competitiveness, rather than short-term factors such as stock market movements, who won the election, or even something as trivial as inclement weather, which is often an excuse proposed by pundits on TV to explain slow Christmas sales. It is not that short-term factors are not important or have no impact, but they simply do not affect competition to the degree that long-term factors do, as revealed in the Five-Forces Model.
As illustrated in Figure 3-3, the Porter’s Five-Forces Model offers guidance to strategists in formulating strategies to keep rival firms at bay. According to Porter, the nature of competitive- ness in a given industry can be viewed as a composite of five forces:
1. Rivalry among competing firms 2. Potential entry of new competitors
3. Potential development of substitute products 4. Bargaining power of suppliers
5. Bargaining power of consumers Rivalry among Competing Firms
Rivalry among competing firms is usually the most powerful of the five competitive forces and the most traditional factor analyzed by managers. It is also the only factor most affected by changes in the other four factors. Strategies pursued by one firm can be successful only to the extent that they provide competitive advantage over the strategies pursued by rival firms. Intense rivalry among competitors in an industry can decrease overall industry profits because firms often lower prices or spend extra on advertising to maintain market share, often transferring profits directly to consumers and other players in the Five-Forces Model. Rivalry among competing firms increases for numerous reasons as given in Table 3-5, including an increase in the number of competitors and a shift towards competitors becoming more equal in size and capability.
As rivalry among competing firms intensifies, industry profits decline, in some cases to the point where an industry becomes inherently unattractive. Changes in strategy by one firm may be met with retaliatory countermoves, such as lowering prices, enhancing quality, adding features, providing services, extending warranties, and increasing advertising—especially when a firm senses weakness from another. Although avoiding high-rivalry industries would be ideal, that is often easier said than done. At times it may be best to look for an industry with more favorable five forces and reduced rivalry, but firms can also compete within a similar or sub-industry by offering products targeting different customer groups with dif- ferentiated products. Offering differentiation helps all firms in the industry by moving away from competing on cost, where unique customers can be better served while maintaining profits for firms.
Potential development of substitute products
Bargaining power of consumers Bargaining power of suppliers
Potential entry of new competitors Rivalry among competing
firms
FIGURE 3-3
The Five-Forces Model of Competition
Potential Entry of New Competitors
Whenever new firms can easily enter a particular industry, existing firms are likely to face threats of reduced market share. In such industries, a firm’s strategies should deter new firms from enter- ing the market to avoid further saturation of the market. Example barriers to entry can include economies of scale, specialized know-how, strong brand reputation, established customer loyalty, high capital requirements, absolute cost advantages, highly efficient supply chains, specialized distribution channels, access to key raw materials, and possession of patents. The automotive oil-change industry, for example, has relatively low barriers to entry; whereas the smartphone industry has much higher barriers to entry.
Despite numerous barriers to entry, new firms sometimes enter industries with higher-quality products, lower prices, and substantial marketing resources. When the threat of new firms enter- ing the market is strong, incumbent firms generally fortify their positions and take swift actions to deter new entrants, such as lowering prices, extending warranties, adding features, or offer- ing financing specials. Even the threat of new entrants can increase rivalry and thus reduce profitability.
Potential Development of Substitute Products
In many industries, firms are in close competition with producers of substitute products in other industries. Examples are beer, wine, and liquor; public transportation and car, bike, and taxi/
Uber; natural gas, electricity, and solar power; glass bottles, paperboard containers, and alumi- num cans. A high threat of substitutes exists when consumer needs can easily be filled by one or more substitute products outside of the firm’s industry. Competitive pressures arising from substitute products increase as the relative price of substitute products decline and as consumers’
costs of switching decrease.
The presence of substitute products puts a ceiling on the price that can be charged before consumers will switch to the substitute product. Price ceilings equate to profit ceilings and more intense competition among rivals. Producers of eyeglasses and contact lenses, for example, face increasing competitive pressures from laser eye surgery. Producers of sugar face similar pres- sures from artificial sweeteners. Newspapers and magazines face substitute-product competitive pressures from the Internet and 24-hour cable television. Substitute products can also come from places not normally expected. For example, a diamond producer may not consider a honeymoon package as a substitute for a less expensive ring. The bottom line with this “force” is that strate- gists must manage the potential threat of substitute products.
