Market maneuvering among industry rivals

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C H A P T E R

3

Evaluating a Company’s External Environment

L E A R N I N G O B J E C T I V E S 1. To gain command of the basic concepts and analytical tools widely used to diag-

nose a company’s industry and competitive conditions. 2. To become adept in recognizing the factors that cause competition in an industry to

be fierce, more or less normal, or relatively weak. 3. To learn how to determine whether an industry’s outlook presents a company with

sufficiently attractive opportunities for growth and profitability. 4. To understand why in-depth evaluation of specific industry and competitive condi-

tions is a prerequisite to crafting a strategy well matched to a company’s situation.

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Analysis is the critical starting point of strategic thinking. — Kenichi Ohmae Consultant and Author

Things are always different—the art is figuring out which differences matter. — Laszlo Birinyi Investments Manager

Competitive battles should be seen not as one-shot skirmishes but as a dynamic multiround game of moves and countermoves. — Anil K. Gupta Professor

In the opening paragraph of Chapter 1, we said that one of the three central questions that man-agers must address in evaluating their company’s business prospects is “What’s the company’s present situation?” Two facets of a company’s situation are especially pertinent: (1) the industry and competi- tive environment in which the company operates and (2) the company’s collection of resources and capa- bilities, its strengths and weaknesses vis-à-vis rivals, and its windows of opportunity.

Insightful analysis of a company’s external and internal environment is a prerequisite for crafting a strategy that is an excellent fit with the company’s situation, is capable of building competitive advan- tage, and holds good prospect for boosting company performance—the three criteria of a winning strategy.

As depicted in Figure 3.1 , the task of crafting a com- pany’s strategy should always begin with appraisals of the company’s external environment and internal environment (as a basis for deciding on a long-term strategic direction and developing a strategic vision), then proceed to an evaluation of the most promising alternative strategic options and business models, and culminate in choosing a specific strategy.

This chapter presents the concepts and analyti- cal tools for zeroing in on a single-business com- pany’s external environment. Attention centers on the competitive arena in which a company operates, the drivers of market change, and rival companies’ actions. In Chapter 4 we explore the methods of evaluating a company’s internal circumstances and competitiveness.

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56 Part 1 Concepts and Techniques for Crafting and Executing Strategy

THE STRATEGICALLY RELEVANT COMPONENTS OF A COMPANY’S EXTERNAL ENVIRONMENT

All companies operate in a macroenvironment shaped by influences emanating from general economic conditions; population demographics; societal values and lifestyles; legislation and regulations; technology; and, closer to home, the industry and competi- tive environment in which the company operates (see Figure 3.2 ). Strictly speaking, a company’s macroenvironment includes all relevant factors and influences outside the company’s boundaries; by relevant, we mean important enough to have a bearing on the decisions the company ultimately makes about its direction, objectives, strategy, and business model. Strategically relevant influences coming from the outer ring of the macroenvironment can sometimes have a high impact on a company’s business situation and have a very significant impact on the company’s direction and strategy. The strategic opportunities of cigarette producers to grow their business are greatly reduced by antismoking ordinances and the growing cultural stigma attached to smok- ing. Motor vehicle companies must adapt their strategies (especially as concerns the fuel mileage of their vehicles) to customer concerns about gasoline prices. The demo- graphics of an aging population and longer life expectancies are having a dramatic impact on the business prospects and strategies of health care and prescription drug companies. Companies in most all industries have to craft strategies that are respon- sive to environmental regulations, growing use of the Internet, and energy prices. Companies in the food processing, restaurant, sports, and fitness industries have to pay special attention to changes in lifestyles, eating habits, leisure-time preferences, and attitudes toward nutrition and fitness in fashioning their strategies.

