CFA Institute

Industry Structure and Competitive Strategy: Keys to Profitability Author(s): Michael E. Porter Reviewed work(s): Source: Financial Analysts Journal, Vol. 36, No. 4 (Jul. - Aug., 1980), pp. 30-41 Published by: CFA Institute Stable URL: http://www.jstor.org/stable/4478361 . Accessed: 05/02/2013 10:12
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Sirneinre IndnItry and Cempellihive Sirhleny: In Kegs PrnlihhbiIiIg

of The intensity competitionin an industrydeterminesthe degree to which investment in inflowsdrive returnsto the freemarketlevel, hence the abilityof firms the industryto of is of sustainabove average returns. Intensity competition not a matter luck. The underlycharacteristics the industry ing economicand technological of determine strength the the of fivebasic competitiveforces-threatof new entrants, bargainingpower of buyers,rivalry between existing competitors,threat of substituteproducts and bargaining power of liketires,paper and steel,where no intensein industries suppliers.These forces rangefrom such as oil fieldequipmentand services, firm to earns spectacularreturns, mildin industries where high returnsare common. cosmeticsand toiletries, for The goal ofcompetitive strategy a companyis to finda positionin itsindustry where forceswill do it the most good or the least harm. A company may take a these competitive so defensiveposture,positioningitself thatits capabilitiesprovide the best defenseagainst it forces.Alternatively, can take an offensive the existingarrayof competitive approach by developing strategiesdesigned to influencethe balance of existingforcesor to exploit a balance beforerivalsrecognize it. change in the competitive in structural in The first environment step analysis is an assessment of the competitive which the company operates-the basic competitiveforcesand the strengthof each in The second is an assessmentofthecompany's own strategy-of structure. shaping industry to Taken together, these steps how well ithas positioneditself prosperin thisenvironment. a are the key to forecasting company's earningpower.

byMichaelE. Porter

HE success of a company's competitive strategydepends on how it relates to its environment. Although the relevant environment is verybroad, encompassing social as well as economic forces,the key aspect ofthe compais or ny's environment the industry industriesin whichitoperates. Industry has structure a strong influencein defining rules ofthe competitive the game as well as the strategiespotentiallyavailable to the company. The intensity competitionin an industryis of a matter of luck. Rather, competition is not rooted in underlyingindustryeconomics and

goes well beyondthe established comnpetitors. Notall industries haveequal potential. Theydiffer in fundamentally their ultimate profit potentialas thecollective of of strength theforces comThis is an adapted version of Chapter 1 in the forthcomingFree Press publicationentitledCOMPETITIVE STRATEGY: TECHNIQUES FOR ANALYZING INDUSTRIES AND COMPETITORS byMichael E. Porter. Copyright? 1980 by The Free Press, a Division of Macmillan PublishingCo., Inc. By permissionof the author and publisher. MichaelPorter Associate is at Professor theHarvardBusinessSchool. El 30

FINANCIAL ANALYSTS JOURNAL / JULY-AUGUST 1980

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Figure I

Forces Driving IndustryCompetition

__

Power Bargaining of rs Supplie rs

fl_
4

Threatof New Entrants

Power Bargaining of Buyers

Substitute Products

Threat of

petitiondiffers; forcesrange fromintense in the industrieslike tires,paper and steel, where no firm earns spectacularreturns, relatively to mild in industries such as oil field equipment and where highreservices,cosmeticsand toiletries, turnsare common. The essence of competitive strategy a comfor pany is to finda positionin its industry where it can best cope with these competitiveforcesor can influence themin itsfavor.Knowledge ofthe underlyingsources of competitivepressure can reveal the basic attractivenessof an industry, highlightthe criticalstrengthsand weaknesses of a company, clarify the areas where strategic changes may yield the greatestpayoffand pinpoint the industry trends that promise the greatest significanceas either opportunitiesor threats. Competitionin an industry continuallyworks to drive down the rate of returnon invested capital toward the competitivefloorrate of return,or the returnthatwould be earned by the economist's "perfectlycompetitive" industry. This competitivefloor,or "freemarket,"return is approximatedby the yield on long-term governmentsecuritiesadjusted upward by the risk of capital loss. Investorswill not toleratereturns below this rate for very long before switching their investment to other vehicles, and firms habitually earningless thanthisreturn willeventuallygo out of business.

