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INDUSTRY
PROFITABILITY




BARGAINING POWER IN INPUT AND OUTPUT MARKETS

Bargaining Power Bargaining Power
of Buyers of Suppliers
Switching costs Switching costs
Differentiation Differentiation
Importance of product Importance of product
for cost and quality for cost and quality
Number of buyers Number of suppliers
Volume per buyer Volume per supplier




¬rms in the industry and their customers and suppliers. We will discuss each of these
industry pro¬t drivers in more detail below.


DEGREE OF ACTUAL AND POTENTIAL COMPETITION
At the most basic level, the pro¬ts in an industry are a function of the maximum price
that customers are willing to pay for the industry™s product or service. One of the key
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determinants of the price is the degree to which there is competition among suppliers of
the same or similar products. At one extreme, if there is a state of perfect competition in
the industry, micro-economic theory predicts that prices will be equal to marginal cost,
and there will be few opportunities to earn supernormal pro¬ts. At the other extreme, if
the industry is dominated by a single ¬rm, there will be potential to earn monopoly prof-
its. In reality, the degree of competition in most industries is somewhere in between per-
fect competition and monopoly.
There are three potential sources of competition in an industry: (1) rivalry between
existing ¬rms, (2) threat of entry of new ¬rms, and (3) threat of substitute products or
services. We will discuss each of these competitive forces in the following paragraphs.


Competitive Force 1: Rivalry Among Existing Firms
In most industries, the average level of pro¬tability is primarily in¬‚uenced by the nature
of rivalry among existing ¬rms in the industry. In some industries, ¬rms compete ag-
gressively, pushing prices close to (and sometimes below) the marginal cost. In other in-
dustries, ¬rms do not compete aggressively on price. Instead, they ¬nd ways to
coordinate their pricing, or compete on nonprice dimensions, such as innovation or
brand image. Several factors determine the intensity of competition between existing
players in an industry:

INDUSTRY GROWTH RATE. If an industry is growing very rapidly, incumbent ¬rms
need not grab market share from each other to grow. In contrast, in stagnant industries,
the only way existing ¬rms can grow is by taking share away from the other players. In
this situation, one can expect price wars among ¬rms in the industry.

CONCENTRATION AND BALANCE OF COMPETITORS. The number of ¬rms in
an industry and their relative sizes determine the degree of concentration in an industry.5
The degree of concentration in¬‚uences the extent to which ¬rms in an industry can co-
ordinate their pricing and other competitive moves. For example, if there is one domi-
nant ¬rm in an industry (such as IBM in the mainframe computer industry in the 1970s),
it can set and enforce the rules of competition. Similarly, if there are only two or three
equal-sized players (such as Coke and Pepsi in the U.S. soft-drink industry), they can
implicitly cooperate with each other to avoid destructive price competition. If an indus-
try is fragmented, price competition is likely to be severe.

DEGREE OF DIFFERENTIATION AND SWITCHING COSTS. The extent to which
¬rms in an industry can avoid head-on competition depends on the extent to which they
can differentiate their products and services. If the products in an industry are very simi-
lar, customers are ready to switch from one competitor to another purely on the basis of
price. Switching costs also determine customers™ propensity to move from one product
to another. When switching costs are low, there is a greater incentive for ¬rms in an in-
dustry to engage in price competition.
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SCALE/LEARNING ECONOMIES AND THE RATIO OF FIXED TO VARIABLE
COSTS. If there is a steep learning curve or there are other types of scale economies in
an industry, size becomes an important factor for ¬rms in the industry. In such situations,
there are incentives to engage in aggressive competition for market share. Similarly, if
the ratio of ¬xed to variable costs is high, ¬rms have an incentive to reduce prices to uti-
lize installed capacity. The airline industry, where price wars are quite common, is an
example of this type of situation.

