ANALYZING THE BUSINESS

ENVIRONMENT
Competition & Strategy, PGP 2019-21, Sec A&B
The Determinants of Company Performance

Company-
Industry National
specific
context context
factors

Company
performance
 Industry Profitability Varies…

Industry Median RoE

1999-2002 (%)
Pharmaceuticals 26.8

Computer Software 13.5

Metals 6.0

Airlines -34.8

Data for U.S. [Source: Hawawini, Subramanian and Verdin, 2003]

“When a management with a reputation for
brilliance tackles a business with a reputation for
poor fundamental economics, it is the reputation of
the business that remains intact.”
National/ Natural
Intnl Environ-
Economy ment

The Industry
Environment
Demogra-
Technology phic
Structure
Suppliers
Competitors
Customers

Govt & Social

Politics Structure

Source: Grant, 2008, p. 66

Porter’s Five-Forces Model
 “The intensity of competition in an industry is
neither a matter of coincidence nor bad luck; it is
rooted in the underlying economic structure of the
industry.”
 Industry: The group of firms producing products
that are close substitutes for each other.
 Competition extends beyond the established
players: extended rivalry
 Focus on industry structure rather than short-run
factors.
Industry Threat of
characteristics Entry by
affect firm New firms
performance

Bargaining Rivalry Bargaining

Power of between Power of
Suppliers Players Buyers

Competition
goes beyond Threat of
rivals Substitutes
Threat of Entry

Barriers to entry + Expected retaliation

 Economies of scale

 Product differentiation

 Capital requirements

 Switching costs

 Access to distribution channels

 Government policy

 Cost disadvantages independent of scale

Threat of Entry

Barriers to entry + Expected retaliation

Cost disadvantages independent of scale
 Proprietary product technology

 Favourable access to raw materials

 Favourable locations

 Government subsidies

 Learning or experience curve

Threat of Entry

Barriers to entry + Expected retaliation

Retaliation is likely when
 A history of vigorous retaliation

 Established firms with excess cash/ unused

borrowing capacity/ excess capacity/ leverage

with channels
 Established firms with strong commitment to industry
and illiquid assets
 Slow industry growth
Intensity of Rivalry

Intense rivalry arises from:

 Numerous or equally balanced competitors

 Slow industry growth

 High fixed or storage costs

 Lack of differentiation or switching costs

 Capacity augmented in large increments

 Diverse competitors

 High strategic stakes

 High exit barriers

Intensity of Rivalry

Sources of exit barriers:

 Specialised assets

 Fixed costs of exit

 Strategic interrelationships

 Emotional barriers

 Government and social restrictions

Intensity of Rivalry

Changes in nature of rivalry due to

 Industry evolution

 Entry of new players, particularly through

acquisitions
 Technological innovation

Combination of nature of entry and exit barriers have

major influence on industry profitability
 Best case: High barriers to entry but low barriers to
exit
Pressure from
Substitute Products
Pay attention to substitute products
 whose price-performance trends are rapidly
improving
 which are produced by firms earning high profits
Bargaining Power of Buyers
A buyer group is powerful when:
 It is concentrated or purchases large volumes
relative to seller sales
 The products it purchases from the industry

represent a significant fraction of the buyer’s costs

or purchases
 The products it purchases from the industry are
standard or undifferentiated
Bargaining Power of Buyers

A buyer group is powerful when:

 It faces few switching costs

 It earns low profits

 Buyers pose a credible threat of backward

integration
 The industry’s product is unimportant to the

quality of the buyer’s products or services

 The buyer has full information
Bargaining Power of Suppliers

A supplier group is powerful when:

 The supplier’s product is an important input to the

buyer’s business
 The supplier group’s products are differentiated

or it has built up switching costs

 The supplier group pose a credible threat of

forward integration
Bargaining Power of Suppliers

A supplier group is powerful when:

 It is dominated by a few companies and is more

concentrated than the industry it sells to.

