average economic profits of u.s. industry groups, 1978-1996

© 1999 Pankaj Ghemawat

ROE-Ke Spread

(15%)

(10%)

(5%)

0%

5%

10%

15%

20%

0 100 200 300 400 500 600 700 800 900 1,000 1,100 1,200 1,300

Average Invested Equity ($B)

Toiletries/Cosmetics

Steel

PharmaceuticalsSoft Drink

TobaccoFood Processing

Household ProductsElectrical Equipment

Financial ServicesSpecialty Chemicals

NewspaperBank

Integrated PetroleumTelecom Retail Store

Tire & RubberElectric Utility - Central

Electric Utility - East

Medical ServicesMachinery

Auto & TruckComputer & Peripheral

Paper & ForestAir Transport

Source: Compustat, Value Line, Marakon Associates Analysis

Average Economic Profits of U.S. Industry Groups, 1978-1996

Value Line Industry Groups

© 1999 Pankaj GhemawatSource: Compustat, Value Line, Marakon Associates Analysis

ROE-Ke Spread

(30%)

(20%)

(10%)

0%

10%

20%

30%

40%

$0 $1 $2 $3 $4 $5 $6 $7 $8 $9 $10 $11 $12 $13 $14 $15

Great Northern Iron

Worthington IndsNucor

Steel TechnologiesOregon Mills

Commercial Metals

CarpenterBirmingham

British Steel PLCCleveland-Cliffs

QuanexLukens

ACME MetalsAmpco

USX-US Steel

Inland Steel

ArmcoWHX BethlehemAverage Invested Equity ($B)

Average Economic Profits in the Steel Industry, 1978 -1996

© 1999 Pankaj GhemawatSource: Compustat, Value Line, Marakon Associates Analysis

ROE-Ke Spread

(80%)

(60%)

(40%)

(20%)

0%

20%

40%

60%

$0 $5 $10 $15 $20 $25 $30

SmithKline

Glaxo

AmericanHomeProducts

Amgen

Merck

Schering PloughWatson

BristolMyers

Rhone-PoulencMylan LabsWarner Lambert

Eli Lilly Pfizer

PerrigoPharmacia & Upjohn

Forest LabsAlza

ICNScherer

IvaxGenetech

BiogenRobertsGenzyme

DuraChiron

CephalonGensiaCygnus

ImmunexAverage Invested Equity ($B)

Average Economic Profits in the Drug Industry, 1978 -1996


30

40

50

60

70

80

90

100

Pro

fita

bilit

y

Choice BChoice A

A Three-Dimensional Business Landscape


Supply

Demand

PhysicalUnits

EquilibriumQuantity

EquilibriumPrice

MonetaryUnits

Supply-Demand Analysis


The “Five Forces” Framework for Industry Analysis

New Entrants

Entry Barriers:

Economies of scaleBrand identityCapital requirementsProprietary product differencesSwitching costsAccess to distributionProprietary learning curveAccess to necessary inputsLow-cost product designGovernment policyExpected retaliation

New Entrants

Entry Barriers:

Economies of scaleBrand identityCapital requirementsProprietary product differencesSwitching costsAccess to distributionProprietary learning curveAccess to necessary inputsLow-cost product designGovernment policyExpected retaliation

Suppliers

Sources of Bargaining Power:

Switching costs Differentiation of inputsSupplier concentration Presence of substitute inputsImportance of volume to suppliersImpact of inputs on cost or differentiationThreat of forward/backward integrationCost relative to total purchases in industry

Suppliers

Sources of Bargaining Power:

Switching costs Differentiation of inputsSupplier concentration Presence of substitute inputsImportance of volume to suppliersImpact of inputs on cost or differentiationThreat of forward/backward integrationCost relative to total purchases in industry

Industry Competitors

Factors Affecting Rivalry:

Industry growth Concentration and balanceFixed costs/value added Intermittent overcapacityProduct differences Brand identitySwitching costs Informational complexityDiversity of competitors Corporate stakesExit barriers