StructuralDeterminantsof Competition

The presence ofratesofreturn higherthan the adjusted freemarketreturnserves to stimulate the inflow of capital into an industry either through new entry or through additional investmentby existingcompetitors.The strength of the competitiveforcesin an industrydetermines the degree to which this inflowof investment drives the returndown to the freemarket level, hence the abilityof firms sustain aboveto average returns. The state of competitionin an industrydepends on five basic competitive forces, illustratedin FigureI. The collectivestrength these of forcesdeterminesthe ultimateprofit potentialin the industry, where profit potentialis measured in termsofreturn investedcapital. As FigureI on demonstrates, competitionextends well beyond the established players. Customers, suppliers, substitutes and potentialentrantsare all competitorsand may be more or less prominentdecircumstances. pending on the particular All five competitiveforcesjointly determine the intensity industrycompetitionand profof itability, the strongest but forceor forcesbecome crucialfrom pointof view of strategy the formulation. For example, even a company witha very strongmarketpositionin an industry where potentialentrantsare no threatwill earn low returnsifit faces a superior,lower cost substitute. Even with no substitutes and blocked entry,intense rivalrybetween existingcompetitorswill limitpotentialreturns. Different forces take on prominence, of
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will enter. will depend The cost of entryintoan industry from existing compein parton theprobable reaction titors.If a potentialentrantexpects the incumto bentsto respond forcefully make itsstayin the industry costlyand unpleasant one, itmay well a decide not to enter.If the industryhas a history to of vigorous retaliation entrants,ifthe incumbent firmshave substantial resources to fight back (includingexcess cash and unused borrowing capacity,excess productivecapacityor great channels or customleverage with distribution ers), or if the industry'sgrowth is sufficiently slow that entryof a new competitorwould deof press the sales and financialperformance esthenpotentialentrants likely are tablishedfirms, fromincumbents. to meet strongretaliation The cost ofentrywill also depend importantly to into the industry.Entrybaron barriers entry thatgive incumriersare features an industry of bents inherent advantages over potential entrants.A number of industrycharacteristics commonlylead to such barriers. in resources order The needtoinvest large financial creates a barrier to entry, whether to compete those resources must be raised in the capital markets not. Whiletoday's majorcorporations or have the financialresources to enteralmost any in industry, huge capital requirements fields the limitthe like computersand mineral extraction pool of likelyentrants.Capital may be required not only for production facilities,but also for Threat of Entry or thingslikecustomercredit,inventories coverNew entrants an industry to bringnew capacity, ing start-up losses. Xeroxcreateda major barrier the desire to gain marketshare and often sub- to entry copiers,forexample, when itchose to in stantialresources. They can bid down prices or rentcopiers ratherthan sell them outright. inflatecosts, reducing profitability. Companies will generallybe at a disadPotentialentrants diversifying throughacquisitionintoan industry vantage in thecapitalmarkets. Unless a company from othermarkets oftenapply their resourcesto is enteringan industrythroughdiversification, cause a shake-up, as Philip Morrisdid withMil- the newcomeris in an inherently riskier position ler beer. Thus acquisition into an industrywith than the established firms,and this will be reintent to build position should probably be flected theriskpremiumsitwill have to pay to in viewed as entry, even ifit doesn't add a compe- attract capital. titorin the literalsense. A potentialentrantwill face barriersifthe inof Most often, the decision whether or not to dustry is characterized by economies scalewilldepend on declines in unitcostsofa product(or operationor enteror diversify an industry into theentry deterring price.The entry deterring price functionthatgoes into producing a product) as is that which, adjusted forproduct quality and the absolute volume produced per period inservice,just balances the potentialrewards from creases. 1 Scale economies deterentryby forcing entry(forecastby the potentialentrant)against the entranteitherto come in at large scale and or the expected costs. Of course, incumbentfirms riskstrongreactionfromexistingfirms to acmay eliminate the threat of entry by pricing cept a cost disadvantage, both undesirable opbelow the hypothetical entrydeterring price. If tions. Scale economies can be present in nearly theypriceabove it,gains in termsof profitability every functionof a business-production, remay be short-lived, since potentialentrantswill search and development, marketing, service forecastabove-average profitsfromentry,and 1. Footnotesappear at the end of article.
FINANCIAL ANALYSTS JOURNAL I JULY-AUGUST 1980 O 32

in course, in shaping competition each industry. In the ocean-going tankerindustry key force the is probablythebuyers(the majoroil companies), while in tires it is powerfuloriginalequipment marketbuyerscoupled with tough competitors. In the steel industry,the key forcesare rivalry with foreigncompetitorsand substitutematerials. The underlyingstructure an industry,reof flected in the strengthof its five competitive forces,should be distinguishedfromthe many short-run factors thatcan affect and competition profitability a transientway. Fluctuationsin in economic conditionsover the business cycle can influencethe short-run profitability nearlyall of firmsin an industry,as can materialshortages, strikes,spurts in demand and the like. While such factorshave tacticalsignificance, focus the of structural the analysis is on identifying stable, underlying characteristicsof an industry-its economic and technological structure-that shape the arena in which competitivestrategy must be.set. Industry structurecan shift gradually over and time, and firmswill have unique strengths weaknesses in dealing with structure.Yet unmustbe the startderstandingindustry structure ing pointforstrategy analysis. The keyeconomic and technological characteristics criticalto the of strength each competitiveforceare discussed below.

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utilization distribution.offoreclosure inputs markets itsproduct or network, sales force for of or in in recompetitors the industry Forexample, scaleeconomies production, ifmostestablished and are the are integrated search,marketing service probably (operatein successivestages of computer production distribution). such cases, inkeybarriers entry themainframe to in In or industry, Xerox as and GE sadlydiscovered. in-houseunitsor sell cumbents purchasefrom to func- their Scale economies mayrelate an entire entrant The unintegrated inputsin-house. or tional area,as inthecase ofa sales force, they will face a difficult time gettingcomparable or maystem from particular operations activities. prices and may get "squeezed" if integrated economiesof competitors In television manufacturing, set those it termsfrom offer different but scale are largein colortubeproduction less offered units. their captive in and need to significant cabinetmaking set assembly. Entry be deterred an entrant's by can be sep- secure Each component costsmust examined of Existfor channels itsproducts. distribution of of ing competitors arately determine extent economies to the may have ties with channels scale. service or highquality based on longrelations, is the contracts whereby channel a Scale economies sig- evenexclusive mayform particularly with manufacturer. in if barrier thecompanies an in- solelyidentified a particular nificant entry channels thatlogicaldistribution inte- To the extent diversified vertically or are dustry generally are the firms, that of A grated. company is part a multibusinessfor product servedby established mustpersuadethe channelsto if firm be abletoachieve scaleeconomies itis the newcomer may cooperausingpricebreaks, or subjectto acceptitsproduct, able to shareoperations functions and other measures allowances in the tiveadvertising of economies scalewithother companies A generally intoprofits. new foodprodcut firm. Consider,forexample,a companythat that from the mustdisplaceothers uct,for example, thatgo into smallelectric motors manufactures via proshelf supermarket competitive and industrial fans,hairdryers coolingsystems fiercely efforts heavyadveror selling intense assembled other di- motions, for by electronic equipment this pull. Sometimes to If visionsof the firm. its economiesof scale in tising createconsumer to to is it, motor manufacturingextend beyond the barrier entry so highthat, surmount a new distribumustcreatean entirely it number motors of neededin anyone market, new firm in to in that willreapeconomies motor manufacturing tionchannel order getintotheindustry. will it difficult to exceed those availableif it only manufactured Newcomers find particularly Thus related competewithestablished for for firms distribution motors use in, say,hairdryers. around commonoperationsor channelsand buyersif the industry characis diversification restraints functions remove can Product differimposed lim- terized product by differentiation. by The itedvolumeofa givenmarket.2 prospective entiationmeans that established firmshave or entrant must appropriately diversified face brand identification and customerloyalties be a costdisadvantage. customer serfrom past advertising, stemming and product are differences. infrequently, Not The benefits sharing particularly of potent vice Joint costs thesefirms benefit can from economies scale of can costs. whena company incur joint A The a occurwherea firm name,for product (or an as a result. costofcreating brand producing be once;thenamemay needonly borne that or of A) operation function is part producing instance, B. of mustinherently applied to otherproducts the produceproduct For exam- thenbe freely limit of constraints theamount company, ple,technological onlyto anycostsofmodificasubject on space airlinepassengerservicescan devoteto tion. A newcomer, the otherhand, must but existing distributor passengers, makeavailablecargospace and spend heavilyto overcome in Sinceitcan spreadthecostof and customer Investments building loyalties. payloadcapacity. the risky, sincethey putting planeintotheairoverbothpassen- a brandname are particularly in the that gersand freight, firm competes both are unrecoverable. is may have a substantial Productdifferentiationperhaps the most passengerand freight in in barrier baby care products, entry competing onlyone important advantageoverthefirm market.A similaradvantageaccruesto busi- over-the-counter investment drugs,cosmetics, in and publicaccounting. thebrewing In result banking nesseswhosemanufacturing processes is coupledwith that the industry, differentiation product The capture by-products. entrant cannot highest incrementalrevenue fromthe by- economies scaleinproduction, and marketing of if highbarriers. products will facea disadvantage incumbent distribution create to firms can. costs if Entry also be deterred switching are can The potential entrant facesthepossibility high. Switchingcosts are one-timecosts of also
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switching brands or switching from one rently For Fraschsulphur exists. example, firms supplier's product another's. to Switching costs likeTexas GulfSulphurgainedcontrol some of mayincludesuchthings employee as retrainingvery favorable domesulphur salt deposits many the years ago, beforemineralrightholderswere costs,thecostof new ancillary equipment, cost and timeneeded to testor qualify new aware of theirvalue as a resultof the Frasch a sourceorto redesign product eventhepsy- mining a or of Discoverers sulphurdetechnology. If a chiccostsofsevering relationship. suchcosts posits were oftendisappointed companies oil in are high,the entrant must offer major im- exploring oil. Similarly, a for established firms provement costor performance inducethe someindustries havecorneredfavorable in to locamay bid buyerto switch.For example,suppliers in- tions of before market forces up prices capture to travenous solutions kitsfor in hospitals their value.Potential and use full will at newcomers enter havedifferent procedures attaching for solutions a permanent competitive disadvantage. to patients, and the hardware hangingthe for solution bottles notcompatible. industry Experience Curve are This that is characterized relatively returns. by high Another factor creates important costadin stantial barrier some industries. Gov- nesses, unit costs tend to declineas the firm entry in can limit gainsmore cumulative experience production. ernment consciously unconsciously or is or even foreclose into industries, kinds of entry using Experience just a name forcertain suchcontrols licensing as requirements limits technological or change.Workers becomemoreefon access to raw materials (the classic learning (e.g., coal lands or ficient curve),layoutimsuitableforski areas). Governmentproves,equipment and processesbecomespemountains regulation restricts entry such industries cialized.Changesin product to as designtechniques trucking, railroads, liquor retailing, broadcastingand operationscontrolmake manufacturing and freight easier. forwarding. on with More subtlerestrictions entrycan stem Costdeclines seemtobe most experience fromgovernment subsidiesto incumbents significant businessesinvolving highlabor or in a fromgovernmental controlssuch as air and contentand/orcomplex assemblyoperations waterpollution standards product or safety and (aircraft, shipbuilding). Theyare nearly always in Pollutioncontrol efficacy regulations. require- greatest the earlyand growthphases of a ments raisecapital can and in neededfor entry can product's development,diminishing later increase requiredtechnological sophisticationphases. and evenoptimal scaleoffacilities. Standards for In some ways,cost declineswithexperience in product testing, common industries food operate thesamemanner scaleeconomies. like in as and otherhealth-related can can products, impose Experience lowercostsin marketing, distrisubstantial timeson getting an indus- butionand other lead into areas as well as production or within and but try, onlyraising costofentry giving operations not the production, each compoestablishedfirms ample notice of impending nentof costsmustbe examinedforexperience full of can entry and,sometimes, knowledge compe- effects. Diversification enhance costdeclines in titor Government products. policy suchareas due to experience, since diversified firms can but or certainly mayhave socialbenefits, it often shareoperations functions subjectto experihas second-order consequences entry go ence costdeclinesand unitsin diversified for that firms unrecognized. can benefit from experience the gainedbyother units.In thecase wherean activity While the barriersmentioned so far can related like to raw material fabrication sharedby multiple is be surmounted entrants perhaps by willing firms investthe capital,established may have business units,experience obviouslyaccumuthanitwouldiftheactivity not wereused other costadvantages replicable potential latesfaster by whattheir size and attained solelyto meettheneeds ofone company. entrants matter no of cited one ofthe as of someindustries Economies scaleareoften economies scale.Forinstance, are characterized by proprietary product reasons costs decline with experience. But of or on technology-know-how techniquesthat are economies scalearedependent volume per In or not and difvolume, arevery keptproprietary through patents secrecy. period, cumulative analytically costdeclines from withexpefirms havelockedup ferent may the others, established of also themost favorable material raw sources, tiedup rience.Economies scale and experience or properties entry as barriers. foreseeable raw material needs earlyat prices have verydifferent reflecting lower demand forthemthan cur- The presence economies scalealwaysleads a of of
FINANCIAL ANALYSTS JOURNAL / JULY-AUGUST 1980 n 34

curve. In some busiGovernment policymay also represent a sub- vantages is the experience

