Industry Analysis: Porter s Five Forces Model Michael McDermott mcdermottm1@nku.edu http://www.linkedin.com/in/michaelcmcdermott www.strategycapstone.ning.com www.mcdermottstrategy.wikispaces.com www.globalbusinessstrategy.wikispaces.com 1
Exhibit 2.1 Layers of the business environment 2
PEST Analysis is Complete (see previous slides) Remember the PEST focuses upon the remote external environment These are the factors that NO company can control But the company MUST heed the conclusions from its PEST analysis Aligning with such trends is very wise Ignoring them is very risky if not foolish 3
Scenario Planning
Scenario Planning This demands consideration of a range of scenarios To be meaningful, if should include the most optimistic and most pessimistic scenarios This is intended to compel executives to ask the what if questions 5
Scenario Planning Organizations sometimes undertake this exercise The aim is to construct scenarios and then consider the strategic implications of these 6
Scenario Planning in the Auto industry Price of oil is $200 per barrel; Price of oil is $100 pb Price of oil is $50 pb Price of oil is $30 pb 7
Scenario Planning and the Auto Industry Scenario Price of oil is $200 per barrel Price of oil is $100 pb Price of oil is $50 pb Price of oil is $30 pb Implication(s) for auto company 8
Scenario Planning in the Auto industry Now that is very simplistic and considers only one variable an economic factor Clearly proper scenario planning would be much more sophisticated, and factor in multiple variables to identify many scenarios 9
Industry Analysis
The point of industry analysis is not to declare the industry attractive or unattractive but to understand the underpinnings of competition and the root causes of profitability Michael Porter, The Five Competitive Forces that Shape Strategy, Harvard Business Review, January 2008. 11
Defining the Relevant Industry Quality of industry analysis is compromised if it is not well defined Avoid defining it too broadly obscures differences among products, customers or geographic regions Avoid defining it too narrowly overlook s commonalities 12
Defining an Industry: Employ two key dimensions Scope of Products or Services The one product may be sold to very different buyers and thus despite product similarities, we have two or more industries: Motor oil is sold for lawn mowers, cars, trucks and thus we have three industries as the industry structure is very different Geographic scope Most industries exist in many countries. Is competition local, national, regional or global? 13
Steps in Industry Analysis 1. Define the relevant industry 2. Identify participants who are: The buyers and buyer groups The suppliers and supplier groups The competitors The substitutes The potential entrants 14
Steps in Industry Analysis 3. Assess the underlying drivers of each competitive force to determine which forces are strong and which are weak and why; 4. Determine overall industry structure Why is the level of profitability what it is? Which are the controlling forces for profitability Are more profitable players better positioned in relation to the five forces 15
Steps in Industry Analysis 5. Analyze recent and likely future changes in each force positive and negative 6. Identify aspects of industry structure that might be influenced by competitors, by new entrants, or by your company 16
Exhibit 2.1 Layers of the business environment 17
Why Undertake Industry Analysis The purpose is to determine the attractiveness or unattractiveness of the industry And in particular the sources of the above by consideration of five key forces (Porter s five forces model, developed in 1979) Unlike factors considered in PEST analysis, a company CAN influence industry attractiveness 18
Industry Analysis Is the Industry Attractive? Yes No Can we increase this? Are we committed to this industry? Can we change this? 19
Porter 2008: Updated Version of The Five Forces In essence, the job of the strategist is to understand and cope with competition Remember this is the dominant view of strategy; Remember in week 1 we posed the question is this view still as applicable today 20
Common Mistake Competition is defined too narrowly Competition includes direct rivals But competition for profits demands considerations of four other competitive forces: These five forces combined define an industry s structure 21
Exhibit 2.2 The five forces framework Source: Adapted with the permission of The Free Press, a Division of Simon & Schuster Adult Publishing Group, from Competitive Strategy: Techniques for Analyzing Industries and Competitors by Michael E. Porter. Copyright 1980, 1998 by The Free Press. All rights reserved 22
Porter s Five Forces and Industry Analysis: His examples Industries with intense forces Airlines Hotels Textiles Industries with benign forces Software Soft drinks Toiletries 23
Industry Analysis Benign Forces Intense forces Many companies are profitable Almost no company earns an attractive ROI 24
Porter s Key Point is this: Industry structure determines profitability Not the nature of the product or service whether the industry is emerging or mature whether high-tech or low-tech whether regulated or unregulated 25
Industry Profitability Determined by In Short term A myriad of factors The weather (severe cold weather deters trips to shops) The business cycle (products at end of PLC vs new products think of Video Game Consoles) In Medium/Long Term Industry structure as manifested in the competitive forces 26