Industry Competitors

Factors Affecting Rivalry:

Industry growth Concentration and balanceFixed costs/value added Intermittent overcapacityProduct differences Brand identitySwitching costs Informational complexityDiversity of competitors Corporate stakesExit barriers

Substitutes

Threat Determined by:

Relative price performance of substitutesSwitching costsBuyer propensity to substitute

Substitutes

Threat Determined by:

Relative price performance of substitutesSwitching costsBuyer propensity to substitute

Buyers

Bargaining Power of Buyers:

Buyer concentration Buyer volumeSwitching costs Buyer informationBuyer profits Substitute productsPull-through Price sensitivityPrice/total purchases Product differencesBrand identity Ability to backward integrateImpact on quality/performance Decision makers’ incentives

Buyers

Bargaining Power of Buyers:

Buyer concentration Buyer volumeSwitching costs Buyer informationBuyer profits Substitute productsPull-through Price sensitivityPrice/total purchases Product differencesBrand identity Ability to backward integrateImpact on quality/performance Decision makers’ incentives


Competitors ComplementorsCompany

Customers

Suppliers

Source: Adam Brandenburger and Barry Nalebuff, Co-opetition(New York: Currency Doubleday, 1996), p. 17

The Value Net


Public Sources of Information about the Business Landscape

Industry studies– Books

– Investment analysts

– Market research

– Business school cases

Trade associations

Business press– General publications (e.g., Wall

Street Journal, Fortune)

– Specialized industry trade journals

– Local newspapers

– Online services (e.g., Bloomberg, OneSource, Compustat)

Government sources– Antitrust, legal, or tax documents

– Census or IRS data

– Regulatory bodies

Industry and company directories– Thomas’ Register

– Dun & Bradstreet

Company sources– Annual reports

– SEC filings

– Public relations/promotional material

– Internet sites

– Company histories


Threat of New Entry• Decline in economies of scale + customer heterogeneity fragmentation of market into niches

• Escalation of sunk costs concentration• Emergence of switching costs entry deterred

Rivalry Among Existing Competitors• Shift in industry growth• Change in mix between fixed and variable costs• Emergence of dominant design or product• Consolidation• Fragmentation / new entry

Availability of Complements• Emergence of new complements• Change in barriers to entry in

complement market

Bargaining Powerof Customers

• Concentration or fragmentation of buyers

• Backward integration• Improvement in buyer information• Surge or decline in demand• Emergence of new distribution

channels• New means for coordinating with

customers• Shifts in customer tastes

Bargaining Powerof Suppliers

• Concentration or fragmentation of suppliers

• Forward integration• Improvement in supplier

information• Surge or decline in supply• Emergence of substitute inputs• New means for coordinating

with suppliers


• Concentration or fragmentation of suppliers

• Forward integration• Improvement in supplier

information• Surge or decline in supply• Emergence of substitute inputs• New means for coordinating

with suppliers

Source: Jan W. Rivkin

Some Common Long-Run Dynamics

Threat of Substitutes• Emergence of new substitute• Improvement or decline in relative price performance

of substitute• Increase in buyer comfort with substitute• Change in barriers to entry in substitute market

Threat of Substitutes• Emergence of new substitute• Improvement or decline in relative price performance

of substitute• Increase in buyer comfort with substitute• Change in barriers to entry in substitute market


0

10

20

30

40

50

60

70

80

90

100

2%

4%

6%

8%

10

%

12

%

14

%

16

%

18

%

20

%

22

%

24

%

26

%

28

%

30

%

32

%

Numberof

Industries

First QuartileAverage

22.2%

Fourth QuartileAverage

9.3%

Note: Return on Equity = Net Income / Year End Shareholders’ Equity; Analysis based on sample of 593 industries

Average = 14.7%Median = 13.8%

11.7%

13.8%

16.5%

Return on Equity (Percent)

