Industry Analysis & Competitive Advantage
In this lesson, you will:
• discover the importance of industry analysis and the concept of competitive advantage
• learn in detail about Porter’s Five Forces
• be introduced to useful competitive strategies
Industry analysis is a tool that facilitates a company’s understanding of its position relative to other companies that produce similar products or services. Understanding the forces at work in the overall industry is an important component of effective strategic planning.
Industry analysis enables small business owners to identify the threats and opportunities facing their businesses, and to focus their resources on developing unique capabilities that could lead to a competitive advantage.
What is Competitive Advantage?
A superiority gained by an organization when it can provide the same value as its competitors but at a lower price, or can charge higher prices by providing greater value through differentiation. Competitive advantage results from matching core competencies to the opportunities.
Porter’s Five Forces model is an analysis tool that uses five industry forces to determine the intensity of competition in an industry and its profitability level.
(1) Threat of new entrants – barriers to entry act as a deterrent against new competitors.
(2) Rivalry among existing firms – intense competition leads to reduced profit potential for companies in the same industry.
(3) Pressure from substitute products or services – availability of substitute products will limit your ability to raise prices.
(4) Bargaining power of buyers – powerful buyers have a significant impact on prices.
(5) Bargaining power of suppliers – powerful suppliers can demand premium prices and limit your profit.
(1) Threat of new entrants New entrants to an industry bring new capacity and the desire to gain market share, and they often also bring substantial resources. As a result, prices can be low, cost can be high, and profits can be low.
There is a relationship between threat of new entrants, barriers to entry, and reaction from existing competitors.
– If barriers are high and reaction is high, then the threat of entry is low.
– If barriers are low and reaction is low, then the threat of entry is high.
There are seven major barriers to entry, including: (1) economies of scale, (2) product differentiation, (3) capital requirements, (4) switching costs, (5) access to distribution channels, (6) cost disadvantages independent of scale, and (7) government policy.
Intense rivalry is the result of a number of interacting structural factors such as:
– numerous or equally balanced competitors
– slow industry growth
– high fixed costs or storage costs
– lack of differentiation or switching costs
– capacity increased in large increments
– diverse competitors
– high strategic stakes
– high exit barriers
The more attractive the price-performance alternative offered by substitutes, the stronger or firmer the lid on industry profits. Substitute products that deserve the most attention are those that are subject to trends improving their price-performance trade-off with the industry’s product or produced by industries earning high profits.
A buyer group is powerful under the following circumstances:
– it 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.
– it faces few switching costs.
– it earns low profits.
– the buyer has full information about demand, prices and costs: informed customers become empowered customers.
A supplier group is powerful if the following apply:
– it is dominated by a few companies and is more concentrated than the industry it sells to.
– it is not obligated to contend with other substitute products for sale to the industry.
– the industry is not an important customer of the supplier group.
– 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.
(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 the participants and segment them into groups, if appropriate:
• the buyers and buyer groups?
• the suppliers and supplier groups?
• the competitors?
• the substitutes?
• the potential entrants?
(3) Assess the underlying drivers of each competitive force to determine which forces are strong and which are weak and why.
• Why is the level of profitability what it is?
• 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 and likely future changes in each force, both positive and negative.
(6) Identify aspects of industry structure that might be influenced by competitors, by new entrants, or by your company.
Porter’s three competitive strategies include:
(2) Low-Cost Leadership
The differentiation strategy involves an attempt to distinguish the firm’s products or services from others in the industry. An organization may use advertising, distinctive product features, exceptional service, or new technology to achieve a product that is perceived as unique.
This strategy usually targets customers who are not particularly concerned with price, so it can be quite profitable – customers are loyal and will pay high prices for the product. Companies that pursue a differentiation strategy typically need strong marketing abilities, a creative flair, and a reputation for leadership.
A differentiation strategy can reduce rivalry with competitors and fight off the threat of substitute products because customers are loyal to the company’s brand. However, companies must remember that successful differentiation strategies require a number of costly activities, such as product research and design and advertising.
The organization aggressively seeks efficient facilities, pursues cost reductions, and uses tight cost controls to produce products more efficiently than competitors. A low-cost position means that the company can undercut competitors’ prices and still offer comparable quality and earn a reasonable profit. Being a low-cost producer provides a successful strategy to defend against the five competitive forces.
For example, the most efficient, low-cost company is in the best position to succeed in a price war while still making a profit. Likewise, the low-cost producer is protected from powerful customers and suppliers because customers cannot find lower prices elsewhere.
If substitute products or potential new entrants occur, the low-cost producer is better positioned than higher-cost rivals to prevent loss of market share. The low price acts as a barrier against new entrants and substitute products.
The low-cost leadership strategy tries to increase market share by emphasizing low cost compared to competitors. This strategy is concerned primarily with stability.
With Porter’s third strategy, the organization concentrates on a specific regional market or buyer group. The company will use either a focused differentiation or focused low-cost, but only for a narrow target market.
Managers must think carefully about which strategy will provide their company with its competitive advantage.
These three strategies require different styles of leadership and can translate into different corporate cultures. A firm that is “stuck in the middle” is the one that has failed to develop its strategy in at least one of the three directions. It has low profitability, lost high-volume customers, lost high-margin businesses and blurred corporate culture.
Risks in pursuing the three generic strategies include:
– failing to attain or sustain the strategy.
– eroding the strategic advantage with industry evolution.
Watch this 13-minute Harvard Business Review interview of Michael Porter where he talks about the Five Forces: