Business strategy is essentially a quest fo profit and we need to identify the sources of profit in external environment.
We are to identify the attractiveness of different industries in search for that profit and establishing competitive advantage.
The starting point would be a framework or system to analysing business environmental information. PEST (Political, Economic, Social and Technological) analysis may be utilised for this. It can be useful in keeping firm alert on what is happening in the world. We must be, however, mindful of information overload and costly research. We need to distinguish the vital factors from merely important ones.
Firstly, we need to create value for customer to make money and understand the customers. Secondly, understanding suppliers and manage relationships with them. Thirdly, we are to research the intensity of competition for the same value-creating opportunities. This way, we form relationships with customers, suppliers and competitors. We must not forget, however about the democratic, regulatory and technological changes affecting the business that may be detrimental to its profitability.
Some businesses consistently earn high profits and some fail to cover their cost of capital. The industry profitability is dependent on certain influences of the industry's structure.
Porter's Five Forces of Competition Framework
The most widely used framework for identifying the competition and profitability is the Porter's Five Forces of Competition Framework. These five forces include: competition from substitutes, competition from entrants, competition from established rivals as well as the power of suppliers and customers.
Competition from Substitutes
The price that the customer is willing to pay for a product depends on the availability of substitutes. The existence of substitutes means that the customers will switch to substitutes in response to price increase of the product. The extend to which substitutes depress prices and profits depends on the propensity of customers to substitute between product offerings. The more complex the product and the more difficult is to discern performance differences, the lower the extend to substitution by customers based on the price.
Competition from Entries
If industry earns the return on capital in excess of it's cost of capital it will act as a magnet to firms outside the industry. If the entry of new firms is unrestricted, the rate of profit will fall to the competitive level. Threat of entry rather then actual entry may be sufficient to ensure that established firms constrain their prices to the competitive level. An industry where no barriers to entry or exit exist is contestable, prices and profits shape to competitive level, regardless of the number of firms in the industry. Contestability depends on the absence of sunk costs - investment whose value cannot be recovered on exit. An absence of sunk costs makes the industry vulnerable to 'hit and run' entry whenever established firms raise their prices above the competitive level.
In the context of industry, 'hit and run' typically refers to a business strategy or practice where a company seeks short-term gains or benefits without long-term commitments or investment. In involves engaging in transaction, such as a business deal or investment, with the intention of quickly profiting or gaining an advantage and then exiting the situation rapidly. It is often used to describe opportunistic behaviour where the focus is on immediate gains rather then building sustainable relationships or long-term success. While a 'hit and run' can lead to short-term benefits, it may have negative consequences. It can harm relationships, damage reputation and create a perception of opportunism or lack of commitment.
In real world, however, new entries cannot enter on equal terms with those established on the market. The barrier is the advantage that the established firms have. The capital cost of becoming established can discourage smaller companies. There might be huge capital costs of establishing R&D, production and facilities. In other industries, entry costs can be modest, such as in service sector.
The sources of high capital requirements are also sources of scale economics. The problem is that new entries generally start with low market share and forced to accept high unit costs. Established firms may have a unit cost advantage, irrespective of scale. It often result from acquisition of low cost raw materials. Cost advantage may also result from economies of learning and wealth of experience.
In an industry where products are differentiated, established firms possess the advantage of brand recognition and customer loyalty. New entries must spend heavily on advertising and brand promotion to gain a level of brand awareness. These can sum up to up to 2% of revenue for new entries.
For many new suppliers of consumer goods the principal barrier to entry is likely to be gaining distribution. Retailers may be reluctant to carry an new product.
Governmental and legal policy may also create barriers, some companies may require licences to operate. In knowledge intensive industries, patents, copyright and other legally protected forms of intellectual property are major barriers to entry. Regulatory requirements and environmental regulation often put new entries at disadvantage in comparison to established firms because of compliance costs.
Retaliation against new entries may take form of aggressive price-cutting, increased advertising, sales promotion or litigation. To avoid this, new entries may seek initial small scale entry into less visible market segments.
Industries protected by high entry barriers tend to earn above the average rates of profits. Capital and advertising tend to be particularly effective. The limitations will depend on the resources and capabilities that potential entries possess.