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to a cost advantage forthelarge-scaleor properly firm diversified overthesmall-scaleor undiversified firm,presupposing that the large firmhas the most efficient facilities, distribution systems, service organizationsand otherfunctionalunits forits size. Experience is a more ethereal entry barrier than scale. The mere presence of an experience curvedoes notensure an entry barrier. The experiencemustbe proprietary-i.e., not available to competitorsand potential entrantsthrough (1) copying,(2) hiring competitors' employees or (3) purchasingthelatestmachinery from equipment suppliersor therelevantknow-howfrom consultantsor others. Ifthe experiencecurvecan be keptproprietary by establishedfirms, thentheycan erectan entry barrier. withno experience, Newly startedfirms, will have inherentlyhigher costs than established firms and will have to incurheavy start-up losses frombelow or near-cost pricing before they can gain the experience requisite to cost paritywith established firms.Because of their lower costs, established firms(particularly the marketshare leader) will have highercash flows to investin new equipmentand technique. New entrantswill never catch up. A numberof firms (notably Texas Instruments,Black and Decker and EmersonElectric) have builtsuccessfulstrategies based on the experiencecurve throughaggressiveinvestments build cumulativevolume to in the development of their industries, early often by pricing in anticipation of futurecost declines. Many times, however, experience cannot be kept proprietary. Even when it can, it may accumulate more rapidlyforthe second and third firmsin the marketthan it did forthe pioneer. The later firms can observe some aspects of the pioneer's operations.In situationswhere experience cannot be kept proprietary, new entrants may actuallyhave an advantage iftheycan buy the latest equipment or adapt to new methods unencumberedby having operated the old way in the past. An experience barrier can be nullified by productor process innovationsleading to a subnew technology thatcreatesan entirely stantially new experience curve.3New entrantscan leapfrogthe industryleaders and alighton the new experience curve, to which the leaders may be poorlypositionedto jump. Similarly, technological change may penalize the large-scale firmif facilities designed to reap economies of scale are specialized, hence less flexiblein adapting to new technologies.

Commitment either to achieving scale economies or to reducingcosts throughexperience has some potentialrisks. It may cloud the perceptionof new technologicalpossibilities,or of other ways of competingless dependent on scale or experience.Emphasis on scale overother valuable entrybarrierssuch as product differentiationmay work against image or responsive service.Hewlett-Packard erectedsubstantial has barriersbased on technologicalprogressiveness in industries likecalculatorsand minicomputers, where otherfirms followingstrategies are based on experienceand scale. All entry barriers can and do change as conditions in the industrychange. The expirationof Polaroid's basic patentson instantphotography, for instance, greatlyreduced its absolute cost barrier builtby proprietary entry it technology; is not surprising thatKodak plunged intothe market. Product differentiation the magazine in printing has industry all but disappeared, reducing barriers. Conversely, in the auto industry economies of scale increased enormously with postwarautomationand vertical virintegration, tuallystopping successfulnew entry. While entry barriers sometimes change for reasons largely outside a company's control, company strategicdecisions can have a major impacton entry barriers. the1960s,manyU. S. In wine producers stepped up product introductions, raised advertising levels and expanded distribution nationally,increasingentrybarriers by raisingeconomies of scale and productdifferentiation and making access to distribution channels more difficult. Similarly,decisions by membersof the recreationalvehicle industryto integrateverticallyhave greatly increased the economies of scale there. Finally,some firms may possess resources or skillsthatallow themto overcome entry barriers into an industrymore cheaply than most other firms.Gillette,withwell developed distribution channels forrazorsand blades, facedlower costs ofentry intodisposable lighters thanmanyother potentialentrantswould have faced. Rivalrybetween existingcompetitorstakes the familiarformof jockeying for position-usingtacticslikepricecompetition, advertising battles, product introductionsand increased customer serviceor warranties.Rivalry occursbecause one or more competitors eitherfeelpressured or see the opportunityto improve position. In most
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Propertiesof EntryBarriers