EXCESS CAPACITY AND EXIT BARRIERS. If capacity in an industry is larger than
customer demand, there is a strong incentive for ¬rms to cut prices to ¬ll capacity. The
problem of excess capacity is likely to be exacerbated if there are signi¬cant barriers for
¬rms to exit the industry. Exit barriers are high when the assets are specialized, or if
there are regulations which make exit costly.


Competitive Force 2: Threat of New Entrants
The potential for earning abnormal pro¬ts will attract new entrants to an industry. The
very threat of new ¬rms entering an industry potentially constrains the pricing of exist-
ing ¬rms within it. Therefore, the ease with which new ¬rms can enter an industry is a
key determinant of its pro¬tability. Several factors determine the height of barriers to en-
try in an industry:

ECONOMIES OF SCALE. When there are large economies of scale, new entrants face
the choice of having either to invest in a large capacity which might not be utilized right
away, or to enter with less than the optimum capacity. Either way, new entrants will at
least initially suffer from a cost disadvantage in competing with existing ¬rms. Econo-
mies of scale might arise from large investments in research and development (the phar-
maceutical or jet engine industries), in brand advertising (soft-drink industry), or in
physical plant and equipment (telecommunications industry).

FIRST MOVER ADVANTAGE. Early entrants in an industry may deter future en-
trants if there are ¬rst mover advantages. For example, ¬rst movers might be able to set
industry standards, or enter into exclusive arrangements with suppliers of cheap raw ma-
terials. They may also acquire scarce government licenses to operate in regulated indus-
tries. Finally, if there are learning economies, early ¬rms will have an absolute cost
advantage over new entrants. First mover advantages are also likely to be large when
there are signi¬cant switching costs for customers once they start using existing prod-
ucts. For example, switching costs faced by the users of Microsoft™s DOS operating sys-
tem make it dif¬cult for software companies to market a new operating system.

ACCESS TO CHANNELS OF DISTRIBUTION AND RELATIONSHIPS. Limited ca-
pacity in the existing distribution channels and high costs of developing new channels
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can act as powerful barriers to entry. For example, a new entrant into the domestic auto
industry in the U.S. is likely to face formidable barriers because of the dif¬culty of de-
veloping a dealer network. Similarly, new consumer goods manufacturers ¬nd it dif¬cult
to obtain supermarket shelf space for their products. Existing relationships between
¬rms and customers in an industry also make it dif¬cult for new ¬rms to enter an indus-
try. Industry examples of this include auditing, investment banking, and advertising.

LEGAL BARRIERS. There are many industries in which legal barriers, such as patents
and copyrights in research-intensive industries, limit entry. Similarly, licensing regula-
tions limit entry into taxi services, medical services, broadcasting, and telecommunica-
tions industries.


Competitive Force 3: Threat of Substitute Products
The third dimension of competition in an industry is the threat of substitute products or
services. Relevant substitutes are not necessarily those that have the same form as the
existing products, but those that perform the same function. For example, airlines and
car rental services might be substitutes for each other when it comes to travel over short
distances. Similarly, plastic bottles and metal cans substitute for each other as packaging
in the beverage industry. In some cases, threat of substitution comes not from customers™
switching to another product but from utilizing technologies that allow them to do with-
out, or use less of, the existing products. For example, energy-conserving technologies
allow customers to reduce their consumption of electricity and fossil fuels.
The threat of substitutes depends on the relative price and performance of the com-
peting products or services, and on customers™ willingness to substitute. Customers™
perception of whether two products are substitutes depends to some extent on whether
they perform the same function for a similar price. If two products perform an identical
function, then it would be dif¬cult for them to differ from each other in price. However,
customers™ willingness to switch is often the critical factor in making this competitive
dynamic work. For example, even when tap water and bottled water serve the same
function, many customers may be unwilling to substitute the former for the latter, en-
abling bottlers to charge a price premium. Similarly, designer label clothing commands
a price premium even if it is not superior in terms of basic functionality, because cus-
tomers place a value on the image offered by designer labels.