Thinking strategically

about a company’s

external environment

Identify promising strategic options for the

company

Select the best

strategy and

business model for the

company Thinking

strategically about a

company’s internal

environment

Form a strategic vision of

where the company needs to

head

Figure 3.1 From Thinking Strategically about the Company’s Situation to Choosing a Strategy

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Chapter 1 Evaluating a Company’s External Environment 57

Happenings in the outer ring of the macroenvironment may occur rapidly or slowly, with or without advance warning. The impact of outer-ring factors on a compa- ny’s choice of strategy can range from big to small. But even if the factors in the mac- roenvironment change slowly or affect a company’s situation only modestly, there are enough strategically relevant outer-ring trends and events to justify a watchful eye. As company managers scan the external environment, they must be alert for potentially important outer-ring developments, assess their impact and influence, and adapt the company’s direction and strategy as needed.

However, the factors and forces in a company’s macroenvironment having the big- gest strategy-shaping impact typically pertain to the company’s immediate industry and competitive environment—the actions of rivals firms, buyer behavior, supplier- related considerations, and so on. Consequently, it is on a company’s industry and competitive environment that we concentrate our attention in this chapter.

Societal values and lifestyles P opu

lati on

de m

og ra

ph ic

s

Le g is

la tio

n a n d

re g

u la

tio n s

T e c h n o lo

g y

Gene ral econo

mic conditions

Macro environment

COMPANY

Substitute products

Suppliers

Rival firms

New entrants

Buyers

Im m

e

d ia

te in

du str

y and competitive enviro

n m

e n t

Figure 3.2 The Components of a Company’s Macroenvironment

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58 Part 1 Concepts and Techniques for Crafting and Executing Strategy

THINKING STRATEGICALLY ABOUT A COMPANY’S INDUSTRY AND COMPETITIVE ENVIRONMENT

To gain a deep understanding of a company’s industry and competitive environment, managers do not need to gather all the information they can find and spend lots of time digesting it. Rather, the task is much more focused. Thinking strategically about a company’s industry and competitive environment entails using some well-defined concepts and analytical tools to get clear answers to seven questions:

1. What are the industry’s dominant economic features? 2. What kinds of competitive forces are industry members facing, and how strong is

each force? 3. What forces are driving industry change and what impact will these changes have

on competitive intensity and industry profitability? 4. What market positions do industry rivals occupy—who is strongly positioned and

who is not? 5. What strategic moves are rivals likely to make next? 6. What are the key factors for future competitive success? 7. Does the outlook for the industry offer the company a good opportunity to earn

attractive profits?

Analysis-based answers to these questions provide managers with the understanding needed to craft a strategy that fits the company’s external situation. The remainder of this chapter is devoted to describing the methods of obtaining solid answers to the seven questions and explaining how the nature of a company’s industry and competi- tive environment weighs on the strategic choices of company managers.

QUESTION1: WHAT ARE THE INDUSTRY’S DOMINANT ECONOMIC FEATURES?

Because industries differ so significantly, analyzing a company’s industry and com- petitive environment begins with identifying an industry’s dominant economic fea- tures and gaining an an accurate and insightful view of the industry landscape. An industry’s dominant economic features are defined by such factors as market size and growth rate, the number and sizes of buyers and sellers, the geographic boundaries of the market (which can extend from local to worldwide), whether sellers’ products are virtually identical or highly differentiated, the pace of technological change, and the extent of vertical integration. Table 3.1 provides a convenient summary of what eco- nomic features to look at and the corresponding questions to consider in profiling an industry’s landscape.

Getting a handle on an industry’s distinguishing economic features not only allows managers to prepare for the analysis to come but also helps them understand the kinds of strategic moves that industry members are likely to employ. For example, in industries characterized by one product advance after another—such as the video game, computer, and pharmaceuticals industries—companies must invest in research and development (R&D) and maintain strong product innovation capabilities. An industry that has recently passed through the rapid-growth stage and is looking at single-digit percentage increases

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Chapter 1 Evaluating a Company’s External Environment 59

Table 3.1 What to Consider in Identifying an Industry’s Dominant Economic Features

Economic Feature Questions to Answer

Market size and growth rate • How big is the industry and how fast is it growing? • What does the industry’s position in the product life cycle (early development,

rapid growth and takeoff, early maturity and slowing growth, saturation and stagnation, decline) reveal about the industry’s growth prospects?

