgo w e ra c r i t i c a l
d e t e r m i n a no tf c o s to f
hnrrnh+-in

nnndc

KEYSUCCESS
FACTORS
O Costefficiency
requires:
l a n t sl,o w l a r g e - s c apl e
costlocation,rapid
capacityadjustment
O Alternatively,
high
technology,
small-scale
p l a n t sc a na c h i e vleo w
c o s t st h r o u g hf l e x i b i l i t y
a n d h i g hp r o d u c t i v i t y
O D i f f e r e n t i a t itohnr o u g h
technical
specifications
quality
and service
O Combiningdifferentiation
with low costs
O Differentiation
requires
to
speedof response
c h a n g i n fga s h i o n ss,t y l e ,
r e p u t a t i o na,n d q u a l i t y
O Costefficiency
requires
m a n u f a c t u ri ne l o w w a g e
countries
O Lowcostsrequire
operational
efficiency,
scale-efficient
stores,large
purchases,
low
aggregate
wagecosts
O Differentiation
requires
largestores(to allow
w i d ep r o d u c rt a n g e ) ,
c o n v e n i e nl ot c a t i o n ,
f a m i l i a r i twyi t h l o c a l
customerpreferences

PART II

THE TOOLS OI' STRATEGY ANALYSIS

Identifying Key SuecessFactors by Modeling Profltability:


Airlines
Profitability,as measuredby operating income
per availableseat-mile(ASM),is determined by
three factors: yield, which is total operating
revenues divided by the number of revenue
passengermiles (RPMs);load factor, which is
the ratio between RPMs and ASMs; and unit

i n d i v i d u afll i g h t s .
its Expenses/ASMs
- Wage ratesand benefit levels.
- Fuelefficiencyof aircraft.
-

Productivityof employees(determined
partly by their job flexibility).

Load factors.

Levelof administrativecost.

cost, which is total operating expensesdivided


b y A S M s .T h u s :
I n c o m e Revenue RPMs,

tacc

ASMs

RPMs

ASMs

Exoenses

Matching airplanesizeto demand for

ASMs

Someof the primarydeterminantsof each of


these measuresare the followinq:

In their battle for survival.the airlines have


sought to optimize as many of these factors as
possiblein order to improve their profitability.
To enhance revenue,severalairlineshave with-

C Revenue/RPMs
- Intensityof competition on routesflown.
- Ef{ectiveyield managementto permit

drawn from their most intensely competitive

quick price adjustmentto changing

superiorpunctuality,convenience,comfort, and

market conditions.
-

services.To improve load factors, companies

Ability to attract businesscustomers.

have become more flexible in their pricing and

Superiorcustomerservice.

in allocatingdifferent planesto different routes.

O Load factors
- Competitiveness
of prices.
- Efficiencyof route planning (e,9.,

costs by increasingemployee productivity, re-

through hub-and-spokesystems).
-

B u i l d i n gc u s t o m e rl o y a l t yt h r o u g h q u a l i t y
of service,frequent-flierprograms.

routes; others have sought to achieve a fare


p r e m i u m o v e r t h e c u t - p r i c e a i r l i n e st h r o u g h

Most notably, companies have sought to cut


ducing overhead, sharing serviceswith other
airlines,and reducingsalariesand benefits.

Sumn

In Chapt
derstand
criticalin
chapteI
proachtc
in ordert
and to id
age. The
five force
the struc
intensity
realizes.,
petition

CHAPTER 3

ntv

INDUSTRY ANALYSIS THE FUNDAMENTALS

FIGURE 3.8 Identifyingkey successfactors through analyzingprofit drivers: the


caseof retailing

Salesmix of oroducts

l{or
!i

Returnon Sales
3;r
rlBryWf$fqFwrySsgqqff41

Maximizebuyingpowerto
minimizecostof goods
purchased

nined

nesnave
actorsas
fitability.
lvewithnpetitive
re a fare
through
rfort,and
rmpanies
icingand
nt routes.
ht to cut
:tivity,rerithother
efits.

