Strategic Management/ Business Policy

Slides 2 Industry Analysis

The Sources Of Competitive Advantage

Some Industries Are More Profitable Than Others.
ROE & ROA - Selected Industries, 1989 30%

25%

20% ROE ROA

15%

10%

5%

0%

Pharmaceuticals

Tires / Rubber

Home Appliances

Profitability of US Industries (selected industries only)

Median return on equity (%), 1999-2005 Household & Personal Products Pharmaceuticals Tobacco Food Consumer Products Securities Diversified financials Beverages Mining & crude oil Petroleum Refining Medical Products & Equipment Commercial Banks Scientific & Photographic Equipt. Apparel Computer Software Publishing, Printing Health Care Electronics, Electrical Equipment Specialty Retailers Computers, Office Equipment 22.7 22.3 21.6 19.6 18.9 18.3 18.8 17.8 17.3 17.2 15.5 15.0 14.4 13.9 13.5 13.1 13.0 13.0 11.7 Gas & Electric Utilities 10.4 Food and Drug Stores 10.0 Motor Vehicles & Parts 9.8 Hotels, Casinos, Resorts 9.7 Railroads 9.0 Insurance: Life and Health 8.6 Packaging & Containers 8.6 Insurance: Property & Casualty 8.3 Building Materials, Glass 8.3 Metals 8.0 Food Production 7.2 Forest and Paper Products 6.6 Semiconductors & Electronic Components 5.9 Telecommunications 4.6 Communications Equipment 1.2 Entertainment 0.2 Airlines (22.0)
3

The Profitability of Global Industries: Return on Invested Capital, 1963-2003

Utilities Telecom s ervices Trans poration Energy Materials OVERALL AVERAGE Retailing Cons um er durables and apparel Food retailing Capital goods Autom obiles and com ponents Technology hardware and equipm ent Hotels , res taurants , leis ure Food, beverages , tobacco Healthcare equipm ernt and s ervices Sem iconductors Com m ercial s ervices Media Com puter s oftware and s ervices Hous ehold and pers onal products Pharm aceuticals
6.2 6.5 6.9 7.7 8.4 9 9 9.5 9.6 9.9 9.9 10.3 10.3 11 11.3 11.9 12.8 14.7 15 15.2 18.4

10

15

20

Average ROIC 1963-2003 (%)

The Sources Of Competitive Advantage

Within Industries, Some Competitors Perform Better Than Others.
ROE - Pharmaceutical Industry 1989
60%

50%

40%

30%

20%

10%

0% Amgen AMP Eli Lilly Merck Mylan Pfizer

Three Factors Determining Company Performance:

Industry Context
e.g., during the last two decades, companies in the airlines industry have been less profitable than those in the pharmaceutical industry

National Context
e.g., worlds most successful consumer electronics firms are in Japan

Company Capabilities and Strategies

e.g., Wal-mart and Southwest Airlines
6

Industry Attractiveness - Economics

"When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is usually the reputation of the business that remains intact."
Warren Buffet

Structure-Conduct-Performance
Market Structure:
Number of buyers and sellers (e.g., CR4) Barriers to entry Substitutes Cost Structures Regulation

The Spectrum of Industry Structures

Perfect Competition Concentration Entry and Exit Barriers Product Differentiation Many firms No barriers Oligopoly Duopoly Monopoly

A few firms

Two firms

One firm

Significant barriers

High barriers

Homogeneous Product Perfect Information flow

Potential for product differentiation

Information

Imperfect availability of information

Drawing Industry Boundaries : Identifying the Relevant Market

What industry is BMW in:
World Auto industry European Auto industry World luxury car industry?

Key criterion: SUBSTITUTABILITY

On the demand side : are buyers willing to substitute between types of cars and across countries On the supply side : are manufacturers able to switch production between types of cars and across countries

We may need to analyze industry at different levels of aggregation for different types of decision
10

Structure-Conduct-Performance
Industry concentration is measured by the four-firm sales concentration ration (CR4). Problem: CR4 = .6 (.15, .15, .15, .15) or CR4 =.6 (.57. .01, .01,.01) Which is more likely to exhibit monopoly power? Alternative Measure: Herfindahl-Hirschman Index (HHI index)
11

Structure-Conduct-Performance
HHI = sum of market shares squared. A monopolist (1 firm with 100% of market) the HHI = 10,000

44 firms (57, 1, 1, 1 ) = 3292 (3249 + 43)

7 firms (15, 15, 15, 15, 15, 15, 10) = 1450 Correlation between CR4 and HHI in 1982 was 0.954

12

Structure-Conduct-Performance
Defining the relevant market:
Even more important than choosing the proper index of concentration is ensuring that the market for which concentration is being measured is properly defined. In the United States, the basic system was called the Standard Industrial Classification (SIC). In 1997 the US

Census Bureau replaced the Standard Industrial Classification system with the North American Industry Classification System. NAICS codes provide common industry definitions for Canada, Mexico and the US.