Why is it essential to understand the forces? 1. These reveal the roots of an industry s current profitability 2. They also provide a framework for anticipating and influencing competition (and profitability) over time 3. Essential for strategic positioning Need to defend against the competitive forces And to shape the forces to the company s advantage 27
Industry Analysis: Example 1: Commercial Aircraft Factor Intensity of Rivalry Buyer Power Supplier Power Threat of Substitute Products Threat of New Entrants Evaluation Strong Force (albeit only two key players Airbus and Boeing) Strong force (airlines placing huge orders eg. Singapore Airlines) Benign Benign (I would suggest that this has become a stronger force due to extension of journey time due to security concerns and technological advances in substitutes such as rapid trains) Benign 28
Key Point The strongest competitive force or forces determine the profitability of an industry and become the most important force for consideration in strategy formulation Porter, 2008, Harvard Business Review 29
Photographic Film Industry Low returns are due not so much to rivalry (i.e. between Kodak and Fuji) But due to the advent of a superior substitute product (i.e. digital photography) Hence coping with this substitute product emerges as the top or number one strategic priority 30
The Five Forces in-depth
FIRST FORCE: THREAT OF NEW ENTRANTS 32
Threat of Entry New entrants increase industry capacity and want to win market share This leads to pressure on prices, costs and the rate of investment required to compete New entrants that emerge from other markets can have a major impact as they can leverage existing capabilities and cash flows to shake up competition: 33
Threat of Entry: Recent Examples Google with Android in smart phones; Apple with ipad in ereader; Pepsico entering bottled water and other beverage segments; Amazon with Online entertainment 34
Threat of entry Is High Deters New Entrants Demands a response from incumbents Or boost investment (erect barriers) They must hold down their prices 35
What determines level of Threat of Entry? 1. The height of entry barriers (i.e. the advantages that incumbents have relative to new entrants) 2. The reaction new entrants provoke from incumbents 36
Nature of Barrier Barriers to Entry: Seven Major sources Comment/Explanation 1. Supply-side economies of scale Firms producing in large quantities enjoy economies of scale and so new entrants can only compete if they enter and they too are prepared to compete on scale, otherwise they suffer a cost disadvantage. Scale economy benefits arise in almost every activity of the value-chain. 2. Demand-side benefits of scale Basically, buyers willingness to buy from a company increases with the number of other buyers the company has. Buyers have higher trust in larger companies. 37
Nature of Barrier Barriers to Entry: Seven Major sources Comment/Explanation 3. Capital requirements The need to invest substantial financial resources in order to compete can deter new entrants; Where capital requirements are modest, many potential entrants exist; 4. Incumbency advantages independent of size However, lenders can be found to provide large sums of capital when risks are low and growth opportunities are strong. Regardless of size, incumbents may possess cost or quality advantages unavailable to potential rivals. Advantages may include proprietary technology; preferential access to raw materials; entrenched in most attractive locations; brand identities etc. 38
Nature of Barrier Barriers to Entry: Seven Major sources Comment/Explanation 5. Customer-switching costs Switching costs are fixed costs that buyers face when they change suppliers; 6. Unequal access to distribution channels The greater the switching costs, the higher the barrier to entry; A new entrant needs to secure distribution, so the more limited the choice of channels the greater the entry barrier. Similarly, the more that incumbents control or have tied up distribution channels, the greater the entry barrier. When such barriers are high, the new entrant must bypass distribution channels altogether or create their own. 39
Barriers to Entry: Seven Major sources Nature of Barrier 7. Restrictive Government Policy Comment/Explanation Government policy can impede or aid new entry directly; It can also exaggerate or minimize other entry barriers 40
Barriers to Entry: Seven Major sources and a practical perspective Nature of Barrier 1. Supply-side economies of scale 2. Demand-side benefits of scale 3. Capital requirements 4. Incumbency advantages independent of size 5. Customer-switching costs 6. Unequal access to distribution channels 7. Restrictive Government Policy Consider these Barriers to Entry for Developed Country Multinational Corporations (MNCs) and the China Market Now consider the extent of these barriers to companies such as Apple, Dell, Google, RIM (ie Blackberry in China) 41
Barriers to Entry: Seven Major sources and Google in China Nature of Barrier 1. Supply-side economies of scale High 2. Demand-side benefits of scale High 3. Capital requirements Low 4. Incumbency advantages independent of size High 5. Customer-switching costs High 6. Unequal access to distribution channels High 7. Restrictive Government Policy Very High Extent of Barrier Could Google possibly ever succeed in China? 42
Big Challenge in Emerging Markets You may be seduced by the opportunities, but often the barriers to entry are very high. Should a company enter a market where the barriers are so high that it is either peripheral or confined to being a niche player? 43