Rivalry between established competitors
Im most industries the the level of profitability is the level of competition between businesses in that industry. In some industries, firms compete aggressively - sometimes with prices pushed below the level of costs and losses are incurred. In other industries competition focuses on advertising, innovation and other non-price dimensions.
These can depend on several factors:
- Seller concentration - the number and size distribution measured by the concentration ratio (the market share of the leading producers). Where a market is dominated by a small number of leading companies, price competition may be restrained and competition focuses on advertising, promotion and product development. As more organisations enters the market, the price becomes less rigid and price cutting may be exercised.
- Diversity of competitors - the extend to which firms can avoid price competition it depends on how similar they are in their origins, objectives, costs and strategies. Sometimes companies have similarities in terms of price structures, strategies and top management mindset.
- Product differentiation - the more similar offerings among the rival firms, the more willing are customers to switch between them thus price cuts appear to boost sales. In industries where products are highly differentiated, price competition tends to be weak.
- Excess capacity and entry barriers - during recession the key is the balance between the demand and capacity. Unused capacity encourages forms to offer price cuts to attract new business. Capacity issues may result from over investment and declining demand. Barriers to exit are costs associated with exiting the market. Where employees jobs are protected, barriers to exit may be substantial, some that may be devastating to profitability. Conversely, rapid demand growth creates capacity shortages and boost margins. On average, companies in growing industries earn higher profits then companies in slow and declining industries.
- Cost conditions - when excess capacity cause price competition, the cost structure will determine how low the prices will go. When fixed costs are high in relation to variable costs forms will take a business on any price that covers variable costs. Scale economics may also encourage firms to compete aggressively on price in order to gain cost benefit of greater volume.
Bargaining Power of Customers
The firms in an industry compete in two types of markets - input market and output market. In input market firms purchase raw materials components and financial and labour services. In the market of outputs firm sells their goods and services to customers. In both markets the transactions create value for both buyers and sellers. The profitability will depend on their economic power.
The strength of buying power depends on two factors:
- Buyers price sensitivity. The greater the importance of the item to the total cost, the more sensitive buyers will be. The less differentiated the product, the more willing the buyer is to switch the supplier on the basis of price. The more intense competition among buyers, the greater their eagerness to price reductions. The more critical the product to the buyers quality, the less sensitive buyers are to the price.
- Relative bargaining power. Bargaining power rest on the refusal to deal with the other party and it depends on the credibility and effectiveness with which each party makes this threat. The size and concentration of buyers relative to suppliers will impact the power. The smaller the number of buyers and the bigger their purchases, the greater the cost of loosing one. Studies show that buyers concentration can lower the prices and profits.
The better informed buyers are about suppliers and their prices and their costs, the better they are able to bargain. Keeping customers ignorant to relative prices in an effective constraint of the buying power.
In refusing to deal with the other party, the alternative to find another supplier is to do it yourself. Sometimes companies resolve this issue through their own supply and production.
Bargaining Power of Suppliers
The key issue here is how easy it is for customer to switch to another supplier and the bargaining power of each party. Raw materials and components are generally commodities supplied by small companies to large ones, their suppliers usually lack bargaining power. Commodity suppliers often seek to boost their bargaining power through cartelization.
Cartelization refers to a formation of a cartel. A cartel is an agreement among competing businesses within an industry to coordinate their actions and control the market dynamics in a way that restricts competition. Cartels typically aim to manipulate prices, limit production or supply, allocate market shares, and maximise profits collectively, rather then competing with each other. Cartelization is generally considered illegal as it undermines free market principles and harms consumer welfare by reducing choices and inflating prices. Many countries have established competition law to detect, prevent and penalise cartel behaviour. This is to promote fair competition, protect consumer's interests and encourage innovation.
However, suppliers of unique components may be able to exercise considerable bargaining power. Labour unions are important sources of supplier power. It employees are unionised, the business profitability is reduced.
Forecasting industry profitability
The first stage in forecasting industry profitability we need to identify the industry structure. This involves identifying who are the main players - customers, producers, suppliers and suppliers of alternative/substitute goods. We then examine some key structural characteristics of each of these groups that will determine competition and bargaining power.