13

Structure-Conduct-Performance
In 1982, the manufacturing sector was divided into 450 such four-digit industries.
SIC Code CR4 # of firms HHI

3632 3511 2082 3011 2834 3237

household refrig. turbines beer tires pharmaceuticals ready-mix concrete

.94 .84 .77 .66 .26 .06

39 71 67 108 584 4161

2745 2602 2089 1591 1306 18

14

Forces Driving Industry Performance

Porters Five Forces Framework
Supplier Bargaining Power

Threat of Entrants

Rivalry Between Competitors

Threat of Substitutes

Buyer Bargaining Power

15

The Structural Determinants of Competition

SUPPLIER POWER
Significance of input to industry Relative concentration

THREAT OF ENTRANTS
Capital requirements Economies of scale Absolute cost advantage Product differentiation Access to distribution channels Legal/ regulatory barriers Retaliation

Concentration Diversity of competitors Product differentiation Excess capacity & exit barriers Cost conditions

INDUSTRY RIVALRY

THREAT OF SUBSTITUTE
Buyers propensity to substitute Relative prices & performance of substitutes

BUYER POWER
Buyers price sensitivity Relative bargaining power 16

Industry Analysis Supports The Identification of Threats & Opportunities Strengths, Weaknesses, Opportunities, & Threats Industry - SWOT Analysis Analysis
Strengths & Weaknesses

Drivers

Opportunities & Threats

Internal Factors Values Of Management

Strategy
Values Of Stakeholders

External Factors

Objectives

17

Efficient Markets
An efficient market (e.g., in financial markets) is one in which prices reflect information instantaneously and one in which extra-ordinary profit opportunities are thus rapidly dissipated by the action of profit-seeking individuals in the market. (e.g.: The value of the stock should reflect the earnings ability of the firm.)
To outperform the stock market you need (1) Luck or (2) Asymmetric information.
18

Threat of New Entrants

The free entry and free exit assumption that works reasonably well for describing financial markets seems to be a premise that strays so far from our world of experience that the assumption impedes our understanding of real-world product competition.
Thus, empirical evidence suggests that (risk-adjusted) ROE does NOT equalize in the long run.

19

Threat of New Entrants

(1) Economies of Scale
Product-specific economies of scale
lower setup costs as a percentage of total costs more specialized machinery and tooling (e.g., Honda)

Plant-specific economies of scale

Engineers 2/3 rule: Since the area of a sphere or cylinder varies as two-thirds power of volume, the cost of constructing process industry plants can be expected to rise as two thirds power of their output capacity. (This rule applies to petroleum refining, cement making, iron ore reduction and steel conversion). Also economies of massed reserves
20

Threat of New Entrants

Economies of Scale
Multi-product economies of scale (economies of scope)
Example: Cost (Iron, Steel) < Cost (Iron) + Cost (Steel) Key idea: Shareable input (In this case, thermal economies in the production of iron and steel) Modern examples: Aircraft, Automobiles, Consumer

electronics, Household Appliances; Personal Computers, Software, Power Tools

Multi-plant economies of scale

Economies of multi-plant production, investment, and physical distribution.
21

Threat of New Entrants

(2) Experience Curve Advantages
Marvin Lieberman, a management professor at UCLA, found that in the chemical industry, on average, each doubling of plant scale over time was accomplished by an 11% reduction in unit costs. Thus, there is an 89% learning curve.
(Note: The mere presence of an experience curve does not insure an entry barrier. Another critical prerequisite is that the experience be kept proprietary, and not available to competitors and potential entrants.)

22

Threat of New Entrants

Limits of Learning Curve Advantages:
Copying and reverse engineering of products; Hiring a competitors employees; Purchasing the know-how from consultants; Obtaining the know-how from customers; Experience advantages are often nullified by innovations.

23

Threat of New Entrants

(3) Intended Excess Capacity
Building extra capacity for the intended purpose of deterring entrants from entering the industry. (note: potential free-rider problems) Excess capacity deters entry by increasing the credibility of price cutting as an entry response by incumbents.
Innocent excess capacity: Demand is cyclical; Demand falls short of expectations; Demand is expected to grow.

24

Threat of New Entrants

(4) Reputation for retaliation
A history of incumbent firms reacting aggressively to entrants may play a role in current market interactions. A firms past decisions and standard operating procedures are important considerations for predicting a firms actions in the near-term future.

