Factors that weaken rivalry among competing sellers include

CHAPTER 3 Evaluating a Company’s External Environment

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Chapter 3 presents the concepts and analytical tools for assessing a company’s external environment. Attention centers on the competitive arena in which a company operates, together with the technological, societal, regulatory, or demographic influences in the macro-environment that are acting to reshape the company’s future market arena.

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Learning Objectives

This Chapter Will Help You Understand:

How to recognize the factors in a company’s broad macro-environment that may have strategic significance.

How to use analytic tools to diagnose the competitive conditions in a company’s industry.

How to map the market positions of key groups of industry rivals.

How to determine whether an industry’s outlook presents a company with sufficiently attractive opportunities for growth and profitability.

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This chapter presents the concepts and analytical tools for zeroing in on a single-business company’s external environment.

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FIGURE 3.1 From Analyzing the Company’s Situation to Choosing a Strategy

Chapter 3 External Environment

Chapter 4 Internal Environment

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As depicted in Figure 3.1, strategic thinking begins with an appraisal of the company’s external and internal environments (as a basis for deciding on a long-term direction and developing a strategic vision), moves toward an evaluation of the most promising alternative strategies and business models, and culminates in choosing a specific strategy.

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Analyzing the Company's Macro-Environment

PESTEL Analysis

Focuses on principal components of strategic significance in the macro-environment

Political factors

Economic conditions (local to worldwide)

Sociocultural forces

Technological factors

Environmental factors (the natural environment)

Legal and regulatory conditions

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The macro-environment encompasses the broad environmental context in which a company’s industry is situated that includes strategically relevant components over which the firm has no direct control.

Analysis of the impact of these factors is often referred to as PESTEL analysis, an acronym that serves as a reminder of the six components involved (Political, Economic, Sociocultural, Technological, Environmental, Legal/Regulatory).

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FIGURE 3.2 The Components of a Company’s Macro-Environment

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Figure 3.2, The Components of a Company’s Macro-environment identifies the arenas within an organization’s macro-environment.

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Assessing the Company’s Industry and Competitive Environment

Thinking strategically about the competitive environment requires managers to use some well validated concepts and analytical tools.

Five forces framework

The value net

Driving forces

Strategic groups

Competitor analysis

Key success factors

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Thinking strategically about a company’s industry and competitive environment entails using some well-validated concepts and analytic tools. These include the five forces framework, the value net, driving forces, strategic groups, competitor analysis, and key success factors. Proper use of these analytic tools can provide managers with the understanding needed to craft a strategy that fits the company’s situation within their industry environment. The remainder of this chapter is devoted to describing how managers can use these tools to inform and improve their strategic choices.

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The Five Forces Framework

The five competitive forces

Competition from rival sellers

Competition from potential new entrants

Competition from producers of substitute products

Supplier bargaining power

Customer bargaining power

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The character and strength of the competitive forces operating in an industry are never the same from one industry to another. The most powerful and widely used tool for diagnosing the principal competitive pressures in a market is the five forces framework.

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FIGURE 3.3 The Five Forces Model of Competition: A Key Analytical Tool

Sources: Adapted from M.E. Porter, “How Competitive Forces Shape Strategy,” Harvard Business Review 57, no. 2 (1979), pp.137-145; M.E. Porter, “The Five Competitive Forces That Shape Strategy,” Harvard Business Review 86, no 1 (2008), pp. 80-86.

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This five forces framework, depicted in Figure 3.3, holds that competitive pressures on companies within an industry come from five sources. These include (1) competition from rival sellers, (2) competition from competition from producers of substitute products, (3) potential new entrants, (4) supplier bargaining power, and (5) customer bargaining power.

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Using the Five-forces Model of Competition

STEP 1: For each of the five forces, identify the different parties involved, along with the specific factors that bring about competitive pressures.

STEP 2: Evaluate how strong the pressures stemming from each of the five forces are (strong, moderate, or weak).

STEP 3: Determine whether the five forces, overall, are supportive of high industry profitability.

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Using the five forces model to determine the nature and strength of competitive pressures in a given industry involves three steps:

∙ Step 1: For each of the five forces, identify the different parties involved, along with the specific factors that bring about competitive pressures.

