1. Chapter 4 Frameworks for the Analysis of Industry Environments Copyright © 1999 by Harcourt Brace & Company All rights reserved. Requests for permission to make copies of any part of the work should be mailed to the following address: Permissions Department, Harcourt Brace & Company, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777. Bourgeois, Duhaime, & Stimpert

2. Copyright © 1999 by Harcourt Brace & Company All rights reserved Chapter Objectives t Develop an understanding of industries, the competitive environments in which firms offer products/services in an effort to compete for resources, customers, sales revenues, and profits. © See Exhibit 4.1 on following slides. t Introduction to SWOT Analysis and the Five Forces Model. © Two frameworks which are commonly used by managers to analyze industries.

3. Copyright © 1999 by Harcourt Brace & Company All rights reserved Chapter Objectives (cont.) t Provide specific illustrations of using the Five Forces Model for industry analysis. t Assess the strengths and limitations of SWOT Analysis and the Five Forces Model as tools for analyzing industry environments.

4. Copyright © 1999 by Harcourt Brace & Company All rights reserved Exhibit 4.1: Model of Strategic Management Industry environments +

5. Copyright © 1999 by Harcourt Brace & Company All rights reserved IntroductionIntroduction t All companies face competition. © For resources, customers, sales revenues, and profits. t All companies face uncertain industry environments. © Managers must position the organizations strategically in order to compete successfully. This is what we call business definition. Requires that managers understand the dynamics of their firms’ markets before formulating strategies.

6. Copyright © 1999 by Harcourt Brace & Company All rights reserved Introduction (cont.) t Rapidly growing markets (emerging industries) tend to be less competitive and often attract new entrants. © Usually provide sufficient room in competitive space for making some mistakes. t Mature, concentrated markets provide firms with very little breathing room. © Mistakes by one firm can significantly impact entire industry. One firm’s price reductions can set off industry- wide price war.

7. Copyright © 1999 by Harcourt Brace & Company All rights reserved How Much Does Industry Matter? t Firm performance depends a great deal on the attractiveness of the industries in which the firms compete. © See Exhibit 4.2 on next slide. © Regression analysis on almost any industry shows that the variation in the average performance of all firms in an industry will explain about 20% of the variation in the performance of any single firm in that industry.

8. Copyright © 1999 by Harcourt Brace & Company All rights reserved Exhibit 4.2: Average Return on Assets of Different Industries

9. Copyright © 1999 by Harcourt Brace & Company All rights reserved How Much Does Industry Matter? (cont.) © One cannot generalize that the “industry is all that matters.” Returns vary in any industry from year to year (see Exhibit 4.3 on next slide). Some industries are more cyclical than others. Evidence indicates that the difference between the performance of the highest- and lowest-performing firms in any industry will be 6 times greater than the difference between the performance of the highest- and lowest-performing industry (see Exhibits 4.4 [A] and [B]).

10. Copyright © 1999 by Harcourt Brace & Company All rights reserved Exhibit 4.3: Average Return on Assets in the Automobile Industry: 1993 - 1997

11. Copyright © 1999 by Harcourt Brace & Company All rights reserved Exhibit 4.4 [A]: High- and Low-Performing Firms in the Steel Industry

12. Copyright © 1999 by Harcourt Brace & Company All rights reserved Exhibit 4.4 [B]: High- and Low-Performing Firms in the Pharmaceuticals Industry

13. Copyright © 1999 by Harcourt Brace & Company All rights reserved SWOT Analysis t Acronym derived from Strengths, Weaknesses, Opportunities, and Threats. © Used for analyzing industry environments and firms’ internal strengths and weaknesses. t Performed in a 2-step process: © Managers thoroughly evaluate their firm’s internal strengths and weaknesses and its environmental (external) opportunities and threats. © Managers use the evaluation developed in the first step to place the firm in one of the quadrants of the SWOT matrix shown in Exhibit 4.5.

14. Copyright © 1999 by Harcourt Brace & Company All rights reserved Exhibit 4.5: SWOT Analysis Overcome Weakness Grow DiversifyRestructure Numerous Environmental Opportunities Major Environmental Threats Substantial Internal Strengths Critical Internal Weaknesses

15. Copyright © 1999 by Harcourt Brace & Company All rights reserved SWOT Analysis (cont.) t Advantages of SWOT Analysis: © Easy to use. © Can be helpful framework for getting managers to think constructively about their firms’ external environments and internal strengths and weaknesses. t Drawbacks of SWOT Analysis: © Subjective. © Biased by managers’ perceptions of their firms’ strengths and weaknesses.