Bargaining Power of Suppliers
The bargaining power of suppliers refers to the ability of suppliers to raise the price of any inputs into the industry. This “force” affects the intensity of competitiveness in an industry, especially when there are few substitutes available for the product offered by suppliers, when the cost of switching to an alternative product offered by a different supplier is high, when the industry is not a key source of the supplier’s revenues, or when there are few suppliers.
TABLE 3-5 Conditions that Cause High Rivalry among Competing Firms 1. When the number of competing firms is high
2. When competing firms are of similar size 3. When competing firms have similar capabilities
4. When demand for the industry’s products is changing rapidly 5. When price cuts are common in the industry
6. When consumers can switch brands easily 7. When barriers to leaving the market are high 8. When barriers to entering the market are low 9. When fixed costs are high among competing firms
10. When products are perishable or have short product life cycles
In some cases, firms pursue a backward-integration strategy to compete with suppliers. This strategy is especially effective when suppliers are unreliable, too costly, not capable of meeting a firm’s needs on a consistent basis, or simply have too much bargaining power and are able to charge absorbent prices. Boeing and Airbus, the two largest jetliner manufacturers, are beginning to make a portion of the parts that go into planes because both firms determined too high of a proportion industry profitability was going to suppliers. A key lesson for suppliers is that if your customer has the means to backward-integrate, it may be best to renegotiate prices.
Overall, firms are in a better position when numerous suppliers exist. It is often in the best interest of both suppliers and producers to assist each other with reasonable prices, improved quality, development of new services, just-in-time deliveries, and reduced inventory costs, thus enhancing long-term profitability for all concerned. In more and more industries, sellers are forg- ing strategic partnerships with select suppliers in an effort to (1) reduce inventory and logistics costs, (2) accelerate the availability of next-generation components, (3) reduce defect rates, and (4) squeeze out important cost savings for both themselves and their suppliers.5
Bargaining Power of Consumers
Bargaining power of buyers refers to the ability of buyers to drive down prices for products offered by companies in a given industry. This force is strong when firms operate in industries that contain a limited number of buyers or that are made up of buyers that have multiple choices of where to buy from; this force is also strong when buyers purchase in volume or have low switching costs. Consumers (buyers) gain bargaining power under the following circumstances:
1. If they can inexpensively switch to competing brands or substitutes 2. If they are particularly important to the seller
3. If sellers are struggling in the face of falling consumer demand 4. If they are informed about sellers’ products, prices, and costs
5. If they have discretion in whether and when they purchase the product6
The impact of this “force” on industry competitiveness is higher when the products being purchased are standard or undifferentiated, enabling consumers to negotiate selling price, war- ranty coverage, and accessory packages to a greater extent. Rival firms may offer extended war- ranties or special services to gain customer loyalty whenever the bargaining power of consumers is substantial. New car buyers, for example, often compare prices of their desired car across several dealerships, often negotiating lower prices and additional services from dealerships in exchange for their business.
As a result of Porter’s Five Forces, the intensity of competition among firms varies widely across industries. Table 3-6 reveals the average operating profit for firms in different industries. Note substantial variation among industries, with the lowest being for bookstores.
The collective impact of competitive forces is so brutal in some industries that the market is
TABLE 3-6 Competitiveness Across a Few Industries (2018 data)
Industry Operating Profit (%)
Banking 30.8
Hotels 18.4
Pharmaceutical 8.7
Oil and Gas Extraction 7.5
Fragrances/Cosmetics 7.1
Telecommunications 6.1
Food Manufacturing 5.4
Machinery/Construction 4.9
Paper Manufacturing 4.9
Bookstores 2.9
clearly “unattractive” from a profit-making standpoint. Strategists must continually monitor the five forces to identify new opportunities and threats facing the firm, and alter strategies accordingly.
Eliminating competition is a possibility and common strategy employed by firms in an indus- try with high rivalry. Firms use mergers and acquisitions and purchase suppliers or buyers (dis- tributors) all as a means to eliminate rivalry, but there are problems associated with this level of thinking. Acquiring the competition often is associated with paying a premium and dealing with different organizational cultures; although there may be no competitors currently, new competitors may enter with different products and ultimately better serve many current customers. Purchasing suppliers or distributors takes a firm away from the business they do best, possibly allowing com- petitors to better develop and improve their products without being bogged down with supply chain issues they know little about.
