CHAPTER 4

Analyzing an Industry

Industry Influences a Company’s Options and Outcomes

The Affordable Care Act (ACA) thrust the healthcare industry into decades of upheaval and uncertainty. The ACA is designed to increase insurance coverage by expanding Medicaid eligibility in 2014 to include individuals within 138 percent of the federal poverty level, and by creating state-based insurance exchanges where individuals and small business can buy health insurance, with federal subsidies available for individuals with incomes less than 400 percent of the federal poverty level.

Accommodating 30 million new consumers, most of whom are low-income patients with little medical care histories, challenges the industry’s established delivery systems. The industry, which was regularly castigated for his escalating costs and low levels of productivity, faces challenges in every facet of its operations. No business, in any segment of the healthcare industry, is immune from meaningful change because of the ACA.

Consequently, McKinsey & Company concluded that healthcare executives have entered an era of an increased number of new competitors, harsher scrutiny of their pricing structures, unprecedented focus on their operational efficiency, heightened customer sophistication, numerous changes in profitable industry segments, and an upsurge in corporate mergers in the industry.¹ Thus, healthcare is a prime example of power of industry to impact the strategic planning of individual competitors and, as we will discuss in this chapter, to influence the likelihood of their economic success.

This example highlights the importance that an industry plays in the strategic success of its corporate competitors. People tend to think of an industry as a group of companies that compete directly with each other in the marketplace. Although intuitive, the simplicity of this definition masks complex issues. Is competition primarily between products, companies, or networks of alliance partners? Should we analyze rivalry at the business unit level or at the functional level? Should we distinguish between regional competition and global rivalry?

As these questions suggest, deciding on industry boundaries is difficult and misspecification of an industry can be extremely costly. The use of too narrow a definition can lead to strategic myopia and cause executives to overlook important opportunities or threats, such as would occur by judging railroads as competing only with other railroads. The use of too broad a definition, such as identifying a firm’s industry simply as “high technology,” can prevent a meaningful assessment of the competitive environment. 

What Is an Industry?

An industry is a collection of firms that offer similar products or services. It can be assessed on four dimensions the products its competitors provide, the customers they serve, the geography in which the customers are located, and the stage in the production–distribution pipeline that is represented by its member companies. The product dimension can be further broken down into its function and technology.

Function refers to what the product or service does. Some cooking appliances bake. Others bake and roast. Still others fry or boil. Functionality can be actual or perceived. Some over-the-counter remedies for nasal congestion, for example, are positioned as cold relievers, whereas others with similar chemical formulations are promoted as allergy medicines. The difference is as much a matter of positioning and perception as of actual functionality. Technology is a second distinguishing factor: Some cooking appliances use gas, whereas others are electric; some cold remedies are available in liquid form, whereas others are sold in gel capsules.

Defining an industry’s boundaries requires the simultaneous consideration of all of these dimensions. In addition, it is important to distinguish between the industry in which a company competes and the market(s) it serves. For example, a company might compete in the large kitchen appliance industry but choose refrigerators as its served market. This can be depicted as a collection of (adjacent) three-dimensional cells, each characterized by a particular combination of functions/uses, technologies/materials, and types of customers. The task of defining an industry, therefore, consists of identifying the group of market cells that are most relevant to the firm’s strategic analysis.

In the process of generating strategic alternatives, it is often helpful to use multiple industry definitions. Assessing a company’s growth potential, for example, might require the use of a different industry/market definition than assessing its current relative cost position.

Industry Structure and Porter’s Five Forces Model

The five forces model developed by Michael Porter is a useful tool for industry and competitive analysis.² It holds that an industry’s profit potential is largely determined by the intensity of the competitive rivalry within that industry, and that rivalry, in turn, is explained in terms of five forces: (1) the threat of new entrants, (2) the bargaining power of customers, (3) the bargaining power of suppliers, (4) the threat of substitute products or services, and (5) the jockeying among current rivals.

The Threat of Entry. When it is relatively easy to enter a market, an industry can be expected to be highly competitive. Potential new entrants threaten to increase the industry’s capacity, to intensify the fight for market share, and to upset the balance between demand and supply. The likelihood of new entrants depends on (1) what barriers to entry exist and (2) how entrenched competitors are likely to react.

There are six major barriers to market entry: (1) economies of scale, (2) product differentiation (brand equity), (3) capital requirements, (4) cost disadvantages that are independent of size, (5) access to distribution channels, and (6) government regulations. Consider, for example, the difficulty of entering the soft drink industry and competing with advertising giants such as Coca-Cola and Pepsi Cola or the plight of microbrewers trying to gain distribution for their brands of beer against major companies such as Anheuser-Busch. In high-technology industries, capital requirements and accumulated experience serve as major barriers. Industry conditions can change, however, and cause strategic windows of opportunity to open.

Powerful Suppliers and Buyers. Buyers and suppliers influence competition in an industry by exerting pressure over prices, quality, or the quantity demanded or sold.

