Final Lecture

· Brief look at Porter’s Five Forces Model (Basically an overview of the course)

· Assignments and Exam

Porter’s 5 Forces Model

Aim: To develop a framework within which we can understand how economics helps businessmen understand their environment and aid

their strategic-decision making

In particular, we want to answer questions:

1). How do I tell how profitable a particular industry is?

2). What are the key factors affecting profitability?

3). How might projected changes in the business environment affect firm performance?

• Business Unit Strategy: The choice of strategy at the level of individual business units

• Focus lies in making appropriate strategic decisions given the market environment faced by the business unit

• Decisions like Pricing, Advertising, Product Characteristics/Features are generally made by firms on a market by market basis

• Corporate Strategy: The choice of strategy at the level of

the Corporation

• Decisions relating to the set of business units which make up the corporation (These decisions affect all the corporations business units)

• The decision to Diversify, Vertically Integrate, engage in International Business

• Broad strategic decisions relating to HR policy and practices, culture etc

• KEY POINT: We're going to concentrate on Business Unit Strategy

Rank IndustryRate of Gross Profit

1 Water 70.2%2 Cement 50.1%3 Pharmaceuticals 45.3%4 Publishing 43.9%5 Glass 42.1%6 Clothing 41.5%7 Footwear 39.1%8 Aerospace 38.3%9 Rubber and Plastic 37.9%

10 Textile Manuf. 37.7%11 Electricity Generation 34.1%12 Paper 33.9%13 Concrete 33.9%14 Vegetable Processing 33.8%15 Electrical equipment 32.6%16 Gas 30.3%17 Construction 29.8%18 Basic Chemicals 28.4%19 Soap & Detergents 28.1%20 Iron & Steel 27.6%21 Beverages 26.8%22 Domestic Apps. 24.2%23 Sawmilling 22.4%24 Cars 21.7%25 Computers 20.7%26 Dairy Products 18.8%27 Tobacco 17.3%28 Oils & Fats 11.1%29 Petrol Refining 7.3%

Average Industry Profitability for 29 UK manufacturing industries. (Averages for 1993-98 incl.)

FirmRate of Gross

ProfitFirm

Rate of Gross Profit

Wessex Water 55.6% United News & Media 11.7%National Grid Group 41.5% BAT Industries 11.6%Southern Electric 39.1% Fuller Smith & Turner 11.6%Glaxo Wellcome 35.5% Cadbury Schweppes 11.6%Pennon Group 34.7% BPB 11.3%Severn Trent 32.2% Whitbread 10.4%Shire Pharmaceuticals 32.0% Shell 9.5%AWG 30.8% Burmah Castrol 8.9%Kelda Group 28.0% Unilever 7.9%British-Borneo Oil & Gas 26.8% Assd. British Foods 7.5%Rio Tinto 24.5% BAE Systems 6.6%Cable & Wireless 24.3% Avon Rubber 6.2%Reuters Group 24.1% BP Amoco 6.2%Reed International 23.8% Glynwed International 5.3%Monument Oil & Gas 23.6% Scottish & Newcastle 5.3%PowerGen 23.4% Allied Domecq 4.9%Sage Group 22.1% Imperial Chemical Inds. 4.7%Scot. & Southern Energy 22.0%Diageo 20.6%

SmithKline Beecham 19.5%Thames Water 19.2%AstraZeneca 18.2%Scottish Power 17.8%Reckitt Benckiser 17.8%Smiths Industries 16.9%Smith & Nephew 16.7%Blue Circle Industries 16.4%Corus Group 15.6%Greene King 15.0%Hanson 14.5%Nycomed Amersham 14.5%Uniq 14.0%Bass 13.1%Wetherspoon J.D. 13.0%Psion 12.9%The Boots Company 12.3%

Average Firm Profitability for some large UK listed firms for 1993-8.

• Our data provide some support for three important empirical stylized facts:

• Some industries are inherently more profitable than others

• Some firms are consistently more profitable than others because they operate in these favourable environments

• Firms with similar activities have widely different rates of profit

• These empirical "facts" are a key part of the genesis of the discipline of Business Strategy

• They imply that:

- A firm's operating environment is important

- At the corporate strategic level firms should try to be involved in "good games“

- At the business unit level firms should try to alter those fundamental characteristics - try to improve their "game“

- There is still scope for firms to do well in relatively poor environments if they have a good enough strategy to out perform their rivals

- Firms should try to choose a strategy that is best given their operating environment

• Porter's framework relates directly to these empirical observations

• His framework consists of two parts:

• Industry Analysis - develop a tool that helps us determine what makes a market tick

• Generic Strategy Formulation - offers strategic prescriptions that are based on industry analysis

• Some basic issues for industry analysis:

• Arriving at a sensible definition of the market/industry is a precursor to conducting industry analysis

• This can be quite difficult!

• By defining the market you define a set of competing products, a geographical area, a set of competitors etc

Too Narrow a Focus canlead to Strategic Myopia -Some important competitivethreats are overlooked

Too Broad a Focus can leadto irrelevant analysis - thefirm may consider non-existent threats or lead to thereally important detail beinglost in the larger picture

• Using a number of alternative definitions of a market can be a useful way of generating a range of strategic options and perspectives

• What characteristics of a market significantly affect the performance potential of the firms operating within them?

