Summary Week 5

The Five Forces Model

The five forces model is a framework entrepreneurs use to understand an industry’s structure. Professor Michael Porter developed this important tool. These forces—the threat of substitutes, the threat of new entrants (that is, new competitors), rivalry among existing firms, the bargaining power of suppliers, and the bargaining power of buyers—determine the average rate of return for the firms competing in a particular industry or a particular segment of an industry.

 

Threat of Substitutes

In general, industries are more attractive when the threat of substitutes is low. This means that products or services from other industries can’t easily serve as substitutes for the products or services being made and sold in the focal firm’s industry. The extent to which substitutes suppress the profitability of an industry depends on the propensity for buyers to substitute alternatives. This is why the firms in an industry often offer their customers amenities to reduce the likelihood they’ll switch to a substitute product, even in light of a price increase.

Threat of New Entrants

In general, industries are more attractive when the threat of entry is low. This means that competitors cannot easily enter the industry and successfully copy what the industry incumbents are doing to generate profits. A barrier to entry is a condition that creates a disincentive for a new firm to enter an industry. Let’s look at the six major sources of barriers to entry:

■ Economies of scale: Industries that are characterized by large economies of scale are difficult for new firms to enter, unless they are willing to accept a cost disadvantage.

■ Product differentiation: Industries such as the soft-drink industry that are characterized by firms with strong brands are difficult to break into without spending heavily on advertising. 

■ Capital requirements: The need to invest large amounts of money to gain entrance to an industry is another barrier to entry.

■ Cost advantages independent of size: Entrenched competitors may have cost advantages not related to size that are not available to new entrants.

■ Access to distribution channels: Distribution channels are often hard to crack. This is particularly true in crowded markets, such as the convenience store market.

■ Government and legal barriers: In knowledge-intensive industries, such as biotechnology and software, patents, trademarks, and copyrights form major barriers to entry.

Rivalry Among Existing Firms

In most industries, the major determinant of industry profitability is the level of competition among the firms already competing in the industry. Some industries are fiercely competitive to the point where prices are pushed below the level of costs. There are four primary factors that determine the nature and intensity of the rivalry among existing firms in an industry:

■ Number and balance of competitors: With a larger number of competitors, it is more likely that one or more will try to gain customers by cutting prices.

■ Degree of difference between products: The degree to which products differ from one producer to another affects industry rivalry.

■ Growth rate of an industry: The competition among firms in a slow-growth industry is stronger than among those in fast-growth industries.

■ Level of fixed costs: Firms that have high fixed costs must sell a higher volume of their product to reach the break-even point than firms with low fixed costs.

Bargaining Power of Suppliers

In general, industries are more attractive when the bargaining power of suppliers is low. In some cases, suppliers can suppress the profitability of the industries to which they sell by raising prices or reducing the quality of the components they provide. If a supplier reduces the quality of the components it supplies, the quality of the finished product will suffer, and the manufacturer will eventually have to lower its price. If the suppliers are powerful relative to the firms in the industry to which they sell, industry profitability can suffer. Several factors have an impact on the ability of suppliers to exert pressure on buyers and suppress the profitability of the industries they serve. These include the following:

■ Supplier concentration: When there are only a few suppliers to provide a critical product to a large number of buyers, the supplier has an advantage.

■ Switching costs: Switching costs are the fixed costs that buyers encounter when switching or changing from one supplier to another. If switching costs are high, a buyer will be less likely to switch suppliers.

■ Attractiveness of substitutes: Supplier power is enhanced if there are no attractive substitutes for the products or services the supplier offers.

■ Threat of forward integration: The power of a supplier is enhanced if there is a credible possibility that the supplier might enter the buyer’s industry.

Bargaining Power of Buyers

In general, industries are more attractive when the bargaining power of buyers (a start-up’s customers) is low. Buyers can suppress the profitability of the industries from which they purchase by demanding price concessions or increases in quality. Several factors affect buyers’ ability to exert pressure on suppliers and suppress the profitability of the industries from which they buy. These include the following:

■ Buyer group concentration: If the buyers are concentrated, meaning that there are only a few large buyers, and they buy from a large number of suppliers, they can pressure the suppliers to lower costs and thus affect the profitability of the industries from which they buy.