Complexity is created here, when a business is within several stages of the value chain. To identify industry structure we need to conduct research and analysis of the industry. This includes studying industry reports, market analysis and other business publications. We need to gain insights into the industry players, market size, growth trends, regulatory requirements, technological advancements. Porter-s Five Forces Analysis can be a tool to analyse industry structure. We also need to determine the level of concentration within the industry, assess the number of dominant players, market share distribution and the presence of significant barriers to competition. The industry life cycle also need to be considered as it affects the competitive dynamics and the opportunities and challenges faced by firms within the industry. We also need to analyse the strategies and behaviours of the competitors, understanding their market position, price strategies, product differentiation, marketing approaches, distribution channels and customer targeting strategies. Through these, we can deeper understand the industry structure.
We then forecast industry profitability. We can use the industry analysis to understand why profitability has been low or high. Current profitability is a poor indicator of future profitability. Changes in industry structure tend to be a result of fundamental shift in customer buying behaviour, technology and firm strategies. We need to examine how the industry's current and future level of competition and profitability are the consequence of present structure and then identify the trends. Perhaps the industry is consolidating, new players may be seeking to enter, products become more differentiated or commoditised. We then can determine how these structural changes affect the five competition forces. It might change the industry structure, cause more or less competition. Some forces may result in competition to increase and others will result in competition to moderate.
Forecasting industry profitability requires a comprehensive analysis of various factors that influence the financial performance of the industry. We must understand the market size, growth rate and potential drivers for demand, democratic trends, technological advancements, regulatory changes and macroeconomic conditions that can impact the industry. We need to recognise the rivals, barriers to entry and the bargaining power of suppliers and buyers. We also need to address the cost structure within the industry, understand the key cost drivers, such as raw materials, labour, energy and distribution. We need to consider factors that can impact costs, including economies of scale, technological effectiveness and pricing power of suppliers.
The pricing trends within the industry should be analysed, price elasticity of demand, competitive pricing pressures. This will be influenced by product differentiation and value proposition relative to customer preferences. There are also industry-specific factors that can influence the profitability. For example, regulatory changes or environmental sustainability requirements may have a significant impact on the profitability. We should also review historical financial data and performance metrics of the industry players. This can be done through KPIs, profit margins, return on investment and other trends. We may also conduct scenario analysis with different scenarios and their impact on industry profitability. We can develop best-case and worst-case scenario based on various assumptions.
Using Industry Analysis to Develop Strategy
Once we have understood how structure drives the competition and profitability, we can develop strategy that influence industry structure to moderate competition and the position the business to shelter it from ranges of the competitors.
Strategies to alter industry structure
Having done the industry structure analysis we can identify opportunities for changing industry structure. We may need to identify the factors also that depress the profitability and how flexible these are to change. Building entry barriers is a vital strategy for preserving the profitability in the long run. Industries are in continuous evolution any any company has the ability to influence the industry structure through architectural advantage.
Architectural advantage refers to competitive advantage that arises from the design, structure and configuration of the product, system or organisation. It involves creating an unique and difficult-to-replicate architecture that provides superior performance, functionality and efficacy compared to competitors. In can relate to unique design with a distinct design or structure of the product, system or organisation. It involves creating innovative and differentiated architectures that are not easily imitated by competitors. Architectural advantage often results in superior performance or functionality and products or systems that outperform competitors in terms of performance, functionality and user experience. Architectural advantage can also lead to improved efficacy and cost savings as well designed architecture may enable streamlined processes, reduced resource requirements, optimised utilisation of resources resulting in lower costs or higher productivity. Architectural advantage creates barriers to replication for competitors. It may require specialised knowledge, unique technologies, designs and complex interdependencies that are challenging to other to reproduce or adopt. When it is difficult for competitors to replicate or overcome, it can result in sustainable competitive advantage. This helps the company to maintain market leadership, command premium pricing, attract customers and differentiate itself in the marketplace. Companies like Apple have achieved architectural advantage through their unique user interface designs, seamless integration of hardware and software and distinctive product aesthetics. Similarly, Tesla has gain an architectural advantage with it's electric vehicle platform, battery technology and integrated software systems. Developing and leveraging architectural advantage require focus on innovation, continuous improvement and deep understanding of customer needs.
Companies are to look broadly at their industry and identify the 'bottlenecks' where the scarcity and potential for control offer superior opportunities for profit. We can create own own bottleneck, like Apple, for example. We can relieve bottlenecks in other parts of the value chain or redefine the responsibilities in the industry.
