Study Notes for External Analysis and Industry Examination

CHAPTER 2: External Analysis: Identification of Opportunities and Threats

Learning Objectives

  • Define Industry and Industry Environment
  • Review the Primary Technique Used to Analyze Competition in an Industry Environment: The Five Forces Model
  • Explore the Concept of Strategic Groups, Including Implications for Industry Analysis
  • Discuss How Industries Evolve Over Time:
    • Reference to the Industry Life Cycle Model
  • Discuss Limitations of Models for Industry Analysis
  • Summarize Ways in Which the Macroenvironment Can Shape the Nature of Competition in an Industry

Overview

  • Strategy Formation:
    • Begins with an analysis of the forces shaping competition within the industry
    • Goal: Understand the opportunities and threats confronting the firm and identify strategies to outperform rivals
  • Opportunities: Arise when conditions in the industry can be leveraged for greater profitability
  • Threats: Occur when the external environment endangers business integrity and profitability

Defining an Industry

  • Industry: A group of companies offering products/services that are closely substitutable for each other
  • External Analysis:
    • Begins by identifying the industry in which a company competes
    • Focus on basic customer needs over product orientation

Industry Boundaries

  • Industry boundaries must be clearly defined for meaningful analysis

Porter’s Competitive Forces Model

  • Focuses on six forces shaping competition within an industry:
    1. Risk of Entry by Potential Competitors
    2. Intensity of Rivalry Among Established Companies
    3. Bargaining Power of Buyers
    4. Bargaining Power of Suppliers
    5. Closeness of Substitutes to an Industry’s Product
    6. Power of Complement Providers (sixth force not recognized by Porter)
  • Implications:
    • Strong competitive forces limit established companies' ability to raise prices and earn profits; weak forces represent opportunities
Risk of Entry by Potential Competitors
  • Potential Competitors: Companies not currently competing but capable of doing so
  • Discouragement of Entry: Established firms attempt to deter entrants due to market share protection
  • Factors influencing the risk of entry:
    • Attractiveness of the industry (profitability, growth)
    • Height of barriers to entry
Barriers to Entry
  • Definition: Factors that make industry entry costly
  • Important Barriers Include:
    • Economies of Scale:
      • Cost reductions achieved through large-volume production
    • Brand Loyalty: Preferences for established brands ensuring customer retention
    • Absolute Cost Advantages: Entrants cannot match lower costs of established firms
    • Customer Switching Costs: Costs incurred by customers when changing providers
    • Government Regulation: Legal barriers that limit competition
  • Economies of Scale Factors:
    1. Cost reductions from standardized output production
    2. Discounts on bulk purchases
    3. Spreading fixed costs over a larger output
    4. Cost savings in distribution, marketing, advertising
  • Brand Loyalty Creation:
    • Continuous advertising, protecting patents, achieving product innovation, emphasizing quality, and exceptional service
  • Absolute Cost Advantages Sources:
    1. Superior operations due to experience or patents
    2. Control over limited resources
    3. Access to cheaper financing
  • Government Regulations Example:
    • Pre-1990s U.S. regulations limiting competition in telecommunication sectors

Rivalry Among Established Companies

  • Rivalry: Competitive battle among industry firms for market share
  • Competitive Factors:
    • Pricing, product design, advertising, direct selling, after-sales support
  • Intensity of Rivalry Impacts:
    • High rivalry can lead to low prices and reduced profit margins
  • Four Factors Influencing Intensity of Rivalry:
    1. Industry Competitive Structure
      • Fragmented Industry: Many small firms, none can set prices (e.g., agriculture)
      • Consolidated Industry: Few large firms that can determine prices (e.g., monopolies)
    2. Demand Conditions
      • Growing demand typically lowers rivalry as firms can sell more
    3. Cost Conditions
      • High fixed costs increase rivalry as firms seek to cover them
    4. Exit Barriers
      • High barriers lead companies to remain in unprofitable markets

Bargaining Power of Buyers

  • Definition: Buyers' power to negotiate lower prices or demand better standards
  • Impact of Powerful Buyers:
    • Can drive down industry profits by squeezing companies' pricing power
  • Circumstances Making Buyers Powerful:
    • Availability of choices among suppliers
    • Bulk purchasing informing bargaining leverage
    • Buyer reliance on supplier's product for significant costs
    • Low switching costs allow buyers to negotiate between suppliers
    • Economic feasibility to source multiple suppliers

Bargaining Power of Suppliers

  • Definition: Suppliers' ability to influence input prices and quality
  • Impact: Strong suppliers can push costs up, squeezing company margins
  • Circumstances Making Suppliers Powerful:
    • Uniqueness of product offered by suppliers
    • Suppliers' profitability not dependent on specific industry purchases
    • High switching costs for companies wanting to change suppliers

Substitute Products

  • Definition: Alternative products satisfying similar needs (e.g., coffee vs tea)
  • Competitive Threat: A close substitute limits pricing power and profitability

Complementors

  • Definition: Companies providing products that enhance the value of industry offerings
  • Importance: Rising complementors can increase demand and profitability; weak complementors can limit industry growth

Implications of Strategic Groups

  • Strategic Groups: Clusters of firms in an industry with similar business models or strategies
  • Differentiation Among Companies: Pivotal in defining strategic groups in terms of market positioning, distribution, product quality, technological leadership, and more

Industry Life Cycle Analysis

  • C.W. Hofer: Life cycle stages are crucial for business strategy formulation
  • Five Stages of Industry Evolution:
    1. Embryonic
    2. Growth
    3. Shakeout
    4. Mature
    5. Decline
  • Challenges for Managers:
    • Anticipate changes in competitive forces as the industry evolves

Limitations of Models for Industry Analysis

  1. Life Cycle Issues:
    • Generalizations may not apply to all industries
  2. Innovation and Change:
    • Innovation can disrupt industry evolution and competitive structures
  3. Company Differences:
    • Overemphasis on structure rather than specific company variations affecting profitability
  4. Macroenvironment Influences:
    • Changes in macroeconomic conditions can significantly impact industry forces

Macroeconomic Forces

  • Four Primary Macro Forces Affecting Industry:
    1. Economic Growth Rate
    2. Interest Rates
    3. Currency Exchange Rates
    4. Inflation/Deflation Rates
  • Global Forces, Technological Forces, Demographic Forces, and Social Forces Impact:
    • Interactions among these forces can shape market dynamics and competitive structures during analysis.