II. Introduction to Module I External fit: How the industry the firm is in affects its profitability

Module I: External Fit and Industry Forces

II. Introduction to Module I

  • This module focuses on the relationship between the industry's characteristics and how they impact a firm's profitability.

  • External Fit: Refers to how the firm’s strategies are aligned with the industry characteristics that affect profitability.

  • Positioning: The act of shaping the firm's strategy to respond effectively to the forces within the industry.

  • Objective: To deflect or mitigate the competitive forces that could negatively influence profitability for the firm.

II.i. Profitability Variances Among Industries

Overview

  • Certain industries show a consistent pattern of higher profitability compared to others.

Average Return on Invested Capital (ROIC) from Selected U.S. Industries (1992-2006)

  • High Profitability Industries:

    • Security Brokers and Dealers: 40.9%

    • Soft Drinks: 37.6%

    • Prepackaged Software: 37.6%

    • Pharmaceuticals: 31.7%

    • Perfumes, Cosmetics, Toiletries: 28.6%

    • Advertising Agencies: 27.3%

    • Distilled Spirits: 26.4%

    • Semiconductors: 21.3%

    • Medical Instruments: 21.0%

    • Men's and Boys' Clothing: 19.5%

    • Household Appliances: 19.5%

    • Tires: 19.2%

    • Child Day Care Services: 19.0%

    • Household Furniture: 17.6%

    • Drug Stores: 16.5%

    • Grocery Stores: 16.0%

    • Iron and Steel Foundries: 15.6%

    • Cookies and Crackers: 15.4%

    • Mobile Homes: 15.0%

    • Wine and Brandy: 13.9%

    • Average Industry ROIC in the U.S.: 14.9%

Other Notable Industries with Lower Profitability:

  • Bakery Products: 13.8%

  • Engines and Turbines: 13.7%

  • Book Publishing: 13.4%

  • Oil and Gas Machinery: 12.6%

  • Soft Drink Bottling: 11.7%

  • Knitting Mills: 10.5%

  • Catalog, Mail-Order Houses: 10.4%

  • Hotels: 5.9%

  • Airlines: 5.9%

Source: Porter (2008)

Industry Forces and Profitability

Definition of Industry

  • An industry is defined as a group of firms that offer products or services that satisfy the same basic customer needs.

Key Industry Forces Influencing Profitability

  • The average profitability of firms within an industry is primarily dictated by the strength of industry forces.

5 Primary Industry Forces:

  1. Strength of Competition: Comprises three elements:

    1. Existing rivals: Companies currently competing in the same market.

    2. Potential newcomers: New firms that could enter the market and compete.

    3. Substitute products: Alternate products that can meet the same customer needs

  2. Bargaining Power of Buyers: Refers to the influence that buyers have on the industry.

  3. Bargaining Power of Suppliers: Refers to the influence that suppliers have over the prices and quality of goods.

The Five Forces Framework

Explanation of Each Force

  1. Strength of Rivalry: Measures how aggressively existing companies compete against each other.

    • This includes comparing similarities in offerings, target markets, and competitive tactics.

  2. Threat of New Entry: Assesses how likely it is for new firms to enter the market and replicate existing business models.

  3. Threat of Substitution: Evaluates the likelihood of emerging alternatives that serve the same consumer needs but through different means.

  4. Bargaining Power of Buyers: The customers' ability to influence contracts and negotiate terms favorable to them.

  5. Bargaining Power of Suppliers: The suppliers' ability to influence pricing or terms of supply based on their importance to the production chain.

Industry Attractiveness

Characteristics of an Attractive Industry

  • Industries with considerable profit potential often exhibit:

    • Weak competitive forces overall.

    • A relatively high level of average profits sustained over time.

Characteristics of an Unattractive Industry Structure

  • An unattractive industry is typically marked by:

    • Products that are undifferentiated, resembling commodities.

    • All producers having similar cost structures and access to technologies.

    • A customer base that is price-sensitive and knowledgeable, often switching producers for better deals.

External Fit and Strategy

Importance of External Fit

  • A successful strategy must have external fit, which implies that:

    • The chosen strategy aligns effectively with the industry environment and its competitive forces.

    • This external fit reduces the impact of the five forces, resulting in competitive advantage and superior profitability.

Competitive Advantage

  • The competitive advantage is achieved through effective positioning relative to the five forces that can deflect them, leading to enhanced profitability.

  • A firm must make specific choices regarding cost or differentiation to develop an appropriate strategy that has external fit with industry forces.

Diagram of the Five Forces

  • The Five Forces That Shape Industry Competition

Threat of New Entrants        Bargaining Power of Suppliers
        |                             |    
        |                             |    
-------------------------------------------------   
        |                             |   
Rivalry Among Existing Competitors
        |                             |   
        |                             |   
Threat of Substitute Products or Services       Bargaining Power of Buyers

Source: Porter (2008)

Application of Five Forces Analysis

Uses of Five Forces Analysis

  • Demonstrates how industry forces generally drive rivalry profitability as well as that of suppliers.

  • Explains how changes in industry dynamics affect profitability.

  • A well-aligned strategy allows a firm to navigate changes in prevailing industry forces effectively.

  • Identifies what actions a specific firm must take to sustain or enhance its profitability by effectively deflecting industry forces.

Break-out Sessions

  • Reference break-outs #2 & #3 for additional resources and detailed discussion (see separate slide deck).