The Analytical Dilemma An effective business strategy should meet the opportunities and threats of the external environment, as well as deal with the strengths and weaknesses of the internal environment. Determining opportunities and threats is traditionally limited to analyzing the social, economic, political, cultural, technological and ecological factors affecting the operation of a firm. However, managers and analysts find this too remote an environment to create an immediate significant impact on the firm. In the literature on strategic planning, is there a construct or model on a more immediate external environment could be used for analysis? Not too far removed from day-to-day operation is the competitive environment, commonly referred to as industry.
If the forces shaping competition in an industry is identified and analyzed and their impact on the profitability potential or attractiveness of the industry are determined, then the discipline of strategic planning has a more pragmatic approach to external environment analysis. This is because an assessment of the competitive forces’ impact on the profitability potential of an industry can pinpoint a firm’s most economically attractive competitive position, thereby presenting a clearer and more solid picture of opportunities and threats in the external environment. As Pearce and Robinson attested, for a firm to establish a strategic business agenda, it must “understand how they (competitive forces) work in its industry and how they affect the company in its particular situation.” (Pearce and Robinson 2000, 85) The Model The more recent contribution to the body of knowledge on strategy formulation precisely answers the need for an analytical tool on the competitive environment. Delving precisely into the industry’s sources of competitive pressure and competitive strength, the Five Forces Model developed by Michael Porter in his landmark book Competitive Advantage: Creating and Sustaining Superior Performance systematically diagnoses the major competitive forces in an industry (Porter 1998; the Five Forces Model is summarized on the first chapter while the rest of the book illustrates application of concepts).
By providing an analysis of the competitive structure, the model presents the interplay of economic and technological forces that affect the profit potential of an industry. “Identifying the profit potential (i.e., attractiveness) of an industry provides the foundation for bridging the gap between the firm’s external environment and its resources.” (Fleisher and Bensoussan 2003, 61).
The main objective of the Five Forces Model is to build a company’s competitive advantage by way of a profitable business and an attractive market position. The competitive environment is attractive when rivalry is tamed, entry barriers are stiff, suppliers and customers are in a weak bargaining position, and good substitutes do not exist. One of the more comprehensive discussions on competitive forces is provided in the book Strategic and Competitive Analysis, as summarized in the foregoing paragraphs (Fleisher and Bensoussan 2003, 61- 64): Threat of New Entrant Entry barriers determine the difficulty level facing new competitors. Low barriers mean that new firms can easily add capacity to the industry and increase demand and prices for inputs, thus lowering industry profitability. Some entry barriers that determine the threat of new entrants are: • Entry-deterring price.
If the marginal costs of entry is higher than the marginal revenues, no new firms will enter the industry. • Incumbent’s retaliation. A signal of high response intensity of existing firms to new rivals (such as control of substantial resources) is enough to discourage new entrants to the industry. • High capital costs.
The capitalization requirement may bar entry to an industry especially if a high proportion of the start-up costs are unrecoverable, more so because new entrants generally build into their capital cost structure a higher risk premium. • Cost advantages of incumbents. Cost advantages of incumbents which are not available to potential rivals are: experience in the industry, easier access to valuable inputs, patents and proprietary technology, government subsidies, or control of best locations. • Product differentiation. Brand-differentiated products can bar entry because they force potential new entrants to spend heavily to overcome existing brand loyalty. • Access to distribution channel.
Having to overcome the incumbent’s established relations with distributors are real obstacles to hurdle for a new entrant trying to make inroads into a new market. • Government. Some of the entry barriers posed by interventionist government policy are subsidies to incumbents, entry restrictions, and regulations that raise capital costs. • Switching cost.
Product switching is often costly to consumers, thus heavily favoring the incumbents’ competitive position. Bargaining Power of Suppliers With the capability of suppliers to influence the cost, availability, and quality of input materials, they can exert pressure on industry players to raise their prices or reduce the quality of the purchased goods or services. Factors that can influence the bargaining power of supplies are: • Concentration. Supplier power is high if the supplier industry is concentrated and dominated by fewer large firms than the industry it sells to, as the buyers will have less choice in matter of supply. The only antidote to this situation is availability of substitute inputs.