RivalryBetween ExistingCompetitors

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industries, competitive movesby one firm have costsis low. A similar situation facesindustries noticeable effects its competitors thus whose products verydifficult costlyto on and are or may inciteretaliation. Firmsare consequentlystore.Here firms be vulnerable temptawill to mutually dependent. tionsto shade pricesin orderto ensuresales. A sequenceof actionsand reactions may or Thissort pressure of keepsprofits in lobster low maynotleavetheinitiating and theindustryfishing in industries manufacture firm and that ceras a wholebetter Ifmovesand countermoves off. tainhazardouschemicals. then firms theindustry suffer Whentheindustry all in escalate, may product perceiveda comis as and be worse offthanbefore.Some forms modity near-commodity, of or buyer choice will competition(notablyprice competition)are largely dictated price be by and service, creating highlyunstableand likelyto leave the entire strong pressures priceand service for competiindustry worse offfroma profitability stand- tion.Differentiation, theother on hand,creates point.Pricecutsarequickly easilymatched layersofinsulation and againstcompetitive warfare byrivals and, oncematched, lowerrevenues for becausebuyers havepreferences loyalties and to all firms unless industry priceelasticity de- particularsellers. Similar insulationagainst of mand is verygreat.Advertising is battles, the rivalry provided switching (defined on by costs earotherhand,maywell expanddemandor raise lier). -the levelofproduct in the differentiation indus- Rivalry increased pressures is by thatlead to try, thebenefit all firms. to of chronic For where overcapacity. example, economin Rivalry someindustries characterized icsdictate capacity be augmented in is that by can only such phrases as "warlike,""bitter"or "cut- large increments, capacity additions can be throat," while in otherindustries is termed chronically it to disruptive the industry supply"polite" or "gentlemanly."The intensity demand of balance, when is particularly there a risk rivalry be traced thepresence a number ofbunching capacity can to of of additions. The industry ofinteracting structural factors. mayfacechronic periodsofthekindofovercaWhenthecompetitors industry numer-pacity price inan are and cutting afflict that chlorine, vinyl ous, thelikelihood mavericks willtouch chloride ammonium of that and fertilizer. off is sincesomefirms believe Competitors arediverse strategies, rivalry great, that in may origins, theycan make moves without being noticed. personalities and relationships theirparent to Even ifthere relatively firms, they are few if are companiescreatevolatilerivalry because they in balanced termsof the resources relatively for have differing goals and differing ideas about sustained and vigorous retaliation, maybe how to competeand are continually they colliding proneto takeeach other On theother on. hand, head-onin the process.Theyhave a hardtime whenan industry highly is concentrated dom- accurately or readingeach others'intentions and inatedbyone ora fewfirms, relative powerwill agreeing therulesofthegamefor induson the be stable and apparentto everyone, and the try. Strategic for choices"right" one competitor leaderorleaders be abletoimposediscipline willbe "wrong"for others. will the through deviceslikepriceleadership. Foreign competitors add a greatdeal of often Slow is a industry growth generallydestabilizingdiversity industries to becauseoftheir differing forceforrivalry, since it can turncompetitioncircumstances and often differinggoals. intoa market sharegame forfirms seekingex- Owner-operators smallmanufacturingserof or pansion.Whenindustry is growth rapid,firms vice firms maybe willing acceptsubnormal to can improve results bykeeping withthe ratesofreturn their just on in up investment capital exin industry; fact, their all financial manage- changefor and suchlow returns independence; may rialresources maybe consumedby expanding appearunacceptable irrational a largepubor to withtheindustry. In liclyheld competitor. such an industry, the costs Highfixed createstrong for pressures all postureof the smallfirms may limitthe proffirms fill to capacity, which often leadstorapidly itability the largerconcern.Similarly, of firms escalatingprice cutting. a as Many basic materialsviewing market a dumping outlet excess for likepaperand aluminum suffer from prob- capacity adopt policiescontrary thoseof this will to lem. The key is fixedcosts relativeto value firms thatview the market their as mainbusiadded, rather than the absolutelevel of fixed ness. costs. Firmspurchasing high proportion a of Differences theway companies in competing costsin outsideinputs(low value added) may in an industry relate their to corporate parents is feelenormous pressures fill to capacity break another to important sourceof diversity. comA even, even if the absoluteproportion fixed panythatis one partofa vertical of chainofbusiFINANCIAL ANALYSTS JOURNAL / JULY-AUGUST 1980 El 36

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nesses within its corporate organization may FigureII Exitand Entry Barriers Combine well adopt goals very different fromthose of a free-standing company competing in the same EXIT BARRIERS industry. A company that represents a "cash Low High cow" in its parent company's portfolio busiof nesses will behave differently fromone being Low Worst Low developed forlong-rungrowth. Returns ENTRY Case Industryrivalry becomes even more volatileif BARRIERS in a numberoffirms theindustry have highstakes High Returns Best High Case But Risky, in achieving success. For example, a diversified firmmay place great importanceon achieving in success in a particular industry orderto further its overall corporatestrategy.Or a foreignfirm high but exitbarriers low. Here entrywill be are likeBosch, Sony or Philipsmay perceivea strong deterredand unsuccessfulcompetitors will leave need to establish a solid position in the U.S. the industry.Where both entryand exitbarriers market in order to build global prestige or are high, profitpotential is high but is usually Such firms technological credibility. maybe will- accompanied by more risk. Although entry is ing to sacrifice profitability the sake ofexpan- deterred,unsuccessfulfirms for will stay and fight in the industry. sion. While the case of low entry Finally,industryrivalry can be volatile when and exitbarriers is an industryfaces high exitbarriers-factors that unexcitingfroma profitability standpoint, the keep companies competing in businesses even worst case is where entrybarriersare low and though they may be earning low or even nega- exit barriersare high. Here entrantswill be attivereturns investment. on Excess capacitydoes tracted by upturns in economic conditions or not leave the industry, and companies thatlose other temporarywindfalls. They will not leave the competitivebattle do not give up. Rather, the industry, however,when resultsdeteriorate. theyhang on grimly and, because of theirweak- As a result,industrycapacity will stack up and ness, sometimesresort extreme will to tactics thatcan profitability usually be chronically poor. destroythe profitability the entireindustry. of Exit barriers may be high when assets are ShiftingRivalry Industryfeaturesthatdeterminethe intensity highlyspecialized to a particular business or location, hence difficult liquidate; when labor of competitiverivalry to can and do change. As an agreements, resettlementcosts or spare parts industrymatures, its growth rate declines, remaintenancecreate fixedcosts of exit; when in- sulting in intensifiedrivalry,declining profits terrelationships between one company and and (often) a shakeout. In the booming recreothersin a multibusinessfirm termsofimage, ationalvehicleindustry the early1970s, nearly in of marketingability, access to financial markets, every producer did well; but slow growthsince shared facilitiesand so on lend the business thenhas eliminatedthe highreturns all except to broader strategic members.The same storyhas been importance;when government the strongest denies or discouragesexitbecause ofjob loss and played out in industry after industryregional economic effects (particularly common snowmobiles, aerosol packaging and sports outside the U.S.); or when managements are equipment, to name a few. unwillingto make economicallyjustifiedexitdeRivalrycan also shiftwhen an acquisition incisions because of loyaltyto employees, fearof troduces a verydifferent personalityinto an inthe consequences fortheirown careers,pride or dustry.This has been thecase withPhilipMorris' otheremotional reasons. acquisitionofMillerBeer and Procter Gamble's & While exitbarriersand entrybarriersare con- acquisition of Charmin Paper Company. Also, ceptually separate, theircombinationis an im- technologicalinnovation can boost the level of Exit fixed costs in the productionprocess and raise portant aspect ofthe analysisofan industry. and entrybarriersoften rise and fall together. the volatility rivalry, it did in the shift of as from The presenceofsubstantialeconomies ofscale in batch to continuous-line photofinishing the in production, for example, usually implies spe- 1960s. cialized assets, as does the presence of proprie- While a company must live with many of the tarytechnology.FigureII illustrates possible factors determining the intensity of industry the combinations.The best case fromthe viewpoint rivalry thatare built into industryeconomics, it of industryprofitsis where entrybarriersare may have some latitude to influence rivalry
FINANCIAL ANALYSTS JOURNAL / JULY-AUGUST 1980 1I 37