Number of rivals • Is the industry fragmented into many small companies or concentrated and dominated by a few large companies?

• Is the industry consolidating to a smaller number of competitors? Scope of competitive rivalry • Is the geographic area over which most companies compete local, regional,

national, multinational, or global?

• Is having a presence in foreign markets becoming more important to a company’s long-term competitive success?

Number of buyers • Is market demand fragmented among many buyers? • Do some buyers have bargaining power because they purchase in large

volume? Degree of product differentiation • Are the products of rivals becoming more differentiated or less

differentiated?

• Are the products of rivals becoming increasingly similar and causing heightened price competition?

Product innovation • Is the industry characterized by rapid product innovation and short product life cycles?

• How important is R&D and product innovation? • Are there opportunities to overtake key rivals by being first-to-market with

next-generation products? Demand–supply conditions • Is a surplus of capacity pushing prices and profit margins down?

• Is the industry overcrowded with competitors? Pace of technological change • What role does advancing technology play in this industry?

• Are ongoing upgrades of facilities/equipment essential because of rapidly advancing production process technologies?

• Do most industry members have or need strong technological capabilities? Why?

Vertical integration • Do most competitors operate in only one stage of the industry (parts and components production, manufacturing and assembly, distribution, retailing), or do some competitors operate in multiple stages?

• Is there any cost or competitive advantage or disadvantage associated with being fully or partially integrated?

Economies of scale • Is the industry characterized by economies of scale in purchasing, manufacturing, advertising, shipping, or other activities?

• Do companies with large-scale operations have an important cost advantage over small-scale firms?

Learning/experience curve effects

• Are certain industry activities characterized by strong learning and experience effects (“learning by doing”) such that unit costs decline as a company’s experience in performing the activity builds?

• Do any companies have significant cost advantages because of their learning/experience in performing particular activities?

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60 Part 1 Concepts and Techniques for Crafting and Executing Strategy

in buyer demand is likely to be experiencing a competitive shake-out and much stronger strategic emphasis on cost reduction and improved customer service.

In industries like semiconductors, strong learning/experience effects in manufactur- ing cause unit costs to decline about 20 percent each time cumulative production vol- ume doubles. With a 20 percent experience curve effect, if the first 1 million chips cost $100 each, the unit cost would drop to $80 (80 percent of $100) when production vol- ume reaches 2 million and then drop further to $64 (80 percent of $80) when production volume reaches 4 million. 1 The bigger the learning or experience curve effect, the big- ger the cost advantage of the company with the largest cumulative production volume. Thus, when an industry is characterized by important learning/experience curve effects (or by economies of scale), industry members are strongly motivated to adopt volume- increasing strategies to capture the resulting cost-saving economies and maintain their competitiveness. Unless small-scale firms succeed in pursuing strategic options that allow them to grow sales sufficiently to remain cost-competitive with larger-volume rivals, they are unlikely to survive. The bigger the learning/experience curve effects and/ or scale economies in an industry, the more imperative it becomes for competing sellers to pursue strategies to win additional sales and market share—the company with the biggest sales volume gains sustainable competitive advantage as the low-cost producer.

QUESTION 2: HOW STRONG ARE COMPETITIVE FORCES?

Competitive forces are never the same from one industry to another. Far and away the most powerful and widely used tool for systematically diagnosing the principal com- petitive pressures in a market and assessing the strength and importance of each is the five-forces model of competition. 2 This model, depicted in Figure 3.3 , holds that the state of competition in an industry is a composite of competitive pressures operating in five areas of the overall market:

1. Competitive pressures associated with the market maneuvering and jockeying for buyer patronage that goes on among rival sellers in the industry.

2. Competitive pressures associated with the threats of new entrants. 3. Competitive pressures coming from the attempts of companies in other industries

to win buyers over to their own substitute products. 4. Competitive pressures stemming from supplier bargaining power and supplier–

seller collaboration. 5. Competitive pressures stemming from buyer bargaining power and seller–buyer

collaboration.

