Note on Industry Analysis'

A strategy is your pian for controlling your organization's economic destiny, and it should
highlight your competitive advantage. In the early days of Federal Express, its major competi-
tion was the Post Office and its key competitive advantage was that it delivered overnight. But
then Federal Express got so much attention that it created its own competition. Over time, as
competitors like UPS and Airborne Express started offering overnight delivery, "overnight" was
no longer a competitive advantage. FedEx's competitive advantage had to shift: now it's not just
overnight delivery, it's reliable overnight delivery; "when it absolutely, positively must be there
overnight." So your competitive advantage must respond to the dynamics of your industry envi-
ronment, and changing dynamics will often require you to reexamine your strategy.
That means that to craft a good strategy, you need some way of understanding the dynamics
of your industry. This involves identif'ing the competitors you face-both those that currently
exist and those that might arise-but it also requires you to understand some broader economic
forces in your industry. One of the key strategic concerns for makers of headache remedies is
not a competitor, it's Wal-Mart, a firm in a completely different industry. Wal-Mart distributes
21% of all the headache medication in the United States and it uses its substantial buyer power to
squeeze the profit margins of headache remedy providers. Industry analysis is a framework for
helping you understand the environment in which you operate and consider all the problems that
your strategy must address. Some firms manage to be successful in even unprofitable industries-
- Southwest Airlines is highly profitable even though the airlines industry is unprofitable for the
typical firm. But strategy becomes more important in difficult industries, and you must make
sure your strategy addresses the dangers inherent in your industry.
The key question of industry analysis is this: What makes some industries profitable (or
comfortable) for the typical firm? The answer turns out to depend on a small number of key fac-
tors that this note outlines below.
First, a note about terminology for organizations in the social sector. This framework uses
two terms that may feel uncomfortable initially. The first is the term profit. Business organiza-
tions are interested in profit whereas social sector organizations are interested in doing good.
But to do good, an organization must be able to raise enough resources that it can control its des-
tiny and do as much good as it wants. The same factors that make an industry profitable for a
business organization make it easier for a social sector organization to acquire the resources to
control its destiny. We'll retain the term "profit" in homage to the fact that the industry analysis
framework arose from research in the for-profit sector; if you want to read more about industry
analysis, you will find many articles that use that term. But we have taught the framework to
hundreds of organizations in the arts, health, and social services and no one has ever complained
that it wasn't relevant to their industry. (And, just to show that cross-sector learning goes both
ways, the mission framework we'll be using involves concepts and language that were developed
in the social sector but have been applied to create better organizations in the for-profit sector).

'This note was prepared by Chip Heath. It is based on two excellent discussions of industry analysis: Michael Por-
ter's Five Forces analysis in his book on Competitive Strategy and the discussion in Saloner, Shepard, and Podolny's
Strategic Management.
 The other tenn that creates more serious concern, is the label "competitor" for other organi-
zations in your industry. A drug counseling center says, 'I don't want to compete with other
counseling centers, I want to cooperate so that more addicts can be treated." That attitude is ap-
propriate, but we use the label competitor to remind you that some degree of competition is
forced on you by your industry, even if your attitude is cooperative. Grant makers have to de-
cide which of many counseling centers to support-that's competition. Experienced counselors
have to decide which of many counseling centers to work for-that's competition. It's always
possible to choose a strategy of cooperating with your competitors on some issues. IBM and
Apple competed in the PC industry but for many years they worked together on the PowerPC
project because they both wanted to reduce the dominance of Intel as a supplier of microproces-
sors. But even when you choose to cooperate in your attitude, you have to realize that when re-
sources are in scarce supply, you can't avoid some degree of competition.

Competitors: An effective place to start analyzing industries is by naming the competitors in the
industry. The first key question is whether competitors are many or few. Industries are less
profitable when competitors are many, the classic wheat market from introductory economics is
"perfectly competitive" because there are tens of thousands of wheat farmers. The competitors
in your industry are generally people you think of by name on a day-to-day basis. Airlines think
about competitors such as Delta, American, Continental, and Southwest. (In contrast, driving" or
"taking the train" are not competitors because they aren't thought of by name. They're substi-
tutes for airline travel, an important factor that will be discussed below).
The profitability of an industry also depends on how the competitors behave. If competitors
behave by specializing in different niches, going to their own corners of the industry and not
bothering others, then competition is reduced and profitability increases. Both the airlines and
the pharmaceuticals industry have only a few firms with large market shares, so both industries
are potentially profitable based on having few competitors. But airlines is a more competitive
industry because every airline tends to compete for every customer on every route (no differen-
tiation) whereas pharmaceutical firms specialize in different niches that bring them into contact
with different customers (e.g, some firms specialize in cardiovascular drugs and others in neuro-
logical drugs).