Identifying bottlenecks in an industry involves recognising areas with operational processes or supply chain where a constrain or limitation occurs, leading to reduced efficacy, capacity or overall performance. We can map the process of value chain and understand the end-to-end flow of activities within the industry. We need to recognise the key steps, activities and handoffs involved in delivering products and services. This will provide a visual representation of the entire process.
Collecting data on various aspects of the industry operations is vital. This can include production volumes, cycle times, lead times, resource utilisation rates, inventory levels, customer complaints and other relevant performance metrics. We need to analyse the flow of materials through the industry processes, look for delays, queues or excessive cycle times at specific stages. Bottlenecks often occur when one step or resource is unable to keep up with the demand of pace of other stages. Using value stream mapping can be a valuable exercise to visually represent the flow of value and information within the industry. This helps to identify areas of waste, inefficiencies or constraints that may be causing bottlenecks.
We may also want to involve different stakeholders in the analysis. They may have valuable insights and firsthand experiences of areas that create bottlenecks or hinder the productivity.
Supply chain disruptions, regulatory requirements, market fluctuations or dependencies on external suppliers may contribute to bottlenecks. Once potential bottlenecks have been identified, we are to conduct root cause analysis to understand the underlying factors contributing to the bottlenecks. This involves identifying the potential reasons behind the constraints and exploring potential solutions to address them.
Positioning the company
Understanding the competitive forces allow to position the firm where competitive forces are weakest. Effective positioning requires the firm to anticipate changes in the competitive forces likely to affect the industry.
Defining industries
Economists define industry as a group of firms that supply a market. Industry analysis looks at industry profitability being determined by competition in two markets: input market and output market. Industries as defined in broad sectors and markets relate to specific products. To identify industry it makes sense to start with the idea of market and which firms compete to supply particular product or service.
The central issue in identifying industries is to establish who is competing with whom. Drawing the boundaries of markets and industries are the matter of judgement and depends on the purpose and context of the analysis. The longer term the decisions are being considered, the broader the identification of the industry should be. For the purpose applying of the five competitive forces analysis, the industry analysis is seldom critical.
Identifying industry key success factors
An organisation need to see how to identify the factors within the industry environment that influence the firm's ability to outperform rivals. These are called the 'key success factors'. This can be straightforward, as to survive a firm must meet two criteria: supply what customer wants to buy and survive competition.
We need to ask ourselves the questions to what customers want to buy and what we need to do to survive competition.
We need to see the customer as the source of buying power and the source of profit. We inquire who are the customers, what are their needs and how do they choose between competing offerings.
We then examine the nature of the competition in the industry, how intense it it and what are their key dimensions.
Identifying key success factors involves identifying the critical factors that are most influential in determining the success and competitiveness of companies within that industry. We need to research the industry, including studying industry reports, market analysis and expert insights. We need to gain the understanding of the business structure, trends, growth drivers and competitive landscape. It might be useful to analyse successful companies within the industry and identify the factors to contribute to their success. We may need to look for commonalities and patterns among these companies, consider aspects such as market position, customer value proposition, competitive advantages, business models and financial performance. We could be able to analyse the competitor strategies, strengths and weaknesses of the competitors, evaluate their product offering, distribution channels, marketing tactics and innovation capabilities.
We must not forget to understand the customer needs and preferences within the industry. Identify factors that customers value the most, such as quality, price, convenience, reliability, customisation or brand reputation. Consider how successful companies meet or exceed those customer expectations.
Assess the role of technology within the industry. Identify technological advancements or innovations that are crucial for success. Determine how companies leverage technology to enhance their products, services, operational efficacy, customer experience or competitive positioning.
Understand the regulatory and legal environment that impact the industry. Identify compliance requirements, licensing, certifications or other legal factors that are critical for success.
Evaluate the supply chain and logistics aspects within the industry. Identify factors such as sourcing, production efficacy, distribution network, inventory management and relationships with suppliers. Determine how successful companies optimise their supply chain to gain a competitive advantage.
Examine the financial performance metrics of companies within the industry. Identify the factors that contribute to profitability, return on investment and long-term sustainability. Consider factors such as cost management. revenue growth, capital allocation and financial stability.
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