25

Threat of New Entrants

(5) Product Differentiation
Brand identification and customer loyalty to incumbent products may be a barrier to potential entrants (e.g. Coca-Cola). Product differentiation appears to be an important entry barrier in the market for over-the counter drugs and in the brewing industry.

(6) Capital Requirements

26

Threat of New Entrants

(7) High Switching Costs of Buyers
e.g., changing may require employee retraining (e.g., IV solutions, computer software).

(8) Access to Distribution Channels

The manufacturer of a new food product, for example, must persuade the retailer to give it space on the fiercely competitive supermarket shelf via promises of promotion, and intense selling efforts to retailers.
27

Threat of New Entrants

(9) Favorable Access to Raw Materials and to Markets
Alcoa --> bauxite Exclusive dealing arrangements Favorable geographic locations

28

Threat of New Entrants

(10) Proprietary Technology
Product know how Low cost product design Patents (and other government restrictions)

(11) Exit barriers (of incumbents) can be entry barriers (to potential entrants)

29

Threat of New Entrants

High exit costs:
high exogenous and endogenous sunk costs (not just high fixed costs!) high asset specificity highly illiquid assets low salvage value if exit occurs high switching costs low mobility of assets credible commitments irreversible investment
e.g., Alaskan pipeline built in 1977 at a cost of $10 billion
30

Threat of Substitutes

Substitute products increase the industrys overall elasticity of demand and limit the potential returns of the industry by placing a ceiling on the prices that firms in the industry can profitably charge. Companies in the coffee industry compete indirectly in the tea and soft-drink industries (all three industries serve consumer needs for drinks).
31

Bargaining Power of Buyers

Buyers compete within the industry by forcing down prices, bargaining for higher quality or more services, and playing competitors against each other. A buyer group is powerful when:
The buyer group is concentrated (potential collusion) The buyer group purchases large volumes relative to seller sales (e.g., HMO power buying drugs) The product is standard and undifferentiated Few switching costs on the part of the buyer High switching costs on the part of the seller Buyers pose a credible threat of backward integration

32

Bargaining Power of Suppliers

Suppliers can be broadly defined as the supplier of any input: Labor, Management, Technology, Physical Materials

The bargaining power of suppliers is high when:

It is dominated by a few companies and is more concentrated than the industry it sells to; It does not contend with substitute products; The suppliers product is an important input to the buyers business; Suppliers products are differentiated (high switching costs for the buyer).
33

Buyers - Suppliers Value Chain

Branded Cereals
Raw materials suppliers Cereal company grocer

.42 +.19
$0.61

.40 overhead
ManuDistribu-Marketfacturing tion ing .52 .14 .75

$2.82

.38 12% of $3.20

$3.20

Private Label Cereals

Raw materials suppliers Cereal company

.38 +.15 $0.53

Food wholesaler

grocer

.38 overhead
ManuDistribu-Marketfacturing tion ing .47 .00 .00

$1.45

.16 10% of $1.61

$1.61

.29 15% of $1.90

$1.90

34

Rivalry Between Competitors

Increases when: Industry Concentration Lower Industry Growth Slower Fixed Costs / Total Costs Greater Product Differentiation Lower Over-capacity Higher Exit Barriers Higher Price competition is highly unstable. Price cuts are quickly and easily matched by rivals, and once matched, they lower revenues for all firms (unless price elasticity of demand is high enough)

35

Rivalry Between Competitors

Advertising battles, on the other hand, may well expand or enhance the level of product differentiation in the industry for the benefit for all firms.
Advertising is not necessarily a zerosum game.
36

The Uses of Industry Analysis

Static Analysis How Do We Explain Current Rivalry and Profitability?

Dynamic Analysis Where Is The Industry Headed In The Future?

37

Industries Evolve Over Time As The Relationships Between The Five Forces Change

Dynamic 5-Forces Analysis

demand

time

38

39

A Sixth Force - The Presence of Complementors Complementors

Industry Participants whose businesses enhance the value of yours The Opposite of Substitutes The Emergence of Networks of Organizations

Examples
Computer Manufacturers & Software Makers Consumer Electronics & Entertainment Companies

The Central Issue

How to get complementors to make strategic investments which mutually benefit both companies
40

A Sixth Force -The Presence of Complementors The biggest benefit of considering complementors is that they add a cooperative dimension to Porters competitive forces model. Thinking [about] complements is a different way of thinking about business. Its about finding ways to make the pie bigger rather than fighting with competitors over a fixed pie. To benefit from this insight, think about how to expand the pie by developing new complements or making existing complements more affordable
Brandenburger and Nalebuff Co-opetition
41