(Originally published on OUBS Blog)
The business environment consists of all external influences that affect its decisions and performance. These should be analysed systematically and with continuous scanning, keeping in mind that it needs to be cost effective and not create too much information. You need to distinguish the vital from the merely important. One can focus on the industry environment for example, especially on customers, suppliers and competitors.
An industries profit comes from how perfect the market is. In general the price a customer wants to pay needs to exceed the cost the company incurrs. With growing competition that gap will close and in a perfect market, there will be perfect competition and hence virtually zero margin. The other extreem would be a monopoly with most markets sitting in between, being oligopolies.
Porter’s five forces framework is one way to look at industry stucture. It looks at the bargaining power of suppliers, threat of substitutes, bargaining power of buyers, threat of new entrants and industry competitors.
Competition from substitutes limits the price that can be asked. In case for gasoline, there is no substitute, meaning demand is inelastic in respect to price.
The threat of entry of other companies is especially valid once companies within that industry earn a return on capital in excees of its cost of capital. In many cases, only the threat is important enough. The absence of sunk costs, make an industry vulnerable to hit and run entry and exit of other companies. Barriers would here be capital requirements, economies of scale, absolute cost advantages, product differentiation (companies have brand recognition and loyalty, meaning high spending necessary.), access to channels of distribution, governmental and legal barriers and retaliation.
The nature and competition between existing firms can be found in:
- Concentration (how many companies make up how much of the market)
- diversity of competitors (more diversity, more competition)
- product differentiation (the more similarities, the more price cuts will likely be there)
- excess capacity and exit barriers (with high exit barriers, excess capacity will be used up just to get more contribution to fixed costs.)
- cost conditions (scale and fixed-variable costs ratios)
Bargaining power of buyers comes from buyers’ price sensitivity and their relative bargaining power (who is bigger, who is better informed, who can integrate vertically)
The bargaining power of suppliers comes together with the ease of changing suppliers and also the relative power they have which can be increased through cooperatives like unions.
This analysis can then be used to forecast industry profitability and to find strategies to alter industry stucture.
Defining the industry
Here you need to see what a relevant market really is. Is Jaguar in the motor vehicle market, automobile market or luxury car market? There needs to be some thing that bounds the industry together. In the major appliances marekt, this would be the use of the same factories for different appliances, not the potential to substitute a dishwasher with a fridge on the buyer side. For geographical boundaries, a good test is the price difference between markets, with markets forming arround a single price.
Porter’s five forces model can be seen as static though, which is something some people complain about. Competition is dynamic though and hence industry structure changes. This is way game theory comes in today.
On top of that there is another effect, which is not a competitive force though, being complements. This can rather change a view you have about an industry though, because it provides some reinforcements that are more important than some problems, potentially at least.
Joseph Shumpeter recognized the dynamic interaction between competition and industry structure. The question was whether current analysis is really a reliable guide to the natore of competition and performance in the future. In case where the pace of transformation is fast, there is little use in analysing structure.
In the new economy, we have a very software-based economy. The important thing here is that the initial cost of creation is high, but the subsequent copies cost much less. This means that the high costs of development lead to high competition for market share. Extreme scale economies, network externalities (users connected in networks) and rapid technology innovation creates “winner-take-all” markets.
Key success factors help identify factors that allow to attract more and more profitable customers. These can be identified through looking through the customers eyes. What will make you successful? What do customers want? How does a firm survive competition? Another method is the identification through modeling profitability. An example is given of the airline industry here, relating to ASMs (available seat miles) and RPMs (revenue passenger miles). Another method is through analyzing profit drivers, going from ROCE to ROS and Sales/Capital Employed and to closer measures from there.
Update: I am not providing free analysis as asked in the comments again and again. These are just course summaries. I am sorry that I am very high in the list on Google for some search terms related to this subject.
Update 2: Removed the comments in a move. Sorry for that.