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throughits choice of strategy.A company may tryto raise buyers' switchingcosts by designing its product into its customers' operations or by making its customers dependent for technical advice. A company can attemptto raise product differentiation through new kinds of service, marketing innovations or product changes. Focusing selling efforts the fastestgrowing on segmentsoftheindustry on market or areas with the lowest fixedcosts can reduce the impact of industryrivalry.If it is feasible,a company can withcompetitors havtryto avoid confrontation ing high exit barriers, thus sidestepping involvementin bitter price cutting. All firms an industry competing,in a broad in are sense, with industries producing substitute products. Substituteslimitthe profit potentialof an industryby placing a ceiling on the prices firms theindustry charge.The moreattracin can tive the price-performance tradeoffofferedby the substitutes,the tighter lid on industryprofits. Sugar producers confronted with the largescale commercializationof high fructosecorn are syrup,a sugar substitute, learningthislesson today, as are producers of acetyleneand rayon, who face tough competitionfromlower cost alternatives. Substitutes not only limit profitsin normal times, but also reduce the bonanza an industry can reap in boom times.In 1978,the producersof fiberglass insulation enjoyed unprecedented demand as a result of high energy costs and severe winterweather. But the industry'sability to raise prices was temperedby the plethora of insulation substitutes,including cellulose, rock wool and styrofoam. These substitutes are bound to become an even stronger force once the currentround of plant additions by fiberglass insulation producers has boosted capacity enough to meet demand (and then some). substitute Identifying productsentails searching forotherproductsthatcan perform same the as funiction the product of the industry.Sometimesthiscan be a subtletask, one thattakes the analyst into businesses seemingly far removed from the industryin question. Securities, for alterexample, face increasingcompetitionfrom nativeinvestments such as real estate,insurance and money marketfunds. Government regulations, subsidies and tax policies should also be considered in the search forsubstitutes. The U. S. government currently is promotingsolar heating,forexample, using tax incentivesand researchgrants.Governmentde-

Pressure from Substitute Products

control of natural gas is quickly eliminating acetylene as a chemical feedstock. Safety and relativecost and pollution standards also affect quality of substitutes. Attention should focuson substitute products that (a) are enjoying steady improvement in price-performance tradeoff with the industry's product, (b) would entail minimal switching costs forprospectivebuyers or (c) are produced by industriesearning high profits.In the latter case, substitutesoftencome rapidlyinto play if some development increases competition in their industries and causes price reduction or performance improvement. defense against substituteproducts Effective action. While admay require collective industry in vertising one firm an industry by does little to bolster the industry'sposition against a substitute, heavy and sustained advertisingby all industryparticipants may well improvethe industry's collective position against the substitute. Similar arguments apply to collective industry response through industry groups and other means in areas such as product quality imand product disprovement,marketingefforts tribution. Trend analysis can be importantin deciding whether company strategyshould be directed toward heading offa substitutestrategically or accepting the substitute as a key competitive force. Electronic alarm systems, for example, represent a potent substitute in the security guard industry.Electronicsystemscan only beas come more important a substitute since laborintensiveguard servicesfaceinevitablecost escalation, while electronicsystemsare highlylikely and decline in cost. to improve in performance Here the appropriateresponse of security guard firms probablyto offer is packages of guards and electronic systems,withthe security guard redefinedas a skilledoperator,rather thanattempt to compete against electronicsystemswith a traditional guard service. Buyers represent a competitive force because theycan bid down prices,demand higherquality or more services, and play competitors off againsteach other-all at theexpense ofindustry The profitability. power ofeach important buyer of group depends on a numberof characteristics its market situation and on the relative imthe comportanceofits purchases from industry pared with the industry'soverall business. A buyer group will be powerfulif itpurchases