• Product differentiation. Supplier power is high if the suppliers’ product is unique or highly differentiated, as buyers have no choice but to buy the product. • Switching costs. The ability of an industry to cost-effectively switch suppliers can decrease supplier influence • Organization. Increase supplier power can come from increased collective bargaining strength of supplier organization (e.g.
, cartels, unions, patents, copyright). • Government. If the government functions as a supplier, it can exert significant bargaining force. Bargaining Power of Buyers The power of the firm’s customers emanates from their potential to push prices down by comparison shopping, or to elevate quality expectations. The following are factors that influence buyers’ bargaining power: • Differentiation.
A unique set of product attributes can decrease buyer power while a commodity product can increase buyer power. • Concentration. Buyer power is high if the buyer represents a high proportion of the firm’s sales. • Importance.
Buyer power is high if the proportion of total buyer’s purchases sold by an industry is high. A slight reaction by the buyers on price or quality will create wide impact on an industry’s sales. • Profitability. Low profitability by a buyer will mean more price sensitivity and more pressure on industry players to lower their costs.
• Importance of Quality. If product quality is important to the buyers, they will be less price sensitive and will unlikely exert pressure on industry players to lower price. • Access to information. The higher the knowledge about industry structure the higher the buyer power. • Threat of backward integration. Opportunities for backward integration will enhance buyer power because this will enable the buyers to have their own ready supply of the product.
Threat of Substitute Products or Services The availability of substitute products can retard the firm’s profit potential because they can place price ceiling, or reduce demand volume. Substitutes will more likely attract buyers in conditions such as these: • Relative price/ Performance trade-off . The threat of substitutes is high if existing or potential competitive products offer a lower cost or more favorable product attributes. • Switching costs. If the switching costs are low, the likelihood of the buyers turning in to substitute products is high. • Profitability.
A high threat of substitution comes from a highly profitable provider of a credible substitute product or service. Rivalry Among Existing Competitors. The intensity of competition within an industry, recognized by many as the principal cost driver of firms, is conditioned by several factors: • Market growth. High market growth decreases rivalry because no sales growth is displaced by the sales growth of another. • Cost structure. A high fixed cost structure brings about overcapacity (and intensified fight for market share) during low demand periods.
• Barriers to exit. Low-profit firms may be forced to remain in the industry for several reasons, including asset specialization, fixed costs of exit, emotional attachment, government restrictions, or product-market importance in the firm’s strategic options. If it is difficult for a player to sell-out, the intensity of rivalry tends to increase. • Switching costs. Differentiated products lock in buyers due to high switching costs. This reduces intensity of rivalry.
• Diversity. Rivalry is high in an industry that is composed of many firms of equal size and competitive position, when new entrants come from different geographic locales, and when strategic intents clash. Limitations of the Model Although the Five Forces Model is one of the more popular frameworks for industry analysis, it suffers from the major disadvantage of overly emphasizing external forces. This emphasis “underestimates the core competencies of a firm that may serve as its competitive advantage.
” (Fleisher and Bensoussan 2003, 66). The overemphasis virtually underplays the internal organizational dynamics which, as experience shows, account for much of the operational problems of firms. Another weakness of the model is its “lack of explicit recognition of the importance of sociopolitical factors” (Fleisher and Bensoussan 2003, 66). This makes the model unrealistic today as sociopolitical factors play a very significant role in shaping industry structure and profitability.
Notwithstanding these limitations, the model “dominates the strategy-making processes used by most companies around the world.” (Onsman 2004, 17). At best, the construct could be used for creating a higher level of awareness about industry issues, as the model could provide a solid platform for extended analysis and for understanding the industry’s impact on the firm’s strategic directions. BIBLIOGRAPHY Fleisher, Craig S.
and Babette F. Bensoussan. Strategic and Competitive Analysis: Techniques for Analyzing Business Competition. New Jersey: Prentice-Hall, 2003. Onsman, Harry.
Management Powertools. Sydney: McGraw-Hill Australia, 2004. Pearce, John A. II and Richard B. Robinson. Strategic Management: Formulation, Implementation and Control.
Boston: Irwin McGraw-Hill, 2000. Porter, Michael E. Competitive Advantage: Creating and Sustaining Superior Performance. London: The Free Press, 1998.