Several pitfalls firms should avoid when using the Five Forces Analysis, include (1) placing equal weight on all five forces instead of identifying the most pressing forces for their industry, (2) defining the industry too broad or too narrow, and (3) using the five forces to pin labels such as attractive or unattractive on an industry rather than using the model to more efficiently formulate strategies. When using Porter’s Five Forces Model as an external assessment tool in doing strategic planning, strive to identify AQCD opportunities and threats most important for success in a given industry, and most relevant to the firm’s vision and mission.
Key Sources of Information for an External Audit
A wealth of strategic information is available to organizations from both published and unpub- lished sources. Unpublished sources include customer surveys, market research, speeches at pro- fessional and shareholders’ meetings, television programs, interviews, and conversations with stakeholders. Published sources of strategic information include periodicals, journals, reports, government documents, abstracts, books, directories, newspapers, and manuals. A company website is usually an excellent place to start to find information about a firm, particularly on the Investor Relations web pages.
There are many excellent websites for gathering strategic information, but six outstanding ones that the authors use routinely in performing an external audit are:
1. http://finance.yahoo.com 2. www.hoovers.com 3. www.morningstar.com 4. www,mergentonline.com
5. http://globaledge.msu.edu/industries/
6. Corporate website of companies
The fifth website listed is operated by Michigan State University and provides industry pro- files that are an excellent source for information, news, events, and statistical data for any industry.
Most college libraries subscribe to excellent online business databases that can then be used free by students to gather information to perform a strategic-management case analysis. Simply ask your reference librarian. Some outstanding library database sources of external audit information are described in Table 3-7; the authors use all of these sources, especially S&P Net Advantage’s Industry Surveys and IBISWorld, to obtain AQCD external factors for inclusion in an external assessment. Note also in Table 3-7 the PrivCo source is helpful for obtaining information about privately held firms; use www.owler.com for information about rival firms.
Forecasting and Making Assumptions
Forecasts are educated assumptions about future trends and events. Forecasting is a complex activity because of factors such as technological innovation, cultural changes, new products, improved services, stronger competitors, shifts in government priorities, changing social values, unstable economic conditions, and unforeseen events. Managers often must rely on published forecasts to effectively identify key external opportunities and threats.
LO 3.4
LO 3.5
A sense of the future permeates all action and underlies every decision a person makes.
People eat expecting to be satisfied and nourished in the future. People sleep assuming that in the future they will feel rested. They invest energy, money, and time because they believe their efforts will be rewarded in the future. They build highways assuming that automobiles and trucks will need them in the future. Parents educate children on the basis of forecasts that they will need certain skills, attitudes, and knowledge when they grow up. The truth is we all make implicit forecasts throughout our daily lives. The question, therefore, is not whether we should forecast but rather how we can best forecast to enable us to move beyond our ordinarily unarticulated assumptions about the future. Can we obtain information and use it to make educated assumptions (forecasts) that better guide our current decisions and foster a more desirable future state of affairs? Assumptions must be made based on facts, figures, trends, and research. Strive for the firm’s assumptions to be more accurate than rival firms’ assumptions.
No forecast is perfect; some are even wildly inaccurate. This fact accents the need for strate- gists to devote sufficient time and effort to study the underlying bases for published forecasts and to develop internal forecasts of their own. Key external opportunities and threats can be effec- tively identified only through good forecasts.
Making Assumptions
Planning would be impossible without assumptions. McConkey defines assumptions as the
“best present estimates of the impact of major external factors, over which managers have little if any control, but which may exert a significant impact on performance or the ability to achieve desired results.”7 Strategists are faced with countless variables and imponderables that TABLE 3-7 Excellent Online Sources to Obtain EFE Matrix Factor Information
• IBISWorld—Provides online USA Industry Reports (NAICS), U.S. Industry iExpert Summaries, and U.S. Business Environment Profiles. A global version of IBIS is also available.
• Lexis-Nexis Academic—Provides online access to newspaper articles (including New York Times and Washington Post) and business information (including SEC filings).
• Lexis-Nexis Company Dossier—Provides online access to extensive, current data on 13 million companies. It collects and compiles information into excellent documents.
• Mergent Online—Provides online access to Mergent’s Manuals, which include trend, descriptive, and statistical information on hundreds of public companies and industries. Unconsolidated company income statements and balance sheets are provided.
• PrivCo—Provides information on privately held companies, including private financials and rev- enues; private M&A deals and deal multiples, private firm valuations, VC funding, private equity deal history. (Go to www.owler.com for information about competitors.)