The way one uses the five-forces model to determine the makeup and strength of com- petitive pressures in a given industry is to build the picture of competitive landscape in three steps:

• Step 1: Identify the specific competitive pressures associated with each of the five forces.

• Step 2: Evaluate how strong the pressures comprising each of the five forces are (fierce, strong, moderate to normal, or weak).

• Step 3: Determine whether the collective strength of the five competitive forces is conducive to earning attractive profits.

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Chapter 1 Evaluating a Company’s External Environment 61

Competitive Pressures Created by the Rivalry among Competing Sellers The strongest of the five competitive forces is nearly always the market maneuvering for buyer patronage that goes on among rival sellers of a product or service. In effect, a market is a competitive battlefield where there’s no end to the maneuvering for buyer patronage. Rival sellers employ whatever weapons they have in their business arsenal to strengthen their market positions, attract and retain buyers, and earn good profits.

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

Suppliers of Raw

Materials, Parts,

Components, or Other

Resource Inputs

Buyers

Competitive pressures stemming

from supplier

bargaining power

and supplier– seller

collaboration

Competitive pressures stemming

from buyer

bargaining power

and seller– buyer

collaboration

Competitive pressures coming from the threat of entry of new rivals

Potential New Entrants

Firms in Other Industries Offering

Substitute Products

Rivalry among

Competing Sellers

Competitive pressures created by jockeying

for better market position, increased sales and market-

share, and competitive advantage

Competitive pressures coming from the market attempts of outsiders

to win buyers over to their products

Source: Adapted from Michael E. Porter, “How Competitive Forces Shape Strategy,” Harvard Business Review 57, no. 2 (March–April 1979), pp. 137–45; and Michael E. Porter, “The Five Competitive Forces That Shape Strategy,” Harvard Business Review 86, no. 1 (January 2008), pp. 80–86.

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CORE CONCEPT Competitive maneuvering among industry rivals is ever changing, as rivals (1) initiate fresh offensive and defensive moves and (2) emphasize first one mix of com- petitive weapons and then another in efforts to improve their market position and boost sales and profitability.

62 Part 1 Concepts and Techniques for Crafting and Executing Strategy

The challenge for company managers is to craft a competitive strategy that, at the very least, allows the company to hold its own against rivals and that, ideally, produces a competitive edge. But competitive contests are ongoing and dynamic. When one firm makes a strategic move that produces good results, its rivals typically respond with offensive or defensive countermoves of their own, shifting their strategic emphasis from one combination of prod- uct attributes, marketing tactics, and capabilities to another. This pattern of action and reaction, move and countermove, adjustment and readjustment produces a continually evolving competitive landscape where the market battle ebbs and flows, sometimes takes unpredictable twists and turns, and produces winners and losers. But the winners—the current market leaders— have no guarantees of continued leadership; their market success is no more

durable than the power of their strategies to fend off the strategies of ambitious chal- lengers. In every industry, the ongoing maneuvering of rivals leads to one or another companies gaining or losing momentum in the marketplace according to whether their latest strategic actions succeed or fail. 3

Figure 3.4 shows a sampling of competitive weapons that firms can deploy in bat- tling rivals and indicates the factors that influence the intensity of their rivalry. A brief discussion of the principal factors that influence the tempo of rivalry among industry competitors is in order: 4

• Rivalry intensifies when competing sellers are active in making fresh moves to improve their market standing and business performance. One indicator of active rivalry is lively price competition, a condition that puts pressure on industry mem- bers to drive costs out of the business and threatens the survival of high-cost com- panies. Another indicator of active rivalry is rapid introduction of next-generation products—when one or more rivals frequently introduce new or improved prod- ucts, competitors that lack good product-innovation capabilities feel considerable competitive heat to get their own new and improved products into the marketplace quickly. Other indicators of active rivalry among industry members include:

• Whether industry members are racing to differentiate their products from rivals by offering better performance features or higher-quality or improved customer service or a wider product selection.