■ Buyer’s costs: The greater the importance of an item is to a buyer, the more sensitive the buyer will be to the price it pays.

■ Degree of standardization of supplier’s products: The degree to which a supplier’s product differs from its competitors’ offering affects the buyer’s bargaining power.

■ Threat of backward integration: The power of a buyer is enhanced if there is a credible threat that the buyer might enter the supplier’s industry.

Industry Types and the Opportunities They Offer

Emerging Industries

An emerging industry is a new industry in which standard operating procedures have yet to be developed. The firm that pioneers or takes the leadership of an emerging industry often captures a first-mover advantage. A first-mover advantage is a sometimes insurmountable advantage gained by the first company to establish a significant position in a new market. Because a high level of uncertainty characterizes emerging industries, any opportunity that is captured may be short-lived. Still, many new ventures enter emerging industries because barriers to entry are usually low and there is no established pattern of rivalry.

Fragmented Industries

A fragmented industry is one that is characterized by a large number of firms of approximately equal size. The primary opportunity for start-ups in fragmented industries is to consolidate the industry and establish industry leadership as a result of doing so. The most common way to do this is through a geographic roll-up strategy, in which one firm starts acquiring similar firms that are located in different geographic areas. This is an often observed path for growth for businesses such as auto repair shops and beauty salons. It is difficult for them to generate additional income in a single location, so they grow by expanding into new geographic areas via either organic growth or by acquiring similar firms.

Mature Industries

A mature industry is an industry that is experiencing slow or no increase in demand, has numerous repeat (rather than new) customers, and has limited product innovation. Occasionally, entrepreneurs introduce new product innovations to mature industries, surprising incumbents who thought nothing new was possible in their industries. The lure of mature industries, for start-ups, is that they’re often large industries with seemingly vast potential if product and/or process innovations can be effectively introduced and the industry can be revitalized.

Declining Industries

A declining industry is an industry or a part of an industry that is experiencing a reduction in demand. Typically, entrepreneurs shy away from declining industries because the firms in the industry do not meet the tests of an attractive opportunity. Entrepreneurial firms employ three different strategies in declining industries. The first is to adopt a leadership strategy, in which the firm tries to become the dominant player in the industry. This is a rare strategy for a start-up in a declining industry. The second is to pursue a niche strategy, which focuses on a narrow segment of the industry that might be encouraged to grow through product or process innovation. The third is a cost reduction strategy, which is accomplished through achieving lower costs than industry incumbents through process improvements. Achieving lower costs allows a firm to sell its product or service at a lower price, creating value for consumers in the process of doing so.

Global Industries

A global industry is an industry that is experiencing significant international sales. Many start-ups enter global industries and from day one try to appeal to international rather than just domestic markets. The two most common strategies pursued by firms in global industries are the multidomestic strategy and the global strategy. Firms that pursue a multidomestic strategy compete for market share on a country-by-country basis and vary their product or service offerings to meet the demands of the local market. In contrast, firms pursuing a global strategy use the same basic approach in all foreign markets. The choice between these two strategies depends on how similar consumers’ tastes are from market to market.

Competitor Analysis

After a firm has gained an understanding of the industry and the target market in which it plans to compete, the next step is to complete a competitor analysis. A competitor analysis is a detailed analysis of a firm’s competition. It helps a firm understand the positions of its major competitors and the opportunities that are available to obtain a competitive advantage in one or more areas.

Identifying Competitors

The first step in a competitive analysis is to determine who the competition is. This is more difficult than one might think.

Sources of Competitive Intelligence

To complete a meaningful competitive analysis grid, a firm must first understand the strategies and behaviors of its competitors. The information that is gathered by a firm to learn about its competitors is called competitive intelligence. Obtaining sound competitive intelligence is not always a simple task. If a competitor is a publicly traded firm, a description of the firm’s business and its financial information is available through annual reports filed with the Securities and Exchange Commission (SEC). These reports are public records and are available at the SEC’s website (www.sec.gov).

Completing a Competitive Analysis Grid

A competitive analysis grid is a tool for organizing the information a firm collects about its competitors. It can help a firm see how it stacks up against its competitors, provide ideas for markets to pursue, and, perhaps most importantly, identify its primary sources of competitive advantage. To be a viable company, a new venture must have at least one clear competitive advantage over its major competitors.

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