What determines level of Threat of Entry? 1. The height of entry barriers (i.e. the advantages that incumbents have relative to new entrants) 2. The reaction new entrants provoke from incumbents 44
Expected Retaliation by Incumbents Retaliation Strong Weak Reduces profit potential Deters new entrants Encourages new entrants 45
Reasons to Fear Retaliation Incumbents have a history of mounting strong defence against new entrants Incumbents have the resources to fight back: Cash Production capacity Clout with distribution channels and customers Incumbents will cut prices to protect market share and/or have high fixed costs Industry growth is slow so the only way for new entrants to gain volume is at the expense of an incumbent 46
1. Threat of New Entrants Vital to stress that it s the mere threat, not actual entry that holds down profitability When threat is high, incumbents need to hold down prices or boost investment to deter entrants Threat of entry is high and profits are moderated when entry barriers are low and newcomers expect little retaliation from incumbents 47
SECOND FORCE: THE POWER OF SUPPLIERS 48
2. Bargaining Power of Suppliers Supplier are more powerful when: They sell to an industry less concentrated than their own The supplier is not heavily dependent on the industry for its revenues Switching costs for industry participants are high Suppliers offer differentiated products No substitutes are available Suppliers could undertake forward integration 49
THIRD FORCE: THE POWER OF BUYERS 50
3. Bargaining Power of Buyers Powerful buyers can: force down prices; Demand better quality or more service (thus driving up costs); and can play industry participants off against each other These all result in a reduction of profitability for those catering to these buyers 51
Bargaining Power of Buyers is Strong when. There are few buyers; Or when each buyer purchases in volumes that are large relative to the size of a single vendor; Buyers perceive vendors products as standardized or lacking in differentiation, so they perceive no advantage in buying from a particular vendor; Buyers have low switching costs in changing vendors; Buyers can credibly threaten backward integration and produce the vendor s product themselves 52
Bargaining Power of Buyers is Weak when. There are many buyers; Or when each buyer purchases in volumes that are small relative to the size of a single vendor; Buyers perceive vendors products as differentiated, so they perceive no advantage in buying from a particular vendor; Buyers have high switching costs in changing vendors; Buyers cannot credibly threaten backward integration and produce the vendor s product themselves 53
Let s Sum Up the Previous Two Slides Factor Trait when Buyer Power is Strong Trait when Buyer Power is Weak Number of buyers Few Many Volume of purchase relative to size of single vendor Nature of Vendor s Product Large Standardized or lacking differentiation Small Buyers and switching costs Low Costs High Costs Threat of backward integration by vendor Strong Strong differentiation Weak 54
Spotting Price Sensitive Buyers A buyer group is price sensitive when: It buys a product from the industry that represents a high percentage of its cost structure E.g. imagine a company buys just one particular component that accounts for 30 per cent of its total cost structure the company will be very price sensitive and seek to lower cost of that component as much as possible 55
Spotting Price Sensitive Buyers A buyer group is price sensitive when: It earns low profits, is strapped for cash, or is under pressure to reduce purchasing costs; Its own products/services are not greatly affected by the quality of the vendors products/services E.g. let s assume that the ducting used in a Dyson hose is not critical to the quality of Dyson would be a very pricesensitive buyer of such ducting; However, the motor may be very important, so for that product Dyson would be much less price sensitive 56
Spotting Price Sensitive Buyers A buyer group is price sensitive when: The industry s product has little effect on the buyer s other costs E.g. an automobile producer may be very price sensitive when it comes to purchase of lights in vehicles, but not at all price-sensitive in choice of CNC machinery 57
Just Think of Yourself as a Consumer! When are you a price sensitive buyer? When you are buying products that lack differentiation; When you are buying products that are relatively expensive to you; When product performance is not a major concern 58
FOURTH FORCE: THE THREAT OF SUBSTITUTES 59
Substitute Products When the threat is high, industry profitability suffers The existence of substitute products/services limits an industry s profit potential by placing a ceiling on prices Therefore an industry needs to reduce the appeal of substitutes through product performance, marketing etc E.g. golf club companies seek to reduce appeal of previous generations of product by regular new product launches and claims of improved performance 60
Substitute Products In Emerging Markets, industries that may have expected to reap the benefits of economic development miss out due to substitute products Rather than subscribe to a wired telephone line, they rely exclusively upon wireless telecommunications 61
The threat from substitute products is high if. 1. it offers an attractive price-performance tradeoff to the industry s product Imagine paying $200 for a set of rarely used golf clubs that retailed for $1,200 only 12 months earlier; People use Skype and Vonage rather than conventional service providers for long-distance calls; TV cable companies in 2010 have seen largest drop in subscriber numbers as people rely on Online services such as Hulu, Netflix and YouTube. 62