Bargaining Power of Buyers

large volumes relativeseller to sales, that so retaining

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to important theseller. products are standard or undifferentiated, itsbusinessis financially potent buyers, Large volume buyersare particularly surethat can alternative they alwaysfind the if costscharacterize indus- suppliers, forces heavyfixed may play one companyagainstanand other, they in aluminum and try in cornrefining bulkchemicals) (as extrusion. as do occupied. raisethestakesto keepcapacity Most sourcesof buyerpower apply to conif and commercial pur- sumeras well as to industrial Buyer poweris enhanced theproducts a tendtobe more chased from industry the representsignificant For consumers buyers. example, In fraction total of purchases. thiscase, thebuyer pricesensitive theyare purchasing if products to orexpensive relative willbe proneto expendtheresources necessary that undifferentiated are priceand to purchase their to shop fora favorable incomes. is If sold bytheindustry selectively. theproduct is and The powerofwholesalers retailers deof a smallfraction thebuyer'scosts,thebuyer termined thesamerules,withone important by Simi- addition.Retailers gain significant willusuallybe muchless pricesensitive. can bargainhas suffering lowprofits great ing powerovermanufacturerstheycan influfrom larly, buyer a if to purchasing costs.Suppliers ence incentive lower to as do consumers' decisions, they in purchasing that for are Chrysler, example, complaining they audio components,jewelry,appliances and are being pressed forsuperiorterms.Highly sporting wholesalers gain can goods. Similarly, are less profitable buyers generally pricesensi- bargaining the can powerifthey influence decitive and more concernedabout the long-run sionsoftheretailers other firms which or to they suppliers (that unlessthepur- sell. is, health their of a of chase represents largefraction their costs). if havea lot Buyer poweris also increased buyers AlteringBuying Power ofinformation market about conditions, supplier The power of buyerscan rise or fallas the to costsand offers other buyers. creating buyer powerchange underlying factors are integratedwithtimeor as a result a company's already partially Ifbuyers either of strategic a orpose strong threat backward integration, decisions.In theready-to-wear they of indusclothing conces- try, example, buyers to are in a position demandbargaining for the stores (department like sions.Majorautomobile producers General and clothing havebecomemoreconcenstores) Motors and Fordfrequently thisbargainingtrated control passedtolarge use as and has chains; a of inte- result, industry come underincreasing lever.Theyengagein thepractice tapered has the needs fora buyerpressure or some of their gration, producing marand suffered falling profit the gins.So far industry been unableto difin-houseand purchasing givencomponent the has outside suppliers.Not only is their ferentiate products to engender rest from its or switching threat further of credible, coststhat integration particularly in to wouldlockitsbuyers sufficiently de- neutralize givesthem butpartial manufacture in-house thesetrends. aid tailedknowledge costs,whichis a great in A company's of choiceofthebuyer groupitsells neu- to is a crucial Buyerpowercan be partially negotiation. decision.A company can strategic in a offer threat improve strategic whenfirms theindustry tralized buyers posture finding by its offorward into industry.who possess the least power to influence integration thebuyer's it the product the adversely-in otherwords, by buyer on selection. of supplier's Finally, impact the a sellsto do groups company will business helpdetermine bargain- Rarely allthebuyer the buyer's sellsto a Even ifa company If ing power of purchasers. the qualityof the enjoyequal power. there are usually segments by buyer'sproductis verymuch affected the single industry, thatexerciseless power the will withinthatindustry of product, buyer quality theindustry's thanothers. are For sensitive) be generally less price sensitive.In oil field (andthat lessprice a for can the market mostprodfor equipment, instance, malfunction lead example, replacement costof ucts is less price sensitivethan the original to largelosses (as witness enormous the the recentfailure a blowoutpreventer a equipment of in market. Mexican offshoreoil well); the quality of medicaland test in- Bargaining Powerof Suppliers enclosuresforelectronic in a force an instruments greatly can influence user's im- Suppliers exert competitive the can the of or of in- dustry raising by prices reducing quality aboutthequality theequipment pression the goods theysell. Such price increasescan side. Finally, switching (defined costs earlier) the squeeze profitability ofan industry lock out unableto in sellersand mitigate buyer recover costincreases itsown prices.Byraisbuyerto particular power. On the otherhand, if the industry'sing theirprices,forexample,chemicalcom/ 1980 FINANCIALANALYSTSJOURNAL JULY-AUGUST a 39