Avoidingmarkdownsthrough
tight inventorycontrol

a customerserviceo qualitycontrol

Sales/Capital l'
Employed g
!8ffi

Frll8ffiffi iqfi rtr$mfiFFqf

Maximizeinventoryturnover
throughelectronicdata
interchange,
closevendor
relationships,
fast delivery

Minimizecapitaldeployment
throughoutsourcingand leasing

Summarv
InChapter
1, we established
that profoundunderstanding
of the competitiveenvironmentis a
critical
ingredient
of a successful
strategy.In this
chapter,
we have developeda systematicapproach
to analyzing
a firm'sindustry
environment
inorderto evaluate
profitpotential
that industry's
andto identifythe sources
of competitive
advantage.Thecenterpiece
of our approachis Porter's
fiveforces
of competitionframework,which links
thestructure
of an industryto the competitive
intensity
within it and to the profitabilitythat it
realizes.
Althougheveryindustryis unique,competition
and profitabilityare the resultof the

systematicinfluencesof the structureof that


industry.
ThePorterframeworkprovidesa simple,
yet powerfulorganizing
frameworkfor classifying
the relevantfeaturesof an industry'sstructure
and predicting
theirimplications
for competitive
behavior.
Theframeworkis particularly
usefulfor
predictingindustryprofitabilityand for identifying how the firm caninfluence
industrystructure
in orderto improveindustryprofitability.
,Aswith mostof the toolsfor strategyanalysis
that we shallconsiderin this book,the Porterfive
forcesframeworkis easyto comprehend.
While
its basisis a substantial
bodvof microeconomic

PART II

T H E T O O L S O F S T R A T E G YA N A L Y S I S

theory,the relationships
it positsare straightforward and consistent
with commonsense.
However,the reallearningaboutindustryanalysis,
and
aboutthe Porterframeworkin particular,
derives
from its application.ltis onlywhen we applythe
Porterframeworkto analyzing
competition
and
diagnosing
the causes
of highor low profitability
in an industrythat we areforcedto confrontthe
complexities
and subtleties
of the model.What
industry(or industries)
doesa companycompete
in?Wheredo the industry's
boundaries
lie?How
wide a rangeof substitutes
do we consider?
How
do excesscapacity,cost structures,and exit
barriersinteractwith one another?
I urgeyou to put the toolsof industryanalysis
to work- not just in yourstrategic
management
coursework,
but also in your interpretation
of

everyday
business
events.Whatwill be the impact
of Linux,Apache,andotheropen-source
software
on Microsoft'shugelyprofitablesalesof operating systemsand serversoftware?What are the
prospectsfor the fixed-linetelecom providers
currentlybatteredby wirelessand internettelephony?ls your cousin'splan to leaveher law
firm to take up the positionof legal counsel
with a majorairlinea good ideagiventhe dil
ferent competitivecircumstances
of the two
industries?
Throughpracticalapplications
of the Porter
framework,we shall also becomeawareof its
limitations.
In the nextchapterwe shallconsider
someof theselimitationsand look to waysin
whichwe canextendand augmentour analysis
with additionalconcepts,
tools,and frameworks,