∙ Step 2: Evaluate how strong the pressures stemming from each of the five forces are (strong, moderate, or weak).

∙ Step 3: Determine whether the five forces, overall, are supportive of high industry profitability.

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Competitive Pressures That Increase Rivalry among Competing Sellers

Buyer demand is growing slowly or declining.

It is becoming less costly for buyers to switch brands.

Industry products are becoming less differentiated.

There is unused production capacity, or products have high fixed costs or high storage costs.

The number of competitors is increasing, or they are becoming more equal in size and competitive strength.

The diversity of competitors is increasing.

High exit barriers keep firms from exiting the industry.

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The strongest of the five competitive forces is often the rivalry for buyer patronage among competing sellers of a product or service. The intensity of rivalry among competing sellers within an industry depends on several identifiable factors.

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FIGURE 3.4 Factors Affecting the Strength of Rivalry

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Figure 3.4 summarizes these factors affecting rivalry in the industry, identifying those that intensify or weaken rivalry among direct competitors in an industry.

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Competitive Pressures Associated with the Threat of New Entrants

Entry threat considerations

Expected defensive reactions of incumbent firms

Strength of barriers to entry

Attractiveness of a particular market’s growth in demand and profit potential

Capabilities and resources of potential entrants

Entry of existing competitors into market segments in which they have no current presence

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New entrants into an industry threaten the position of rival firms since they will compete fiercely for market share, add to the number of industry rivals, and add to the industry’s production capacity in the process.

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Market Entry Barriers Facing New Entrants

Sizable economies of scale in production, distribution, advertising, or other activities

Hard-to-replicate learning curve and industry relationship cost advantages of incumbents

Strong brand preferences and high customer loyalty

Patents and other intellectual property protection

Strong “network effects” in customer demand

High capital requirements

Building distributor and/or dealer networks and securing adequate space on retailers’ shelves

Restrictive regulatory and trade policies

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The strength of the threat of entry is governed to a large degree by the height of the industry's entry barriers. High barriers reduce the threat of potential entry, whereas low barriers enable easier entry.

Whether an industry’s entry barriers ought to be considered high or low depends on the resources and capabilities possessed by the pool of potential entrants. High entry barriers and weak entry threats today do not always translate into high entry barriers and weak entry threats tomorrow.

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FIGURE 3.5 Factors Affecting the Threat of Entry

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Figure 3.5 summarizes the factors that cause the overall competitive pressure from potential entrants to be strong or weak. An analysis of these factors can help managers determine whether the threat of entry into their industry is high or low.

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Competitive Pressures from the Sellers of Substitute Products

Substitute products considerations

Readily available and attractively priced?

Comparable or better in terms of quality, performance, and other relevant attributes?

Offer lower switching costs to buyers?

Indicators of substitutes’ competitive strength

Increasing rate of growth in sales of substitutes

Substitute producers adding new output capacity

Increasing profitability of substitute producers

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Companies in one industry are vulnerable to competitive pressure from the actions of companies in a closely adjoining industry whenever buyers view the products of the two industries as good substitutes.

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FIGURE 3.6 Factors Affecting Competition from Substitute Products

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Figure 3.6 depicts three factors that determine whether the competitive pressures from substitute products are strong or weak. Competitive pressures are stronger when:

Good substitutes are readily available and attractively priced.

Buyers view the substitutes as comparable or better in terms of quality. performance, and other relevant attributes.

The costs that buyers incur in switching to the substitutes are low.

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Competitive Pressures Stemming from Supplier Bargaining Power

Supplier bargaining power depends on:

Strength of demand for and availability of suppliers’ products.

Whether suppliers provide a differentiated input that enhances the performance of the industry’s product.

Industry members’ costs for switching among suppliers.

Size and number of suppliers relative to industry members.

Possibility of backward integration into suppliers’ industry.

Fraction of the cost of the supplier’s product relative to the total cost of the industry’s product.

Availability of good substitutes for suppliers’ products.

Whether industry members are major customers of suppliers.

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Whether the suppliers of industry members represent a weak or strong competitive force depends on the degree to which suppliers have sufficient bargaining power to influence the terms and conditions of supply in their favor. Suppliers with strong bargaining power are a source of competitive pressure because of their ability to charge industry members higher prices, pass costs on to them, and limit their opportunities to find better deals.