 It is not obliged to contend with other substitute

products for sale to the industry.

 The industry is not an important customer of the

supplier group
TO SUMMARIZE…
The “Five Forces” Framework
 Industry Analysis: Putting it all together
INDUSTRY PROFITABILITY

Difficult Weak Weak Weak Poor

to Enter Rivalry Buyers Suppliers Substitutes

High Levels of Industry Profitability

Low Levels of Industry Profitability

Easy Strong Close

Powerful Powerful
To Enter Rivalry Substitutes
Buyers Suppliers

Entrants Rivalry Buyers Suppliers Substitutes

INDUSTRY ACTORS
Does Industry Environment Matter?

 10%–20% of the variation in businesses’

accounting profitability reflects the industries in
which they operate
Why Industry Matters?
Some evidence from seminal studies

Percentage of variance in firms’ return on assets

explained by:
Industry effects Firm-specific Unexplained
effects variance
Schmalensee 19.6% 0.6% 80.4%
(1985)
Rumelt (1991) 4.0% 44.2% 44.8%
McGahan & Porter 18.7% 31.7% 48.4%
1997)
Hawawini et al 8.1% 35.8% 52.0%
(2003)
 The five forces and the broader environment
Technological Factors
•Maturity & Volatility
•Complexity
Market Factors
•Patents
•Market Size
•Product R&D requirements
•Market Growth
•Process R&D Requirements
•Cyclicality/Seasonality

Social Factors Economic & Govt. Factors

•Ecological Impact •Inflation
•Work Ethic •Wage level
•Consumer protection •Foreign Exchange Fluctuations
•Demographic changes •Manpower Supply
•Degree of Unionization •Legislation/Protection
•Regulation
•Taxation
 Steps in Industry Analysis

1. Define the relevant industry:

✓ What products are in it? Which ones are part
of another distinct industry?
✓ What is the geographic scope of competition?

2. Identify participants & segment them into groups,

if appropriate:

3. Assess the underlying drivers of each force to

determine which are strong or weak and why.
 Steps in Industry Analysis
4. Determine overall industry structure, and test the analysis for
consistency:
✓ Why is level of profitability what it is?
✓ Which are the controlling forces for profitability?
✓ Is the industry analysis consistent with actual long-run
profitability?
✓ Are more-profitable players better positioned in relation to the
five forces?

5. Analyze recent & likely future changes in each force, both positive
& negative.

6. Identify aspects of industry structure that might be influenced by

competitors, by new entrants, or by your company.
Questions to Ask When Analyzing
Industry
 What are the Industry’s dominant economic factors?
 Is the industry attractive – what are the prospects for
long term profitability?
 What are the key factors for success?
 What is causing the industry’s competitive structure &
business environment. to change?
 What is the competition like & how strong are the
competitive forces?
Mistakes to avoid when analyzing
the Industry
 Defining the industry too broadly or too narrowly.
 Paying equal attention to all of the forces rather
than digging deeply into most important ones.
 Confusing effect (price sensitivity) with cause
(buyer economics).
 Using static analysis that ignores industry trends.
 Confusing cyclical or transient changes with true
structural changes.
Quantity

30
Defend
advantage Play the “endgame”
Reinforce
advantage

Determine
competitive
Place advantage
strategic
bets

Time

Product/technology/industry life cycle

 The Driving Forces of Industry Evolution
Grant 2009

BASIC CONDITIONS INDUSTRY STRUCTURE COMPETITION

Customers become
more knowledgeable Customers become
& experienced more price conscious
Quest for new
sources of
differentiation
Products become
more standardized

Diffusion of
Price competition
technology Production intensifies
Production shifts
becomes less R&D
to low-wage
& skill-intensive
countries

Excess capacity
increases
Demand growth Bargaining power
slows as market of distributors
saturation approaches Distribution channels increases
consolidate
32 End