• How frequently rivals resort to such marketing tactics as special sales promo- tions, heavy advertising, rebates, or low-interest-rate financing to drum up additional sales.

• How actively industry members are pursuing efforts to build stronger dealer networks or establish positions in foreign markets or otherwise expand their distribution capabilities and market presence.

• How hard companies are striving to gain a market edge over rivals by develop- ing valuable expertise and capabilities that rivals are hard-pressed to match.

• Normally, competitive jockeying among rival sellers is active and fairly intense because competing companies are highly motivated to launch whatever fresh actions and creative market maneuvers they can think of to try to strengthen their market positions and business performance.

• Rivalry is usually stronger when buyer demand is growing slowly and weaker when buyer demand is growing rapidly. Rapidly expanding buyer demand pro- duces enough new business for all industry members to grow. But in markets

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Chapter 1 Evaluating a Company’s External Environment 63

• Competing sellers are active in making fresh moves to improve their market standing and business performance.

• Buyer demand is growing slowly. • Buyer demand falls off and sellers find

themselves with excess capacity and/or inventory.

• The number of rivals increases and rivals are of roughly equal size and competitive capability.

• Buyer costs to switch brands are low. • The products of rival sellers are

commodities or else weakly differentiated.

• One or more rivals are dissatisfied with their current position and market share and make aggressive moves to attract more customers.

• Rivals have diverse objectives and strategies and/or are located in different countries.

• Outsiders have recently acquired weak competitors and are trying to turn them into major contenders.

• One or two rivals have powerful strategies and other rivals are scrambling to stay in the game.

Typical ”Weapons“ for Battling Rivals and Attracting Buyers

• Lower prices. • More or different features. • Better product performance. • Higher quality. • Stronger brand image and appeal. • Wider selection of models and styles. • Bigger/better dealer network. • Low-interest financing. • Higher levels of advertising. • Stronger product innovation capabilities. • Better customer service capabilities. • Stronger capabilities to provide buyers with custom- made products.

Rivalry is generally stronger when:

• Industry members move only infrequently or in a nonaggressive manner to draw sales and market share away from rivals.

• Buyer demand is growing rapidly. • The products of rival sellers are strongly

differentiated and customer loyalty is high.

• Buyer costs to switch brands are high. • There are fewer than 5 sellers or else so

many rivals that any one company’s actions have little direct impact on rivals' business.

Rivalry is generally weaker when:

How strong are the competitive

pressures stemming from the efforts of rivals to gain better market

positions, higher sales and market shares, and competitive advantages?

Rivalry among

Competing Sellers

Figure 3.4 Weapons for Competing and Factors Affecting the Strength of Rivalry

where growth is sluggish or where buyer demand drops off unexpectedly, expan- sion-minded firms and/or firms with excess capacity often are quick to cut prices and initiate other sales-increasing tactics, thereby igniting a battle for market share that can threaten the survival of competitively weak firms.

• Rivalry increases when buyer demand falls off and sellers find themselves with excess capacity and/or inventory. Excess supply conditions create a “buyer’s mar- ket,” putting added competitive pressure on industry rivals to scramble for profitable

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64 Part 1 Concepts and Techniques for Crafting and Executing Strategy

sales levels. When a product is perishable, seasonal, or costly to hold in inventory, competitive pressures build quickly anytime one or more firms decide to cut prices and dump supplies on the market. Likewise, whenever fixed costs account for a large fraction of total cost (so that unit costs tend to be lowest at or near full capac- ity), firms come under significant pressure to cut prices or otherwise try to boost sales whenever they are operating below full capacity. Unused capacity imposes a significant cost-increasing penalty, because there are fewer units over which to spread fixed costs. The pressure of high fixed costs can push rival firms into price concessions, special discounts, rebates, low-interest-rate financing, and other volume-boosting tactics.

• Rivalry is stronger in industries where the number of rivals increases and com- petitors are equal in size and capability. Competitive rivalry in the quick-service restaurant industry is particularly strong, where there are numerous relatively equal-sized hamburger, deli sandwich, chicken, and taco chains. For the most part, McDonald’s, Burger King, Taco Bell, KFC, Arby’s, and other national fast-food chains have comparable capabilities and must compete aggressively to hold their own in the industry.