• Regional Business News—Provides comprehensive full-text coverage for regional business publica- tions; incorporates coverage of more than 80 regional business publications covering all metropolitan and rural areas within the United States.
• Standard & Poor’s NetAdvantage—Provides online access to Standard & Poor’s (S&P) Industry Surveys, stock reports, corporation records, The Outlook, mutual fund reports, and more. Locate the
“Company” tab at the top of the page or the “Simple Search” option located on the right side of the page. Use the “Company Profile” option.
• Value Line Investment Survey—Provides excellent online information and advice on approximately 1,700 stocks, more than 90 industries, the stock market, and the economy. Company income state- ments and balance sheets are provided.
• U.S. Securities and Exchange Commission—Provides the Form 10K for publicly held companies in the United States. Use the search box at the top of the page or look under the “Filings” tab along the top of the page.
• Company Annual Reports On-Line (CAROL)—Provides direct links to publicly held companies’
financial statements in both Europe and the United States.
Source: Based on information at www.fmarion.edu/library.
can be neither controlled nor predicted with 100 percent accuracy. Wild guesses should never be made in formulating strategies, but reasonable assumptions based on available information must always be made.
By identifying future occurrences that could have a major effect on the firm and by making reasonable assumptions about those factors, strategists can carry the strategic-management process forward. Assumptions are needed only for future trends and events that are most likely to have a significant effect on the company’s business. Based on the best information at the time, assumptions serve as checkpoints on the validity of strategies. If future occurrences deviate significantly from assumptions, strategists know that corrective actions may be needed. Firms that compile the best information generally make the most accurate assumptions, which can lead to major competitive advantages.
The External Factor Evaluation Matrix
An External Factor Evaluation (EFE) Matrix allows strategists to summarize and evaluate economic, social, cultural, demographic, environmental, political, governmental, legal, techno- logical, and competitive information. The EFE Matrix provides an empirical assessment of how well a firm is handling external factors overall, including the firm’s effectiveness at capitalizing on opportunities and minimizing threats.
Steps to Develop an EFE Matrix An EFE Matrix can be developed in five steps:
Step 1: Develop a Full and Narrow List of Key External Factors
Conduct research about the focal company using the resources listed in Table 3.7. Compile and organize information into two data sets, opportunities and threats, developing a full list of per- haps 50 to 100 opportunity and threat factors relevant to the 10 external areas described previ- ously. Include factors most important to your firm’s industry, vision, mission, and strategies, considering the five forces just discussed. Then, narrow your data sets down to 20 key external factors that include specifically 10 opportunities and 10 threats. (Note: We use 10 and 10 because organizations commonly use this breakdown and the template at www.strategyclub.com uses 10 and 10). List opportunities first and then threats. Also, do not include strategies as opportunities, so for example, “to build two new manufacturing plants in Europe” is a strategy, not an oppor- tunity; there may be an underlying opportunity that could make that strategy reasonable, such as
“eight European countries have repealed restrictions on the sale of generic drugs.”
Firms determine the most important 20 factors among a full list usually by rating the factors according to importance (1 = least important to 10 = most important) and consolidating the rat- ing data or by ranking the factors (1 = most important to 50 = least important) and consolidating the ranking data. Both methods will yield the 20 most important factors to include. The impor- tant point here is that companies (and students) never should include just the first 20 factors that come to mind. For example, someone recently included as a threat in his EFE Matrix that “a hurricane can come.” Ninety-nine percent of the time that factor should not be included in the matrix; instead, conduct research to identify external factors that relate to the firm’s vision, mis- sion, strategies, and competitive advantages.
When determining particular factors to include in an EFE Matrix, and when assigning weights and ratings (Step 2) focus on a narrow industry perspective. For example, for Spirit Airlines, the industry is discount airlines, rather than all airlines, and for Lamborghini, the industry is high-end sports cars, not simply automobiles. This narrow industry perspective is important to facilitate external factors being stated in terms that meet the AQCD Test discussed earlier.
In developing a list of key external factors, be mindful of the AQCD Test because vagueness in stating factors must be avoided; vagueness gives analysts no guidance in assigning weights or ratings in developing an EFE Matrix. Recall that Edward Deming said, “In God we trust.
Everyone else bring data.” Include “actionable” factors as defined previously in this chapter.
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