Average Return on Equity in US Industries, 1982-1993

Distribution of Industry Returns

Source: Jan W. Rivkin’s Analysis Based on Dun and Bradstreet Data


Source: Jan W. Rivkin based on Compustat

Computer system design

Operating Income / Assets, 1988-95 (%)

0 5 10 15 20 25

Scheduled airlines

Motor vehicles

Cable TV service

Engineering services

Trucking except local

Race track operations

Petroleum / natural gas

Drug stores

Eating places

Dental equipment

Women's clothing stores

Semiconductors

Prepackaged software

Pharmaceuticals

Profitability Differences Across Selected Industries


You need structured ways of thinking about the environment– …that capture the richness of the real business world

– …but separate signal from noise

The Managerial Problem

To craft an effective strategy, you must take account of the external environment (the landscape)– To decide whether to put your firm in an environment (entry)

– To decide whether to extricate your firm from an environment (exit)

– To position your firm to succeed in a given environment

– To assess the effect of a major change (e.g., deregulation)

– To shape the environment But the environment is enormously complex


Some (Complementary) Solutions

Supply / demand diagrams Industry structure analysis (Five Forces) Value net Ecological metaphors


Supply / demand analyses say little about what determines the position and shape of the two curves

From Supply / Demand to the Five Forces

What determines the long-run supply / demand balance?– Entry barriers and intensity of rivalry affect whether firms will add capacity

in response to excess demand

– Exit barriers affect whether firms will retire capacity in response to excess supply

What determines the effect of a supply / demand imbalance on profitability?– In industries with intense rivalry or powerful buyers, small amounts of

excess capacity tend to lead to big price wars

– In industries with powerful suppliers, the benefits of excess demand may accrue to the suppliers


Threat of New Entry

Rivalry Among Existing Competitors


Threat of Substitutes


• Economies of scale• Proprietary product

differences• Brand identity• Switching costs

• Capital requirements• Access to distribution• Absolute cost advantages• Government policy• Expected retaliation

• Relative price performance of substitutes• Switching costs• Buyer propensity to substitute

• Industry growth• Fixed costs / value

added• Overcapacity• Product differences• Brand identity

• Switching costs• Concentration and balance• Informational complexity• Diversity of competitors• Corporate stakes• Exit barriers

• Differentiation of inputs• Switching costs• Presence of substitute

inputs• Supplier concentration• Importance of volume to

supplier• Cost relative to total

purchases• Impact of inputs on cost or

differentiation• Threat of forward

integration

• Buyer concentration• Buyer volume• Buyer switching costs• Buyer information• Ability to integrate

backward• Substitute products• Price / total purchases• Product differences• Brand identity• Impact of quality /

performance• Buyer profits

Industry Analysis: Factors to Consider

Source: Michael E. Porter, Competitive Advantage(New York: Free Press, 1985)


Typical Uses of Industry Analysis

Understand current profitability levels Identify forces that must be countered in order to

achieve superior profitability Test decision to enter an industry Test decision to exit an industry Assess effect of a major change (e.g., deregulation) Identify ways to alter industry structure


Other Users

Entrepreneurs Investment bankers Financial analysts Venture capitalists Consultants Anyone making a career choice


Customers

Firm

Suppliers

Competitors Complementors

A player is your complementor with respect to customers if customers value your product more when they have the other player’s product as well

A player is your competitor with respect to customers if customers value your product less when they have the other player’s product as well

A player is your complementor with respect to suppliers if it is more attractive for a supplier to provide resources to you when it is also supplying the other player

A player is your competitor with respect to suppliers if it is less attractive for a supplier to provide resources to you when it is also supplying the other player

The Value Net

Source: Adam Brandenburger and Barry Nalebuff, Co-opetition (New York: Currency Doubleday, 1996)


What the Value Net Adds

Complementors Symmetry


Threat of New Entry

Rivalry Among Existing Competitors


Threat of Substitutes


Availability of Complements

Expanded Industry Analysis


Degree of Rivalry

Concentration and balance Industry growth Fixed (or storage costs)/Value added Product differences Brand identity Switching costs Intermittent cover-capacity Diverse stakes Exit barriers