• Fundamentally market (and hence firm) performance is hypothesised to be a function of the strength of 5 forces

• Note the two hypotheses implicit in this view of the world:

- Market performance is a relatively simple function of a set of underlying market characteristics

- Firm performance is primarily determined by the inherent profitability of their environment

The degree of threat from Substitute Products

Threat of exercise of

buyer power

The Size of Barriers to

Entry

The extent and nature of Industry Rivalry

Threat of exercise of

supplier power

Porter’s 5 ForcesPorter’s 5 Forces

• Barriers to Entry

• Provide incumbents with advantages over entrants(which affect market structure)

Sources of Entry Barriers:

High capital requirements, brand loyalty, economies ofscale, control of inputs or distribution channels, and strategic actions from incumbents Where any of these are significant the threat of entry isreduced and the prosperity of the market is enhanced

• Threat of Substitutes

• Substitutes do the same job as the industry's product - they are "functionally equivalent" (to some degree)

• Falls in the prices of existing substitutes or the introduction of new substitute goods threaten the profitability of the industry

• E.g. the introduction of pay-per-view technology has had a big impact upon the market for home video rental

• Bargaining Power of Suppliers & Customers

• If strong suppliers can bid up their prices then the industry's costs rise and it's profitability falls

• E.g. Strong unions threaten the profitability of labour intensive businesses, oil price rises threaten the profitability of distributors

• If powerful buyers can force down the industry's price then industry profits fall

• E.g. Supermarkets power over many agricultural markets

• Power is enhanced if there are few substitutes or if switching buyer or supplier is costly

• Intensity and Form of Industry Rivalry

• Intense rivalry (especially when concentrated on price rivalry) reduces industry profitability

• Often rivalry is intense when: -

• The market is mature/ the business cycle is recessionary - firms fight for a larger piece of a shrinking/static pie

• Fixed costs are large - then firms must sell high volumes to cover costs and hence reduce prices

• Now we want to move on to looking at what makes some firms in a market more profitable than others

• Porter argues that this is due to differences in their business unit strategy

• Furthermore he identifies two fundamental routes to gaining a long term competitive advantage

• A Low Cost Strategy

• A Differentiation Strategy

The Generic Strategy Framework

Porter suggests that there are two fundamental routes

to gaining long run competitive advantage:

The DifferentiationStrategy

The Cost LeadershipStrategy

KEY POINT: Firms should only try to pursue one of these strategies - otherwise they "get stuck in the middle

• The Differentiation Strategy

• Pursuing a differentiation strategy involves making your product different from rivals

• That might involve providing extra benefits to the product

For example:

• Airlines might differentiate themselves from one another by offering more legroom, better in-flight entertainment or food

• Pharmaceutical companies might seek to offer new drugs that offer new therapeutic benefits

• Soap Companies differentiate themselves by adding different moisturising ingredients, scents, antibacterial agents, deodorising ingredients etc

• KEY POINT: Differentiation often (always?) involves incurring extra costs

• Differentiation confers improved profitability relative to average performing rivals if:

• Consumers are willing to pay a price that more than

compensates for the higher costs of achieving differentiation:

PROFIT

COSTCOST

PROFIT

• The Low Cost Strategy

• A firm pursuing a low cost strategy tries to improve profitability by reducing costs to the minimum

• They typically offer a basic product that meets the needs of some consumers but without the frills of some differentiated goods

• For Example:

• Many supermarket own branded goods offer fundamental product attributes to consumers in basic packaging

• Hotel chains like Travellodge who avoid costs of having swimming pools, gyms, and just offer a basic hotel service

• Budget Airlines offer basic economy air travel without fancy in flight meals, extra space, or entertainment

• Key Point: Reducing costs almost certainly involves reducing the quality of the product relative to differentiated goods

• Low cost firms usually undercut other firms in the market (sometimes selling volume is key to the low cost strategy if there are economies of scale)

• They make higher margins by reducing costs by more than the price reduction

PROFIT

COSTCOST

PROFIT

Implementing a low cost strategy involves making cost reduction a part of the corporate culture

• Q: How do we decide which generic strategy we should choose?

A: By understanding the drivers in our environment (Understanding the market we are in!)

• Critical perspectives on Porter's framework

• Things to note about Porter:

• It's an "externally oriented", "market driven" or "Outside-In" perspective on strategy formation

• Firms analyse their environments and position them selves with respect to the important competitive threats

• As such, it relegates the importance of firm specific resources, capabilities, competencies etc

• Other problems:• Are generic strategies really a route to competitive advantage?• Generic = Standard / General / Available to all

• Is being "stuck in the middle" so bad?

• There's plenty of evidence to show that:• Firms can successfully pursue strategies involving both cost

reduction and elements of differentiation (E.g. Nissan - low cost and emphasis on reliability)

• Firms that single mindedly focus on a particular generic strategy can fail (E.g. Caterpillar - endeavoured to make the best earth moving equipment in the world (highly differentiated) but the costs of doing so meant that they were vulnerable to attack by cheaper imports)

• Such Hybrid strategies are commonly accepted as being viable