16. Copyright © 1999 by Harcourt Brace & Company All rights reserved SWOT Analysis (cont.) For example, managers of strong firms will likely view environmental phenomena as opportunities, while his counterpart in a weak company will likely view them as threats. © The use of SWOT Analysis is likely to yield few clear-cut recommendations.

17. Copyright © 1999 by Harcourt Brace & Company All rights reserved The Five Forces Model t Devised by Michael Porter of Harvard. © Examines the 5 forces which influence the structure of industries Framework suggests that industry structure will impact the competitive behavior of firms in that industry. Also suggests that firms’ conduct will influence the average performance of firms in that industry. As intensity of forces increases, the industry environment becomes more hostile and overall industry profitability will decline.

18. Copyright © 1999 by Harcourt Brace & Company All rights reserved Exhibit 4.6: Five Forces Model Industry Competitors Intensity of Rivalry

19. Copyright © 1999 by Harcourt Brace & Company All rights reserved Threat of New Entry t Incumbent firms erect barriers to prevent entry by potential rivals. © Cost barriers Incumbent firms might enjoy economies of scale, benefits of learning effects, or privileged access to key raw materials or technologies. –High level of minimum efficient scale (MES) might prevent new entrants from being profitable.

20. Copyright © 1999 by Harcourt Brace & Company All rights reserved Threat of New Entry (cost.) © Marketing advantages enjoyed by incumbents. Incumbents might have brand loyalty or access to certain distribution channels. If customers of incumbent firms might incur “switching costs” by buying products from another firm, then they will be more hesitant to shift allegiance to new entrant.

21. Copyright © 1999 by Harcourt Brace & Company All rights reserved Threat of New Entry (cost.) © Government restrictions might minimize entry. Industry regulation causes potential entrants to gain government approval before they could begin offering products or service. © Fourth set of barriers referred to as “behavioral” entry barriers can be very effective in limiting entry. Incumbents might signal that they would lower prices considerably if another firm were to enter the industry.

22. Copyright © 1999 by Harcourt Brace & Company All rights reserved Threat of Substitutes t If substitute products or services are readily available, then firms in the industry are likely to enjoy lower average profitability. © Margarine is a substitute for butter. © Substitutability depends on value-price ratios of the two products. When VCRs were first introduced, their prices were much higher than they are today -- only a few consumers chose to buy (as opposed to going to a movie).

23. Copyright © 1999 by Harcourt Brace & Company All rights reserved Power of Suppliers t If suppliers to an industry have enough power, they may be able to extract higher prices for critical components, thereby reducing average industry profitability. © Two factors are generally the most critical in determining supplier power: If only a few suppliers of a particular component exist relative to the number of buyers, then those suppliers will tend to have more bargaining power. If the component is a critical component, then the suppliers generally will have greater power.

24. Copyright © 1999 by Harcourt Brace & Company All rights reserved Power of Buyers t Powerful buyers of an industry’s products/services extract price concessions, thus reducing industry profitability. © Critical factors: If only a few buyers exist relative to number of firms, then those buyers will have greater bargaining power. If the product/service is not particularly important to buyers or does not incorporate proprietary technologies, then buyers will have greater power.

25. Copyright © 1999 by Harcourt Brace & Company All rights reserved RivalryRivalry t Rivalry will either drive down prices or increase the costs of doing business (as firms seek to add more features without raising prices for those features). t Several factors tend to increase rivalry: © Generally, the more firms in an industry, the greater will be the rivalry. The trucking industry. © Mergers and acquisitions are often pursued in an effort to reduce rivalry.

26. Copyright © 1999 by Harcourt Brace & Company All rights reserved Rivalry (cont.) © Growth rate of an industry will affect rivalry. Slower growth or declines in overall industry sales tend to increase rivalry. –Cigarette industry. © Excess capacity tends to increase rivalry and usually results in lower prices, lower profit margins, and a less attractive industry.

27. Copyright © 1999 by Harcourt Brace & Company All rights reserved Five Forces Model - Summary t Nearly all of the forces are present in most industries, but it is the intensity of the forces that will determine their impact on any industry. © As intensity of the forces increases, the industry environment becomes more hostile and overall industry profitability will decline.

28. Copyright © 1999 by Harcourt Brace & Company All rights reserved Application of the Five Forces Model t Use Exhibit 4.12 as a Guide to Using the Five Forces Model for Industry Analysis. t Two industries will be examined: © Steel © Pharmaceutical

29. Copyright © 1999 by Harcourt Brace & Company All rights reserved Steel: A Five Force Conspiracy t Consistent low industry performance average. © All but one of the five forces are intense. Remember that as the intensity of any of the forces becomes higher, the industry becomes less attractive and industry performance tends to decline. t Threat of Entry © Threat is very real. Initial investment required is very large, but several Minimills have entered industry in last 25 years.