The threat from substitute products is high if. 2. The buyer s cost of switching to the substitute is low Consumers may switch at minimal cost from branded products (e.g cereals, drugs) to generics 63
Substitute Products Changes in other industries may render them attractive substitutes when they were not before Consider some examples: Steel may be replaced by plastics as the latter innovates; Nuclear power may be replaced by renewable energy sources as the latter innovates 64
Threat of Substitute Products A substitute performs the same or similar function as an industry s product by a different means video conferencing is a substitute for travel; Plastic for aluminum Email for fax/letters Facebook for email 65
Threat of Substitute Products Substitutes are always present though they can often easily be overlooked; Valentine s Day is approaching so think of the range of substitute products Think of what you may choose to buy for your partner that list of potential purchases are in fact all substitute products Consider your gift purchases at Christmas time the options that you faced in each purchase again highlights the nature of substitutes 66
It is a substitute to do without you may decide not to make a purchase (e.g. buy a car; book a vacation) buy used (so this can be a strong substitute for cars, sports equipment, books etc internet and ecommerce has perhaps increased the strength of this force) do it yourself (e.g. remodel yourself rather than employ a contractor; wash your own car rather than go to commercial carwash) 67
FIFTH FORCE: INTENSITY OF RIVALRY 68
Think of How Rivals Compete What do auto companies do in order to win sales? What do mobile phone service carriers do in order to win subscribers? What do retailers to in order to attract customers? 69
Rival s Means of Competing Auto Companies Fast Food Restaurants Mobile Phone Service Carriers Retailers Price Discounts on Original Purchase Price Low Maintenance Costs (eg Warranty) Advertising New Product Introductions Service Improvements Other 70
High Rivalry Limits The Profitability of the Industry Industry s Reduced Profitability determined by. Intensity of Rivalry Basis on which they compete 71
Intensity of Rivalry Greatest if.. Competitors are numerous, or are roughly equal in size and power Industry growth is slow Exit barriers are high Rivals are highly committed to the business and seek market leadership Implications of trend Rivals struggle to avoid poaching business from each other; In the absence of an industry leader, there is no enforcer of practices best suited to the industry Leads to fights for market share Companies cannot exit easily as their assets are highly-specialized; Often management have an emotional commitment to the industry and only its removal results in exit from the industry Often results in all competing on the same dimensions, and this damages prospects of profitability 72
Price Competition is most likely if Trend Products or services of rivals are nearly identical and few switching costs to buyers Fixed costs are high and marginal costs are low Capacity must be expanded in large increments to be efficient The product is perishable Comment This encourages rivals to cut prices to secure new customers Again intensifies pressure for rivals to cut costs below their average costs Can lead to excess capacity issues and price-cutting Intensifies pressure to cut prices whilst product has some value; Fruit may rot; electronics may become obsolete; services are perishable an unsold hotel room can never be recovered 73
Common Errors in Industry Analysis: Factors Not Forces Common Error Fast-growing industries are always attractive Technology and Innovation make an industry attractive Government Fast growth can make suppliers powerful; High growth with low entry barriers will draw in entrants; Even without new entrants, customers may be powerful or substitutes are attractive, reducing profitability opportunities. Often industries with low technology can be more profitable than technologyintensive industries (eg software) Can affect the forces, but is not a force per se 74
Intensity of Rivalry In addition to the dimensions of rivalry, intensity increases when firms compete on the same dimensions Firms aim to meet the same needs Or compete on the same attributes 75
The Five forces In an ideal world what would the analysis conclude for an organization competing in a particular industry? What would be the worst case scenario? Does the ideal scenario ever exist in a free market economy? 76
The Five Forces in Operation Let s identify an industry/industries and examine it using the five forces model Often students are confused by this tool They talk of substitutes when they mean rivals They are not clear on who the suppliers are Or do not distinguish between different types of buyers 77
Porter s Five Forces Model It is vital that you grasp this concept and can apply it any context It needs to be applied at the SBU level of the organization It reveals the nature of competition in the present, but also needs to be employed to consider the nature of each force in the future This future orientation allows the organization to develop strategies to deal with each force in the future Changes in the remote environment can exert enormous impact upon the nature of a particular force 78