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FIGURE 3.7 Factors Affecting the Bargaining Power of Suppliers

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Figure 3.7 shows a variety of factors that determine the strength of suppliers’ bargaining power.

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Competitive Pressures Stemming from Buyer Bargaining Power and Price Sensitivity

Buyer bargaining power considerations

Strength of buyers’ demand for sellers’ products

Degree to which industry goods are differentiated

Buyers’ costs for switching to competing sellers or substitutes

Number and size of buyers relative to number of sellers

Threat of buyers’ integration into sellers’ industry

Buyers’ knowledge of products, costs and pricing

Buyers’ discretion in delaying purchases

Buyers’ price sensitivity due to low profits, size of purchase, and consequences of purchase

Product quality not at issue price is primary concern

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Whether buyers can exert strong competitive pressures on industry members depends on (1) the degree to which buyers have bargaining power, and (2) the extent to which buyers are price-sensitive. Buyers with strong bargaining power can limit industry profitability by demanding price concessions, better payment terms, or additional features and services that increase industry members’ costs. Buyer price sensitivity limits the profit potential of industry members by restricting the ability of sellers to raise prices without losing revenue due to lost sales.

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FIGURE 3.8 Factors Affecting the Bargaining Power of Buyers

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Figure 3.8 summarizes the factors determining the strength of buyer power in an industry. Note that the first five factors are the mirror image of those determining the bargaining power of suppliers.

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Is the Collective Strength of the Five Competitive Forces Conducive to Good Profitability?

Answers to three questions are needed:

Is the state of competition in the industry stronger than normal?

Can industry firms expect to earn decent profits given prevailing competitive forces?

Are some of the competitive forces sufficiently powerful to undermine industry profitability?

Even one powerful competitive force may be enough to make the industry unattractive in terms of its profit potential.

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Assessing whether each of the five competitive forces gives rise to strong, moderate, or weak competitive pressures sets the stage for evaluating whether, overall, the strength of the five forces is conducive to good profitability. Are any of the competitive forces sufficiently powerful to undermine industry profitability? Can industry firms reasonably expect to earn decent profits considering the prevailing competitive forces?

The strongest of the five forces determines the extent of the downward pressure on an industry’s profitability. Having more than one strong force means that an industry has multiple competitive challenges with which to cope.

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Matching Company Strategy to Competitive Conditions

Effectively matching a firm’s business strategy to prevailing competitive conditions has two aspects:

Pursuing avenues that shield the firm from as many competitive pressures as possible

Initiating actions calculated to shift competitive forces in the firm’s favor by altering underlying factors driving the five forces

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Working through the five forces model step by step aids strategy-makers in assessing whether the intensity of competition allows good profitability and promotes sound strategic thinking about how to better match company strategy to the specific competitive character of the marketplace.

A company’s strategy is strengthened when it provides some insulation from competitive pressures, shifts the competitive battle in the company’s favor, and positions firms to take advantage of attractive growth opportunities.

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Complementors and the Value Net

How the value net differs from the five forces

Focuses on the interactions of industry participants with a particular (focal) company

Defines the category of competitors to include the focal firm’s direct competitors, industry rivals, the sellers of substitute products, and potential entrants

Introduces a new category of industry participant—complementors—producers of products that enhance the value of the focal firm’s products when they are used together

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Not all interactions among industry participants are necessarily competitive in nature. Some have the potential to be cooperative, as the value net framework demonstrates. Like the five forces framework, the value net includes an analysis of buyers, suppliers, and substitutors. But it differs from the five forces framework in several important ways.

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FIGURE 3.9 The Value Net

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Figure 3.9 depicts the value net used in an analysis of buyers, suppliers, and substitutors.

Complementors are the producers of complementary products, which are products that enhance the value of the focal firm’s products when they are used together.

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Industry Dynamics and the Forces Driving Change

Driving forces analysis has three steps.