RELATIVE BARGAINING POWER
IN INPUT AND OUTPUT MARKETS
While the degree of competition in an industry determines whether or not there is poten-
tial to earn abnormal pro¬ts, the actual pro¬ts are in¬‚uenced by the industry™s bargain-
ing power with its suppliers and customers. On the input side, ¬rms enter into
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transactions with suppliers of labor, raw materials and components, and ¬nances. On the
output side, ¬rms either sell directly to the ¬nal customers, or enter into contracts with
intermediaries in the distribution chain. In all these transactions, the relative economic
power of the two sides is important to the overall pro¬tability of the industry ¬rms.


Competitive Force 4: Bargaining Power of Buyers
Two factors determine the power of buyers: price sensitivity and relative bargaining
power. Price sensitivity determines the extent to which buyers care to bargain on price;
relative bargaining power determines the extent to which they will succeed in forcing the
price down.6

PRICE SENSITIVITY. Buyers are more price sensitive when the product is undiffer-
entiated and there are few switching costs. The sensitivity of buyers to price also de-
pends on the importance of the product to their own cost structure. When the product
represents a large fraction of the buyers™ cost (for example, the packaging material for
soft-drink producers), the buyer is likely to expend the resources necessary to shop for
a lower cost alternative. In contrast, if the product is a small fraction of the buyers™ cost
(for example, windshield wipers for automobile manufacturers), it may not pay to
expend resources to search for lower-cost alternatives. Further, the importance of the
product to the buyers™ product quality also determines whether or not price becomes the
most important determinant of the buying decision.

RELATIVE BARGAINING POWER. Even if buyers are price sensitive, they may not
be able to achieve low prices unless they have a strong bargaining position. Relative bar-
gaining power in a transaction depends, ultimately, on the cost to each party of not doing
business with the other party. The buyers™ bargaining power is determined by the number
of buyers relative to the number of suppliers, volume of purchases by a single buyer,
number of alternative products available to the buyer, buyers™ costs of switching from
one product to another, and the threat of backward integration by the buyers. For exam-
ple, in the automobile industry, car manufacturers have considerable power over compo-
nent manufacturers because auto companies are large buyers, with several alternative
suppliers to choose from, and switching costs are relatively low. In contrast, in the per-
sonal computer industry, computer makers have low bargaining power relative to the
operating system software producers because of high switching costs.


Competitive Force 5: Bargaining Power of Suppliers
The analysis of the relative power of suppliers is a mirror image of the analysis of the
buyer™s power in an industry. Suppliers are powerful when there are only a few compa-
nies and there are few substitutes available to their customers. For example, in the soft-
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drink industry, Coke and Pepsi are very powerful relative to the bottlers. In contrast,
metal can suppliers to the soft drink industry are not very powerful because of intense
competition among can producers and the threat of substitution of cans by plastic bot-
tles. Suppliers also have a lot of power over buyers when the suppliers™ product or ser-
vice is critical to buyers™ business. For example, airline pilots have a strong bargaining
power in the airline industry. Suppliers also tend to be powerful when they pose a cred-
ible threat of forward integration. For example, IBM is powerful relative to mainframe
computer leasing companies because of IBM™s unique position as a mainframe supplier,
and its own presence in the computer leasing business.


APPLYING INDUSTRY ANALYSIS:
THE PERSONAL COMPUTER INDUSTRY
Let us consider the above concepts of industry analysis in the context of the personal
computer (PC) industry.7 The industry began in 1981 when IBM announced its PC with
Intel™s microprocessor and Microsoft™s DOS operating system. In 1997 the U.S. had an
installed base of 100 million personal computers. The shipments in 1997 alone totaled
30 million units, up 21 percent from 1996. Despite this spectacular growth, however, the
industry in 1998 was characterized by low pro¬tability. Even the largest companies in

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