SelI'-StudyQuestions
The major forcesshapingthe businessenvironment of the fixed-linetelecomindustry are
technologyand governmentpolicy.The industry has been influencedby fiber-optics(greatly
increasingtransmissioncapacity),new modesof telecommunication(wirelessand internet
telephony),deregulation,and privatization.Using the five forcesof competition framework, show
how each of these developmentshas influenced competition in the fixed-line telecom industry.
From Thble 3.1, selecta high-profit industry and a low-profit industry.From what you know
of the structureof your selectedindustry,use the five forcesframework to explain why
profitability has been either high or low
With referenceto StrategyCapsule3.1, use the five forcesframework to explain why the US
smokelesstobacco industry is so profitable (asindicatedby the profitability of its dominant firm).
Despitehigh fuel costs,profitability in the world airline industry increasedsubstantially
during 2005 and 2006 - even while fuel costswere rising sharply.\X/hy?
!7al-Mart (like Carrefour,Ahold, and Metro) competesin severalcountriesof the world,
yet most shopperschoosebetweenretailerswithin a radius of a few miles. For the purposes
of analyzingprofitability and competitive strategy,should lfal-Mart consider the discount
retailing industry to be global, national, or local?
What do you think are key successfactorsin:
a)
b)

The deliveredpizza industry?


The investmentbanking industry?

Noter

1 B. Eil
with i
/htt..

PEST
2 M.E.
Analy
Press
"How
Busine
3 "For f
Hole,
4 'iflJ. B
Marke
York: I
Micha
of Indr
Econor
5 'Annua
6 "Brand

Journal
R.D.B
Consun
Strateg,
Indiana
8 In Octo
America
to monc
(http://ra
9 M. Liebr
7

Journal t
argues tt
to be suJ
giving th
10 See for e
(Cambrir

H.M.M
Rates of
Economi
11 W S. Cor
Pouter (C
J. L. Sieg
Entry anr
Industria,
12 G. S. Yip.
60 (Septe
13 F. M. Sch
Structure

CHAPTER 3

INDUSTRY ANALYSIS: THE FUNDAMENTALS

Notes
rtheimpact
'cesoftware
s of operat'hat
are the
n providers
rternettelelve her law
gal counsel
venthe difof the two
f the Porter
awareof its
hallconsider
l to ways in
our analysis
frameworks.

-l
I
are

3,T::''
I
rrk,show
industry.
u know

hvl

I
I

rtheuS I

antfirm).
I
rlly
I

;i:h.,
II
.nurr,

II
I

II

1 B. Eilert, "Ignite your Strategic Planning Process


with a PEST Analysis," Strategy Knowledge
(http://strategyknowhow.bnet.com/
PEST_analysis_primer.html),
September2004.
2 M. E. Portet, Competitiue Strategy: Tbcbniquesfor
Analyzing Industries and Competitors (New York: Free
Press,1980): Chapter 1. For a summary, see his article,
"How Competitive Forces ShapeStrategy,"Haruard
BusinessReuiew 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 BraceJovanovich, 1982). Seealso
Michael Spence,"Contestable Markets and the Theory
of Industry Structure: A Review Article," Journal of
E c o n o m i cL i t e r a t u r e2 1 ( S e p t e m b e r1 9 8 3 ) : 9 8 1 - 9 0 .
'Annual
Frarrchise500," Entrepreneur (January 2006).
5
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
C o n s u m e rG o o d s I n d u s t r i e s , "i n H . T h o r e l l i ( e d . ) ,
Strategy+ Strilcture = Perftirmance(Bloomington, IN:
IndiarraUniversity Press,1977): 128-9.
8 l n O c t o b e r1 9 9 9 , t h e D e p t . o f J u s t i c e a l l e g e ctlh a t
AmericanAirlines was using unf:rir means in irttempting
to monopolize air tr:rffic out of Dallas-Fort Worth
(http://www.aeroworldnet.com/1tw05 I 79.htm).
9 M. Lieberman ("ExcessCapacity as a Barrier to Entry,"
Journalof Industrial Economics 35, June 1987: 607-27)
arguesthat, to be credible, the threat of retaliation needs
to be supported by incumbents holding excesscapacity
givingthem the poter-rtialto flood the market.
10 Seefor example:J. S. Bain, Barriers to New Competition
( C a m b r i d g eM, A : H a r v a r d U n i v e r s i t yP r e s s ,1 9 5 6 ) a n d
H . M . M a n n , " S e l l e rC o n c e n t r a t i o n ,E n t r y B a r r i e r s ,a r . r d
Ratesof Return in Thirty Industries," Reuieruof
Economicsand Statistics48 (1966\: 296-307.
1 1 !( S. Cornanor and T. A. \/llson, Aduertising and Market
Power(Cambridge:H:rrvard University Press,1974);
J. L. Siegfriedand L. B. Ev:rns,"Empirical Stucliesof
Entry and Exit: A Survey of the Evidence," Reuiew of
IndustrialOrganization 9 (1994): 121-5 5 .
12 G . S .Y i p . " C r t e w a y ' t o E n r r y , " H a r u a r d B u s i n c s sR c u i t w