Identifying what the driving forces are

Assessing whether the drivers of change are acting to make the industry more or less attractive

Determining what strategy changes are needed to prepare for the impact of the driving forces

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Driving forces are the major underlying causes of change in industry and competitive conditions. Driving forces analysis has three steps: (1) identifying what the driving forces are; (2) assessing whether the drivers of change are acting to make the industry more or less attractive; and (3) determining what strategy changes are needed to prepare for the impact of the driving forces.

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Identifying the Forces Driving Industry Change

Changes in the long-term industry growth rate

Increasing globalization

Emerging new Internet capabilities and applications

Shifts in buyer demographics

Technological change and manufacturing process innovation

Product and marketing innovation

Entry or exit of major firms

Diffusion of technical know-how across firms and countries

Changes in cost and efficiency

Reductions in uncertainty and business risk

Regulatory influences and government policy changes

Changing societal concerns, attitudes, and lifestyles

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The most important part of driving forces analysis is to determine whether the collective impact of the driving forces will increase or decrease market demand, make competition more or less intense, and lead to higher or lower industry profitability.

The real payoff of driving-forces analysis is to help managers understand what strategy changes are needed to prepare for the impacts of the driving forces

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Assessing the Impact of the Factors Driving Industry Change

Are the driving forces, on balance, acting to cause demand for the industry’s product to increase or decrease?

Is the collective impact of the driving forces making competition more or less intense?

Will the combined impacts of the driving forces lead to higher or lower industry profitability?

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The second step in driving forces analysis is to determine whether the prevailing change drivers are acting to make the industry environment more or less attractive. Three questions need to be answered:

Are the driving forces, on balance, acting to cause demand for the industry’s product to increase or decrease?

Is the collective impact of the driving forces making competition more or less intense?

Will the combined impacts of the driving forces lead to higher or lower industry profitability?

Getting a handle on the collective impact of the driving forces requires looking at the likely effects of each factor separately, since the driving forces may not all be pushing change in the same direction.

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Adjusting Strategy to Prepare for the Impacts of Driving Forces

What strategy adjustments will be needed to deal with the impacts of the driving forces?

What adjustments must be made immediately?

What actions currently being taken should be halted or abandoned?

What can we do now to prepare for adjustments we anticipate making in the future?

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The third step in the strategic analysis of industry dynamics—where the real payoff for strategy making comes—is for managers to draw some conclusions about what strategy adjustments will be needed to deal with the impacts of the driving forces. But taking the “right” kinds of actions to prepare for the industry and competitive changes being wrought by the driving forces first requires accurate diagnosis of the forces driving industry change and the impacts these forces will have on both the industry environment and the company’s business.

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Strategic Group Analysis

Strategic group

Consists of those industry members with similar competitive approaches and positions in the market

Having comparable product-line breadth

Emphasizing the same distribution channels

Depending on identical technological approaches

Offering the same product attributes to buyers

Offering similar services and technical assistance

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Within an industry, companies commonly sell in different price/quality ranges, appeal to different types of buyers, have different geographic coverage, and so on. Some are more attractively positioned than others. Understanding which companies are strongly positioned and which are weakly positioned is an integral part of analyzing an industry’s competitive structure. The best technique for revealing the market positions of industry competitors is strategic group mapping.

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Using Strategic Group Maps to Assess the Market Positions of Key Competitors

Constructing a strategic group map

Identify the competitive characteristics that delineate strategic approaches used in the industry.

Plot the firms on a two-variable map using pairs of competitive characteristics.

Assign firms occupying about the same map location to the same strategic group.

Draw circles around each strategic group, making the circles proportional to the size of the group’s share of total industry sales revenues.

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A strategic group is a cluster of industry rivals that have similar competitive approaches and market positions.

Strategic group mapping is a technique for displaying the different market or competitive positions that rival firms occupy in the industry.

Evaluating strategy options entails examining what strategic groups exist, identifying the companies within each group, and determining if a competitive “white space” exists where industry competitors can create and capture new demand.

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Typical Variables Used in Creating Group Maps

Price and quality range (high, medium, low)

Geographic coverage (local, regional, national, global)

Product-line breadth (wide, narrow)

Degree of service offered (no frills, limited, full)

Distribution channels (retail, wholesale, Internet, multiple)

Degree of vertical integration (none, partial, full)

Degree of diversification into other industries (none, some, considerable)

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