Potential entrants: The profitability of an industry also depends on how easy it is to keep out
additional competitors who would like to enter a market. The theater business will never be
wildly profitable because if it were, thousands of amateur theater companies would rent an un-
used stage in some high school gym and start putting on plays. Competition is more relaxed
when there are barriers that keep potential entrants out. The most common sources of entry bar-
riers are:
• Barriers of reputation (e.g., brand name). Firms establish reputations for quality through
years of experience with their customers. Even if a new competitor entered with a very
large advertising budget, customers wouldn't be willing to switch their loyalties over-
night. No one wants to buy the first ticket on a new airline, or the first automobile from a
new producer. Trust takes time to develop.
 • Barriers from the technology that firms use to produce or distribute their products.
Sometimes there are economies of scale in producing products that make it much cheaper
to produce a product in large quantities. There are only a few automotive firms because
it requires large factories to produce cars and an extensive dealer network to distribute
them. If the efficient scale of production is large relative to the size of the market, a new
competitor will never be able to enter and compete against larger competitors by offering
a lower price.
• Legal barriers. Governments establish legal barriers to regulate who can enter various
markets. Patents and copyrights protect investments in research for a particular period of
time. Regulatory agencies may determine what kinds of food products or drugs can be
distributed, or what airlines can fly.

Supplier Power: Organizations take in supplies from suppliers and deliver their products or
services to buyers. Both suppliers and buyers can extract profits from industries they don't even
belong to. Most of the profits in the PC industry are not earned by Dell, Sony, Gateway, or other
PC manufacturers, they're earned by two suppliers to the PC industry-Intel and Microsoft. So
in thinking about the profitability of an industry, we often have to think about the power of buy-
ers and suppliers.
The major question about supplier power is: Are there many suppliers or few? If there are
many suppliers, the market for supplies will be highly competitive and any one supplier cannot
be very powerful. Steel composes a big fraction of the cost of a high-rise building, but steel-
makers are not very powerful suppliers in the building industry because there are so many of
them spread around the world. If U.S. Steel tries to raise its prices on structural steel, a real es-
tate developer can easily buy its steel from another steel manufacturer in the U.S. (or Europe or
China). In contrast, an airline looking to buy a new plane only has two suppliers to check (Boe-
ing and Airbus), and a PC manufacturer looking for a new chip has effectively one supplier (In-
tel). That's supplier power.
One useful heuristic to assess supplier power is the "Hollywood test." Suppose a supplier
said, "If you blow this negotiation, you'll never work in this industry again." Would the person
on the other side of the negotiation quake in fear or laugh in amusement? If the chief negotiator
for the pilot's union said this to the CEO of an airline, the CEO would be scared (unions have
high supplier power). But the chief negotiator for firm that makes airline meals would produce
laughter (meal providers have low supplier power).

Buyer power: As with supplier power, the major question about buyer power is: Are there
many buyers or few? In many areas of health and social services, the federal government may
supply 30 or 40 percent of all the funding in a whole industry. That's buyer power. Wal Mart
buys 33% of the dog food in the United States. That's buyer power.
One analytical trap to avoid: Sometimes a buyer may seem powerful when they actually
aren't. Auto firms sell 10 million cars per year; so even a large buyer has little power because
that buyer is only one of many, many buyers. If GM doesn't give someone a good deal, that per-
son will happily walk down the street to Ford or Toyota. The automotive industry has become
more difficult over the years not because the "consumer has become more powerful," but be-
cause competitors have taken actions that make competition more intense. Automotive firms
have systematically taken actions that place them in competition for every consumer on every
purchase; Chrysler introduces the minivan, and within 5 years everyone else has a minivan,
Auto firms used to have a captive domestic market: General Motors only had to worry about the
actions of Ford and Chrysler. Now buyers can buy cars from the United States, Germany, Japan,
and Korea. Often we are tempted to say that buyers are powerful when really we should be say-
ing that competitors are competitive.

Potential Industry Earnings (PIE). Everyone listed above-competitors, buyers, and suppli-
ers-is trying to reach into an industry and grab some of the Potential Industry Earnings, their
slice of the PIE.
The overall size of the PIE depends on general trends in population, demographics, income,
and society. The market for pharmaceuticals is increasing because of the aging population in the
Western World and the change in social acceptance of "lifestyle" drugs such as Prozac or Viagra.
The market for airline tickets shrunk in the months after the 9/11 terrorist attacks.
But in addition to these general trends there are two other factors to consider. Perhaps the
major determinant of PIE is:
Substitutes: The size of any industry is limited by the substitutes available for that indus-
try. Metal can producers will make less money when technology makes plastic containers
cheaper. Airline tickets will be sold less often when videoconferencing software im-
proves. The PIE for an industry shrinks when new substitutes are created or when exist-
ing substitutes become cheaper.
In addition, some industries have important:
Complements: Sales of PC hardware depend heavily on the quality of available software,
so software and hardware are complements. Indeed, PC sales have slowed over the last
few years because everyone's computer is already powerful enough to run the software
they have. PC makers keep praying for new complements-Video conferencing! Video
on demand!-that will drive sales for more sophisticated hardware. The PIE of an indus-
try grows when complements are created or when they become cheaper.