19ti2):tl5-93.
60(September-October
13 F.M. Scl.rerer
andD. R. Ross,lndustrialMarket
Structure
andEconomicPerformance.3rd
edn (Boston:

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


Behavior in the UK \JfholesaleMarket for Petrol. A
'Structure-Conduct
Analysis'," /o urnal of Industrial
E c o n o m i c s3 0 ( M a r c h 1 9 8 2 ) .
14 R. Schmalensee,"Inter-Industry Studies of Structure and
Performance," in R. Schn-ralensee
and R. D. Willig,
Handbook of Indwstrial Organization,2nd edn
( A m s t e r d a m :N o r t h H o l l a n d , 1 9 8 8 ) : 9 7 6 ; M . A .
Salir-rger,
"The Concentration-Margins Relationship
Reconsidered," Broo kingsPapers: Microe conomics
(1990\: 287-335.
15 The problems causedby excesscapacity and exit barrters
are discussedin C. Baden-Fuller (ed.), Strategic
Management of ExcessCctpdcity(Oxford: Basil
B l a c k w e l l ,1 9 9 0 ) .
.16
" B o o m a n d B u s t a t S e a , "E c o n o m l s l ( A u g u s t1 8 , 2 0 0 5 ) .
17 S. H. Lustgarten, "The Impact of Buyer Concentration
in Manufacturir-rgL'rdustries,"Reuiew of Economics and
Statistics57 (L975): 125-32; T. Kelly and M. L.
Gosman, "lncreaseclBuyer Concentration and
its Effects on Profitability in the Manufacturing Sector,"
Reuien,of lndustrial Organization 17 (2000): 41-59.
1tl "Globafization or Concentration?" BusinessV/eek
( N o v e m b e r 8 , 2 0 0 4 ) : 5 4 ; " M i t t a l : B l o o d , S t e e la n d
k (February 1,3, 200 6).
Empire Bui ldi ng," Busines s'V/ee
19 J. Bower, Wben Markcts Quake (Boston: Harvard
B u s i n e s sS c h o o lP r e s s ,1 9 8 6 ) .
'Airline
Hubbing,
2 0 M . C a r n a l l ,S . B e r r y ,a n d P S p i l l e r ,
Costs and Dernand," in D. Lee (ed.), Aduancesin Airline
E c o n o m i c sv o l . 1 ( E l s e v i e r2, 0 0 6 ) .
of market definition see Office
21 For a concise discr,rssion
of Fair Trading, Marl<et Definition (London: December
2 0 0 4 ) , e s p e c i a l l yp p . 7 - 1 7 .
22 The term was coinedby Chuck Hofer and Dan Schendel
- StrdtegyFormulation: Analytical Concepts (St. Paul:
W e s t P u b l i s h i n g ,1 9 7 7 ) : 7 7 - w h o d e f i n e d k e y s u c c e s s
factors irs "those variablesthat managementcan
influence through its decisionsand that can affect
significantly the overall competitive positions of the
firrls in an industry . . . Vithin any particular industry
thev are derived fronr the interaction of two setsof
variables,namely, the economic and technological
char:rcteristicsof 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
( N e w Y o r k : F r e eP r e s s1, 9 9 1 ) : 1 1 .