• Rivalry increases as it becomes less costly for buyers to switch brands. The less expensive it is for buyers to switch their purchases from the seller of one brand to the seller of another brand, the easier it is for sellers to steal customers away from rivals. But the higher the costs associated with switching brands, the less prone buyers are to make the switch. Abandoning a familiar brand may entail added time, inconvenience, or psychological costs.

• Rivalry increases as it becomes less costly for buyers to switch brands and dimin- ishes as buyer switching costs increase. The less expensive it is for buyers to switch their purchases from the seller of one brand to the seller of another brand, the easier it is for sellers to steal customers away from rivals. But the higher the costs buyers incur to switch brands, the less prone they are to brand switching Even if consumers view one or more rival brands as more attractive, they may not be inclined to switch because of the added time and inconvenience that may be involved or the psychological costs of abandoning a familiar brand. Distributors and retailers may not switch to the brands of rival manufactures because they are hesitant to sever longstanding supplier relationships, incur any technical support costs or retraining expenses in making the switchover, go to the trouble of testing the quality and reliability of the rival brand, or devote resources to marketing the new brand (especially if the brand is lesser-known). Apple Computer, for exam- ple, has long struggled to convince PC users to switch from Windows-based PCs because of the time burdens and inconvenience associated with learning Apple’s operating system and because so many Windows-based applications will not run on a MacIntosh due to operating system incompatibility. Consequently, unless buyers are dissatisfied with the brand they are presently purchasing, high switch- ing costs can significantly weaken the rivalry among competing sellers.

• Rivalry increases as the products of rival sellers become more standardized and diminishes as the products of industry rivals become more differentiated. When the offerings of rivals are identical or weakly differentiated, buyers have less reason to be brand-loyal—a condition that makes it easier for rivals to convince buyers to switch to their offering. And since the brands of different sellers have comparable attributes, buyers can shop the market for the best deal and switch brands at will. On the other hand, strongly differentiated product offerings among rivals breed

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Chapter 1 Evaluating a Company’s External Environment 65

high brand loyalty on the part of buyers—because many buyers view the attributes of certain brands as better suited to their needs. Strong brand attachments make it tougher for sellers to draw customers away from rivals. Unless meaningful num- bers of buyers are open to considering new or different product attributes being offered by rivals, the high degree of brand loyalty that accompanies strong product differentiation works against fierce rivalry among competing sellers.

• Rivalry is more intense when industry conditions tempt competitors to use price cuts or other competitive weapons to boost unit volume. When a product is perish- able, seasonal, or costly to hold in inventory, competitive pressures build quickly anytime one or more firms decide to cut prices and dump supplies on the market. Likewise, whenever fixed costs account for a large fraction of total cost so that unit costs tend to be lowest at or near full capacity, firms come under significant pressure to cut prices or otherwise try to boost sales whenever they are operating below full capacity. Unused capacity imposes a significant cost-increasing pen- alty because there are fewer units over which to spread fixed costs. The pressure of high fixed costs can push rival firms into price concessions, special discounts, rebates, low-interest-rate financing, and other volume-boosting tactics.

• Rivalry increases when one or more competitors become dissatisfied with their market position. Firms that are losing ground or in financial trouble often initiate aggressive (perhaps even desperate) turnaround strategies that can involve price discounts, greater advertising, or merger with other rivals—such strategies can turn competitive pressures up a notch.

• Rivalry becomes more volatile and unpredictable as the diversity of competitors increases in terms of visions, strategic intents, objectives, strategies, resources, and countries of origin. A diverse group of sellers often contains one or more mavericks willing to try novel or rule-breaking market approaches, thus generat- ing a livelier and less predictable competitive environment. Globally competitive markets usually boost the intensity of rivalry, especially when aggressors having lower costs or products with more attractive features are intent on gaining a strong foothold in new country markets.