Generally, suppliers are more powerful when (1) there are a few dominant companies and they are more concentrated than the industry they serve; (2) the component supplied is differentiated, making switching among suppliers difficult; (3) there are few substitutes; (4) suppliers can integrate forward; and (5) the industry generates but a small portion of the suppliers’ revenue base.

Buyers have substantial power when (1) there are few of them and/or they buy in large volume; (2) the product is relatively undifferentiated, making it easy to switch to other suppliers; (3) the buyers’ purchases represent a sizable portion of the sellers’ total revenues; and (4) buyers can integrate backward.

Substitute Products and Services. Substitute products and services continually threaten most industries and, in effect, place a lid on prices and profitability. HBO and pay-per-view are substitutes to the movie rental business and effectively limit what the industry can charge for its services. Moreover, when cost structures can be changed, for example, by employing new technology, substitutes can take substantial market share from existing businesses.

The increased availability of pay-per-view entertainment over cable networks, for example, erodes the competitive position of movie rental companies. From a strategic perspective, therefore, substitute products or services that deserve scrutiny are those that (1) show improvements in price performance relative to the industry average and (2) are produced by companies with deep pockets.

Rivalry Among Participants. The intensity of competition in an industry also depends on the number, relative size, and competitive prowess of its participants; the industry’s growth rate; and related characteristics. Intense rivalry can be expected when (1) competitors are numerous and relatively equal in size and power; (2) industry growth is slow and the competitive battle is more about existing customers than about creating new customers; (3) fixed costs are high or the product or service is perishable; (4) capacity increases are secured in large increments; and (5) exit barriers are high, making it prohibitively expensive to discontinue operations.

Andrew Grove, founder of Intel, has suggested adding a sixth force to Porter’s model: the influence of complementary products. Computers need software, and software needs hardware; cars need gasoline, and gasoline needs cars. When the interests of the industry are aligned with those of complementors, the status quo is preserved. However, new technologies or approaches can upset the existing order and cause complementors’ paths to diverge.³ An example is a change in technological standards, which renders previously compatible products and services incompatible.

The influence of these forces continues to shift as industry structures and business models change. For example, companies are increasingly using the Internet to streamline their procurement of raw materials, components, and ancillary services. To the extent this enhances access to information about products and services and facilitates the valuation of alternate sources of supply, it increases the bargaining power of manufacturers over suppliers. However, the same technology might reduce barriers to entry for new suppliers and provide them with a direct channel to end users, thereby reducing the leverage of intermediaries.

The effect of the Internet on the possible threat of substitute products and services is equally ambiguous. On the one hand, by increasing efficiency, it can expand markets. On the other hand, as new uses of the Internet are pioneered, the threat of substitutes increases. At the same time, the Internet’s rapid spread has reduced barriers to entry and increased rivalry among existing competitors in many industries. This has occurred because Internet-based business models are generally hard to protect from imitation and, because they are often focused on reducing variable costs, they create an unwanted focus on price. Thus, although the Internet does not fundamentally alter the nature of the forces affecting industry rivalry, it changes their relative influence on industry profitability and attractiveness.⁴

Industry Evolution

Industry structures change over time. Entry barriers can fall, as in the case of deregulation, or rise considerably, as has happened in a number of industries where brand identity became an important competitive weapon. Sometimes industries become more concentrated as real or perceived benefits of scale and scope cause businesses to consolidate. Models of industry evolution can help us understand how and why industries change over time. Perhaps the word evolution is somewhat deceptive; it suggests a process of slow, gradual change. Structural change can occur with remarkable rapidity, as in the case when a major technological innovation enhances the prospects of some companies at the expense of others. 

Four Trajectories of Change

Industries evolve according to one of the four distinct trajectories of change: radical, progressive, creative, and intermediating.⁵ Two types of obsolescence define these paths of change: (1) a threat to an industry’s core activities, which account for a significant portion of an industry’s profits; and (2) a threat to the industry’s core assets, which are valued as differentiators. The steady decrease in importance of a dealer’s traditional sales activities as online shopping has increased is a good example of the first type of obsolescence. The eroding brand value of many prescription drugs in the face of generic competition illustrates the second.

Radical change occurs when an industry is threatened with obsolescence of both its core activities and core assets at the same time. Professor Anita McGahan cites the major changes in the travel business as an example. As airlines modernized and began to compete more directly with enhanced reservation systems, and corporate travel clients turned to Internet-based service providers such as Expedia and Travelocity, many traditional travel agents had to reinvent themselves as a matter of survival.

Progressive change can be expected when neither form of obsolescence is imminent. This is the most common form of industry change. The long-haul trucking industry has seen changes, but its fundamental value proposition has remained the same. In such environments, competitive strategies and innovation are often targeted at increased efficiencies through scale and cost reduction.

