Profitability Differences Across

Selected Industries
Pharmaceuticals
Prepackaged software
Semiconductors
Women's clothing stores
Dental equipment
Eating places
Drug stores
Petroleum / natural gas
Race track operations
Trucking except local
Engineering services
Computer system design
Cable TV service
Motor vehicles
Scheduled airlines
Source: Jan W. Rivkin
based on Compustat

10

15

Operating Income / Assets, 1988-95 (%)

20

25

1. Rating the Five Forces of the Airline Industry (1980s-1990s)

(5 = strong, 1 = weak)

a. Threats of Entry--Weighting 5
Massive deregulation in the 1980s reduced legislative barriers
Capital intensity offset by ability to lease aircraft and hire ground crews on
contract
Limited availability of terminal slots offset by use of secondary airports

The airline deregulation act (1978)

gradually eliminated the Civil Aeronautics Board's authority to set fares;
liberalized standards for the establishment of new airlines;
allowed airlines to take over service on routes underutilized by competitors or on which
the competitor received a local service subsidy;
authorized international carriers to offer domestic service;
placed the evidentiary burden on the CAB for blocking a route as inconsistent with
"public convenience";
prohibited the CAB from introducing new regulation of charter trips;
terminated certain subsidies for carrying mail
terminated existing mutual aid agreements between air carriers;
directed the Federal Aviation Administration (FAA) to develop safety standards for
commuter airlines;

 required air carriers, in hiring employees, to give preference to terminated or

furloughed employees of another carrier for 10 years after enactment;
gradually transferred remaining regulatory authority to the U.S. Department of
Transportation (DOT), and dissolved the CAB itself.

b. Bargaining Power of Buyers--Weighting 5

! Hypercompetition has made air travel a commodity
! Price sensitivity of consumers has not been significantly offset by
loyalty programs
! Market share warfare is the industry norm
c. Bargaining Power of Suppliers---Weighting 5
! Few aircraft suppliers!
Militant pilot and machinist unions have eroded economic rent
associated with producer surplus
d Substitutes: Weighting 3
! No substitutes for long distances
! Substantial substitutes for local travel

d. Rivalry: Weighting 4
The problem of capacity utilization...
Majority of costs are fixed regardless of load
! Resulting variable cost pricing through heavy discounting to maximize
contribution margin from excess capacity
Market Growth:
! Total growth is relatively high but only in price-sensitive travel class
! Growth in travel class offset by larger planes and competitive entry,
resulting in overcapacity and lower margins! !
! Market growth of profitable business class is slowing
Low differentiation

!
Barriers to Exit:
! Lax bankruptcy legislation allows airlines to essentially tear up union
contracts and continue operations
! Government ownership of international airlines makes exit or capacity
reduction unlikely due to conflicting sociopolitical considerations

-> Competitive forces are strong, profitability of the airline industry is low

The Five Forces of the Pharmaceutical Drug Industry

a. Threat of Entry--Weighting 1
High capital requirements (average drug requires $200 million in R&D and
substantial unrecoverable marketing expenditures)
Hence, niche strategies are the only feasible basis of competition for new
entrants that, if successful, are frequently subject to aggressive takeover
overtures

b. Bargaining Power of Buyers Weighting 1

Doctors, not patients, usually make the purchase decision based on product
attributes and efficacy, not price
When consumers do make the purchase decision, they show a high brand
loyalty that works against private-label drugs
Patent protection promotes and protects innovation

c. Bargaining Power of Suppliers--Weighting 3

Many of the raw inputs to pharmaceuticals are commodities
Biotechnology and gene therapy are still in the developmental stage
Many of the promising new biotech firms have or will be acquired by
established drug firms

d. Substitutes Weighting 1
Few substitutes for pharmaceutical drug therapy, and it is often much
cheaper than surgical interventions

e. Rivalry 2
Market Growth:
Continual product innovation creates demand
Aging baby boomers will foster growth
Increased longevity of humans
Highly differentiable products
..but emergence of generic pharma competition
Barriers to Exit:
A high percentage of unrecoverable costs such as R&D and marketing/
! distribution increase barriers to exit