Entry Barriers

Economies of scale Product differences Brand identity Switching costs Capital requirements Access to distribution

Absolute cost advantages– Learning curve

– Access to necessary inputs

– Low cost product design

Government policy Expected retaliation


Power of Buyers

Intrinsic Strength Buyer concentration Buyer volume Switching costs Buyer information Ability to backward

integrate Substitute products Pull through

Price Sensitivity Price/Total purchase Product differences Brand identity Impact on

quality/performance Buyer profits Decision maker’s

incentives


Power of Suppliers

Supplier concentration Substitute suppliers Supplier volume Product differences Brand identity Switching costs Low buyer information Threat of forward integration Pull through


Threat of Substitution

Product function not form Entire value added chain Thread depends on

– Relative price/performance

– Switching costs Often an S-curve process


The Power of Complementors

Relative concentration Relative buyer or supplier switching costs Ease of unbundling Differences in pull-through Asymmetric integration threats Rate of growth of the pie


Issues with the Five-Forces Framework

Industry definition

Completeness (e.g., import competition)

Consistency (e.g., import strategic variety)

Duplication (e.g., switching costs)

Symmetry (e.g., buyer substitution vs. supplier substitution, complements)

The role of informational conditions

The need for macroenvironmental analysis

Long-run focus vs. change– shocks– cycles– trends

Product rather than resource focus


Landscapes

Landscape is broader than industry

Landscape includes firms, institutions, and other players which often are not viewed as part of an industry

Landscape includes networks of firms (from different industries) whose profits may be interdependent (e.g. Microsoft-Intel)


Commitment Opportunities and Structure

Production scale economies set a lower bound on concentration

Many settings are more concentrated than production scale economies would imply

Opportunities to commit resources to advertising and R & D in ways that enhance willingness-to-pay to some minimal degree are what lead to “excess” concentration


Steps in Landscape Analysis

Define the landscape: what is in, what is out Identify the players

– e.g., who are the customers, really? Who are the competitors?

Assess the relationships among players– See Porter (1979, 1980) for some factors to consider

Sniff-test– Is assessment in line with actual profitability?

– Are more profitable players better positioned vis-a-vis competitive forces?

Assess recent and future changes


Identify forces that must be countered in order to achieve superior profitability

Test decision to enter

Test decision to exit

Assess effects of a major change

Identify ways to alter structure

Pinpoint most threatening force and seek ways to counter (e.g., build switching costs, find new sources of supply)

Consider effect of entry on structure; choose relative position; select entry vehicle; compare costs of entry to benefits

Identify options for improving structure or relative position; select exit vehicle; compare costs of exit to benefits

Consider how change will affect each force

Assess consolidation, backward integration, forward integration, investments that raise entry costs, entry into substitute market, etc.

Purpose Common steps

Steps in Landscape Analysis (cont.)


Common Pitfalls in Landscape Analysis

Failing to define the landscape clearly– A clear definition is more important that the “right” definition

Confusing transient effects with structural forces Ignoring changes in structural forces Assuming that competitive forces cannot be altered Confusing evidence of a force with its underlying cause

– e.g., blaming customer power on customer price sensitivity rather than exploring root causes of price sensitivity

Ignoring the full range of substitutes Paying equal attention to all the forces


Lessons

Industries or landscapes are neither created equal nor stay equal

The concept of “extended competition” provides a comprehensive framework for assessing structural attractiveness

A firm’s strategy can increase or decrease its exposure to competitive forces

Other things being equal, a firm should seek to trigger actions that improve structural attractiveness

But it isn’t enough to look at just structural attractiveness: competitive position must also be considered


Conclusion

Envisioning the business landscape Adapting to the business landscape Shaping the business landscape

average economic profits of u.s. industry groups, 1978-1996

Documents