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panies have contributed theerosionof prof- the westernUnited States. Many times govto itability contract of aerosolpackagers becausethe ernment's role as a supplieror buyeris deterpackagers, facingintense competitionfrom mined than more political by factors byeconomic self-manufacture their by customers, have lim- circumstances, thisis probably fact life. and a of itedfreedom raisetheir to prices. The conditions determining supplierpower beyond a company's control. are are frequently The conditions making suppliers powerful can largely inverse thosemaking the of buyers pow- However,as withbuyerpower,the firm erful.If a suppliergroupis dominated a few sometimes improve its situation through by It a of than industry strategy. can promote threat backward it and concentrated the companies more seek to eliminate switching costs influ- integration, considerable sellsto,itwillbe able to exert and terms. theother and thelike. On ence on prices, quality hand, the power of even large, powerful if Analysisand can havetocompete Structural suppliers be checked they with Industries alternative Competitive substitutes. producing Strategy in affecting competition an infor sweeteners, example,competesharplyfor Once the forces and theirunderlying dustry causes have been many applications even though individual a is to are to custom- diagnosed, company ina position identify suppliers largerelative individual its strengths weaknessesrelative theinand to ers. The crucialstrengths weaknesses and If suppliers to a number industries, dustry. of so sell a standpoint the company's are a thatone particular industry notrepresent from strategic does will causes ofeach significant fractionsales, of they be muchmore posturevis'a vis the underlying force. Wheredoes it standagainst If is pronetoexert pricing pressure. theindustry competitive will substitutes? fortunes barAgainstthe sourcesof entry an important customer, suppliers' fromestablished will riers?In copingwith rivalry and tied be closely totheindustry, suppliers wantto protect industry the through reasonable competitors? in and assistance activities research Competitive like pricing is offensive deor strategy taking and in and development lobbying. a company's fensive to action order strengthen andswitching cutoff costs buyers' position in relation to the five competitive Differentiation one supplier againstan- forces-positioningthe company so that its off optionsin playing the otherand raise supplierpower. And a crediblecapabilities the provide bestdefense against threat forward of integration provides a check existing of array competitive forces, influencing an the to moves against industry's ability improve terms the balance of forces through strategic whichit purchases. on thatimprove company's the relative or position Itis important recognize as to labor a supplier, anticipating in shifts the factors the underlying and one that exerts great powerin manyindus- forces responding as toexploit and so change by that choosing strategy tries. There substantial is evidence a to empirical appropriate thenewcomit. skilled balancebefore rivals recognize scarce, highly employees (e.g., engineers petitive A positioning and scientists) and/or unionized takes of laborcan strategy thestructure the tightly bargainaway a significant fraction potential industry givenand matchesthe company's of as in The thatdeter- strengths and weaknessesto it, buildingdeprofits an industry. features mine the potentialpower of employeesas a fenses forces finding or againstthecompetitive wherethe forces are supplier include those outlined above plus positionsin the industry and of labor'sdegree organization theability the weakest. Knowledge of the company's of of to of varieties employees expand. capabilities ofthecauses ofthecompetitive and supply scarce and will highlight areas wherethe comWhere laboris strongly the of forces organized supply from and scarceemployeesconstrained expansion, panyshouldconfront competition whereit in can If they be a factor competition. should avoid competition. the companyis a which it Government, hasbeendiscussed primar- low costproducer, example, maychooseto for on of bar- confront ilyin terms itspossibleimpact entry powerful buyerswhileit takescare to as riers,mustalso be recognized a potentiallysellthem not to onlyproducts vulnerable compepowerful buyerand supplier.In these roles, tition from substitutes. can influence a company takean offensive can compe- Alternatively, government often industry titionby the policies it adopts. Government approach developing to by strategies designed inplaysa crucial as a buyer defense-related uence balance competitive Innovations role of fi the of forces. the in marketing raise brandidentification products as a supplier timber and of through can or Forest Service's control vasttimber of reserves otherwise in differentiate company's the product.
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costsandtheeventual of capital importance fixed costsin production. Of course,no structural can analysis be complete without diagnosisof how presentand a future government at policy, all levels,mayaffectcompetitive conditions.For purposes of it strategic analysis is usuallymoreilluminating In in sources competition.the toconsider of exploit changes the howgovernment affects competition de- through five familiar productlifecyclepatternofindustry the competitive forces thanto convelopment,forexample, growthrateschange ag sider it as a forcein and of itself.However, the business matures, advertisingdeclines and strategy maywell involvetreating government vertically. companies tend to integrate as a factor be influenced. to
Capital investments in large-scale facilitiesor vertical integrationcan bolster entry barriers. Structuralanalysis can be used to identifythe thatwillbe most suscompetition factors driving action. ceptibleto strategic Industry evolution is importantstrategically because evolution can present opportunitiesto These trends are not so importantin themthe is selves; what is critical whethertheyaffect structural sources of competition.For example, both in manufacextensiveverticalintegration, turingand in softwaredevelopment, is taking place in the maturingminicomputerindugtry. trendhas greatlyincreased This verysignificant economies of scale as well as the amount ofcapital necessaryto compete in the industry.This in turn has raised entrybarriersand threatensto out drivesome smallercompetitors ofthe industry. Obviously, the trends carryingthe highest a standpointare those that priority from strategic the sources ofcompetition affect mostimportant in the industry and those thatelevate new strucIn turalfactors the forefront. contractaerosol to packaging, forinstance, the dominanttrendtohas ward less product differentiation increased the power of buyers, lowered the barriers to competition. entryand intensified

The framework analyzing for industry compeis useful setting in tition obviously diversification a sinceitprovides guidefor strategy, answering the extremely difficult in questioninherent diversification decisions: Whatis the potential of thisbusiness? The framework allowa commay pany to spot an industry with a good future thispotential reflected thepricesof before is in acquisition candidates. will also help a comIt panyidentify industries whereitsstrengths will allowittoovercome entry barriers morecheaply thanother firms. theframework helpin And can identifying that acquisitions can takeadvantage ofexisting operations-for example, acquisitions thatwould allow a firm overcome entry to key barriers providing by sharedfunctions preor withdistribution existing relations channels.M

Structural Analysisand Diversification

in long is to Footnotes run Thetask structural analysis the of the "product," the each examine competitive forecast magnitude1. To avoid needlessrepetition, term force, rather than"product service," used throughor is a cause ofeachunderlying and constructcomposite outtorefer the to output an industry. princiof The Of profit potentialthe of industry. picture the of likely ples of structural analysiswill apply equally to

considerablyfrom course, thispicturemay differ product service and businesses. Theyalso applyto industry in competition any country internaor presentrealities.Today, the solar heating busitionalmarket, although some of the institutional ness is populated by dozens and perhaps huncircumstances differ. may dreds of companies, none with a major market 2. Forthisentry barrier be significant,is crucial to it is are position. Entry easy and competitors battlthat sharedoperation function subject the or be to ing to establishsolar heatingas a superiorsubstieconomies scale thatextend of beyondthesize of anyone market. thisis notthecase,costsavings If tute forconventionalheatingmethods. ofsharing be illusory. company A can maysee its The potential of solar heating will depend costs declineafter a entering relatedbusinessas largelyon the shape of futurebarriersto entry, o7t"headis spread, thisdependssolely the but on of the improvement the industry'spositionrelapresence excess of in capacity theoperation funcor the of tiveto substitutes, ultimateintensity comin tion thebase business. Sucheconomies short are run,and oncecapacity fully is utilized true the cost petitionand the power thatwill be captured by ofthesharedoperation becomeapparent. will will, buyers and suppliers. These characteristics of drawn from history the the of in turn,be influencedby such factors the es- 3. Foran example this as automobile industry, William Abernathy see J. and tablishmentof brand identities,the creation of KennethWayne, "The Limitsof the Learning significant economies of scale or experience Curve," HarvardBusinessReview,Septemberthe ultimate October curves in equipment manufacture, 1974,p. 109.

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