30. Copyright © 1999 by Harcourt Brace & Company All rights reserved Steel: A Five Force Conspiracy (cont.) t Threat of Substitutes © Significant factor in this industry. Aluminum Plastics Composite materials t Power of Steel Buyers © Also significant. Small number of companies account for very large proportion of steel purchases. –Normal threat is to take their business elsewhere.

31. Copyright © 1999 by Harcourt Brace & Company All rights reserved Steel: A Five Force Conspiracy (cont.) t Rivalry © Very intense. Key reason is the significant overcapacity which still exists today despite the closing of many mills over the last 20 years. –Mills try to keep running at full capacity in order to spread their fixed costs over a large volume. –Price of steel today is about the same as 20 years ago.

32. Copyright © 1999 by Harcourt Brace & Company All rights reserved Pharmaceuticals: Best of all Possible Industry Worlds? (cont.) t Marked contrast to steel industry. © Suppliers exercise little power because most of raw materials are commodities that can be obtained from a large number of suppliers. t Significant barriers to entry reduce the threat of new entrants. © R&D costs and personnel. © Operating finances for many years while new drugs are developed and approved by FDA. © Must build large professional sales force.

33. Copyright © 1999 by Harcourt Brace & Company All rights reserved Pharmaceuticals: Best of all Possible Industry Worlds? (cont.) t Few true substitutes exist. © Very small market (in relative terms) of natural medicines. © Healthy living styles have not been adopted by majority of U.S. population. t Buyers exercise very little control. © Sick patients typically do not argue with drug company over price of product. Normally, insurance company pays the bill.

34. Copyright © 1999 by Harcourt Brace & Company All rights reserved Pharmaceuticals: Best of all Possible Industry Worlds? (cont.) t Rivalry. © Industry enjoys an almost “friendly” competition. Patent protection for 17 years. t Summary © Low intensity of all five forces helps to explain the high performance of firms in this industry. New HMO realities may change that situation. Many patents due to expire soon.

35. Copyright © 1999 by Harcourt Brace & Company All rights reserved Limitations of the Five Forces Model t Inability to suggest strategies for managers. © Porter states that managers have two options if they find their firms in unattractive industries: Diversify their firms away from or exit completely the industry. –Firms often lack sufficient resources to do this. –Diversification can be risky for firms with little diversification experience.

36. Copyright © 1999 by Harcourt Brace & Company All rights reserved Limitations of the Five Forces Model (cont.) Attempt to minimize the impact of any of the forces that are acting to make the industry unattractive. –Make their industries more attractive by reducing the power of the five forces; or –Shield or protect their companies from the power of the forces. Certain action may lead to allegations of collusion or other unfair practices (Microsoft vs. Justice Department).

37. Copyright © 1999 by Harcourt Brace & Company All rights reserved Limitations of the Five Forces Model (cont.) t Another key limitation is suggested by changes occurring in pharmaceutical industry: © Model provides “snapshot” of industry at that time, but fails to show how industry is changing. Most managers assume that conditions will remain relatively stable.

38. Copyright © 1999 by Harcourt Brace & Company All rights reserved Key Points Introduced in Chapter 4 t Industry environments vary considerably. © Some industries are relatively young, emerging industries, while others are more mature. © Some industries are characterized by fierce competition, while others are characterized by very little rivalry. © Some industries are, on average, more profitable than others in any one year.

39. Copyright © 1999 by Harcourt Brace & Company All rights reserved Key Points Introduced in Chapter 4 (cont.) t SWOT analysis can be used to analyze industry environments and organizational capabilities. © It specifically examines organizational Strengths and Weaknesses and environmental Opportunities and Threats. The major limitation of SWOT analysis is that it lacks objective dimensions -- any conclusions tend to reflect managers’ subjective evaluations of their industry environments.

40. Copyright © 1999 by Harcourt Brace & Company All rights reserved Key Points Introduced in Chapter 4 (cont.) t The Five Forces Model analyzes five aspects of industry structure in order to assess the relative attractiveness of different industries. © Use of the Five Forces Model I straightforward: As the intensity of forces increases, the industry environment becomes more hostile and overall industry profitability will decline.

41. Copyright © 1999 by Harcourt Brace & Company All rights reserved Key Points Introduced in Chapter 4 (cont.) t Both SWOT analysis and the Five Forces Model are static frameworks. © Users must recognize that most industry environments can be quite dynamic. © Any conclusions based on these models may not be appropriate in the future (due to changes in a firm’s industry environment).