-> competitive pressures low, profitability high

Generic strategies

Defining generic defendable strategies that can yield superior return on

investment
three internally consistent strategies
overall cost leadership
differentiation
focus

overall cost leadership

functional policies aimed at achieving lowest cost in industry
scale
experience
cost control & minimization
-> market-share maximization...

low cost provides defenses against:

internal rivalry: can still earn returns when others dont
powerful buyers: buyers can exert power to drive down cost to the level of
the next most efficient competitor
powerful suppliers: more flexibility to cope with input price increases
entry threat: scale, cost advantage
substitutes: defends from price/quality drops in substitutes

Differentiation
create something perceived industrywide as unique
design and brand image
technology
features
customer service...
-> need for exclusivity may conflict with large market share
-> trade-off with cost dominance: differentiation costly to achieve

differentiation provides defenses against:

internal rivalry: insulation due to customers loyalty, low sensitivity to price
powerful buyers: they lack alternatives due to differentiation
powerful suppliers: protected from higher margins
entry threat: customer loyalty (costly to overcome by new entrants)
substitutes: diminishes cross elasticity of demand

Focus
strategies targeted not at the entire industry but at specific segments
by focussing, even with limited resources a firm can gain advantages over
forms competing more broadly

news JO-JO

requirements?

news JO-JO

Stuck in the middle?

Failing to develop in one of the three generic directions creates
undefendable positions...
stuck in the middle
runs in all trade-offs..
(ex: Continental Lite)

Coherent low cost strategy: Southwest Airlines

San Antonio (Texas) 1967
offering trasportation services:
safe
reliable
short distance low cost
- six-seven flights a day per route
- rapid ground turnaround
- point-to-point routes (hub vs spoke)
- no connecting flights (no delays/waiting time)
- frequent reliable departures

- small, secondary airports (almost no connections with other lines..

but spare 15-25% time for transportation and waiting in the air - non stop
passengers, ca 80% in 2002
- high capacity utilization
- limited ground service, simplified ticketing, automated check-in, seats are
not numbered
- lean ground crew
- low fares

Stuck in the middle: Continental Airlines

continental lite:
no 1st class & food
short routes
more frequent departures, less boarding time
but: maintains on other routes full-service
different types of airplanes
travel agents
ground personnel for luggage check-in and seat reservation

troubles:
delays
no way to deal without travel agents, but reduced margin for them
no frequent flyer programs for low cost?.. compromise: lower rewards for
f.f.
high ground cost
clients and travel agents dissatisfied, loss of customers, loss of margins

Risks of generic strategies

Overall cost leadership

technological change that nullifies past investments or learning;
low-cost learning by industry newcomers or followers,
through imitation or through their ability to invest in stateof-the-art facilities;
inability to see required product or marketing change because
of the attention placed on cost;
inflation in costs that narrow the firm's ability to maintain
enough of a price differential to offset competitors' brand
images or other approaches to differentiation.
ex: Ford in the 20s

Differentation
the cost differential between low-cost competitors and the
differentiated firm becomes too great for differentiation to
hold brand loyalty. Buyers thus sacrifice some of the features,
services, or image possessed by the differentiated firm
for large cost savings
buyers' need for the differentiating factor falls. This can occur as buyers
! become more sophisticated;
imitation narrows perceived differentiation, a common occurrence as
! industries mature.
ex: Kawasaki vs Harley Davidson, Triumph

Focus
the cost differential between broad-range competitors and the focused firm
! widens to eliminate the cost advantages of serving a narrow target or to
! offset the differentiation achieved by focus;
the differences in desired products or services between the
! strategic target and the market as a whole narrows;
competitors find submarkets within the strategic target and outfocus the
! focuser.

Readings:
Porter, M. E. "How Competitive Forces Shape Strategy." Harvard Business
Review, MarchApril 1979: 137145.

Porter, M. E. "The Five Competitive Forces That Shape Strategy." Harvard

Business Review January 2008: 25-40.