Creative and intermediating change paths are defined by the dominance of one of the two forms of obsolescence. Under creative change, the core assets are threatened, but the core activities retain their value. Strategically, this scenario calls for the renewal of asset values; think of a movie studio having to produce another blockbuster. Under intermediating change, the core assets remain valuable, but the core activities are threatened. Museums are highly valuable as repositories of art, for example, but modern communication methods have reduced their power as educators.

Industry Structure, Concentration, and Product Differentiation

It is useful to analyze changes in industry structure in terms of the movement from a primarily vertical to a more horizontal structure, or vice versa; increases or decreases in the degree of product differentiation; and changes in the degree of industry concentration.

These dimensions are illustrated by the convergence of three industries that originated some 50 years apart: telecommunications, computers, and television. This convergence has spawned an integrated multimedia industry in which traditional industry boundaries have all but disappeared. Instead of consisting of three distinct businesses in which being vertically integrated was key to success, the industry has evolved into five primarily horizontal segments in which businesses can successfully compete: content (products and services), packaging (bundling of content and additional functionality), the network (physical infrastructure), transmission (distribution), and display devices. In this new structure, strategic advantage for many companies is determined primarily by their relative positions on one of the five segments. However, vertical integration is likely to become an important business strategy once again when economics of scale and scope become more critical to competitive success.

In fragmented industries, which characterized by a relatively low degree of concentration, no single player has a major market share. Such industries are found in many areas of the economy. Some are highly differentiated, such as application software; others tend to commodity status, as in the case of lumber. In the absence of major forces for change, fragmented industries can remain fragmented for a long time.

Industry Concentration

When economies of scale are important and market share and total unit costs are inversely related, industry structures are often concentrated. In such industries, the size distribution of business firms is often highly skewed. In stable markets, there may be very few significant competitors and they will share a high total percentage of industry sales.

Research into approximately 200 industries has revealed that markets evolve in a highly predictable fashion, supporting a “Rule of Three.”⁶ When market forces are free to operate, unrestricted by regulatory constraints and artificial entry barriers, two kinds of competitors emerge, called full-line generalists and product/market specialists:

Researchers Jagdish Sheth and Rajendra Sisodia found that in competitive, mature markets, there is only room for three full-line generalists, plus several product or market specialists. In some combination, the three generalists typically control between 70 and 90 percent of the total sales in the industry. The smallest of these generalists must control no less than a 10 percent market share to remain competitively profitable.

The financial performance of specialists drops rapidly as their market share increases. In contrast, the three market-driven generalists enjoy profit improvement with gains in market share. These relationships are shown in Figure 4.1 to illustrate the central paradigm of the Rule of Three. The figure plots financial performance against market share, for generalists and specialists separately.

Figure 4.1 The financial consequences of growth for specialist and generalist companies

Sheth and Sisodia also found that a number of firms typically operate as large market share specialists (with less than 5 percent of total industry revenues) or small market share generalists (with less than 10 percent of total industry revenues). Both groups suffer from low levels of profitability and poor prospects if they continue to operate as independent firms. As shown in Figure 4.1, these companies are labeled as being in the “ditch.” Therefore, the most desirable competitive positions are those furthest away from the ditch.

Common Elements in Market Evolution

By analyzing the evolution of about 200 competitive markets, Sheth and Sisodia reached many important generalizations.⁷ The following seem particularly useful:

These generalizations—and The Rule of Three—are dependable only when market structure is determined by competitive market forces caution.⁸ Therefore, we are not likely to see the Rule apply in mature markets with government regulations that:

Ultimately, the Rule of Three is evidence that the highest operating efficiency is being achieved in a competitive market. Sheth and Sisodia also found that industries with four or more major players, as well as those with two or fewer, tend to be less efficient than those with three major players, and they warn that the role of the government is to ensure that free market conditions prevail so that such efficiency can be achieved and sustained. 

Power Curves

Strategic managers have a new tool that helps them to assess industry structure, which refers to the enduring characteristics that give an industry its distinctive character. According to Michele Zanini of the McKinsey Group, from whose work this discussion is derived, power curves depict the fundamental structural trends that underlie an industry.⁹ While major economic events like the worldwide recession of 2007–2009 are extremely disruptive to business activity, they do little to change the relative position of most businesses to one another over the long term.

In many industries, the top firm is best described as a mega-institution—a company of unprecedented scale and scope that has an undeniable lead over competitors. Walmart, Best Buy, McDonalds, and Starbucks are examples. However, even among these firms, there is a clear difference in size and performance. When the distribution of net incomes of the global top 150 corporations in 2005 was plotted, as shown in Figure 4.2, the result was a “power curve,” which implies that most companies, even in the set of superstars, are below average in performance.

A power curve is described as exhibiting a small set of companies with extremely large incomes, followed quickly by a much larger array of companies with significantly smaller incomes that are progressively smaller than one another, but only slightly.

As Zanini explains, low barriers to entry and high levels of rivalry are positively associated with an industry’s power curve dynamics. The larger the number of competitors in an industry, the larger the gap on the vertical axis usually is between the top and median companies. When entry barriers are lowered, such as occurs with deregulation, revenues increase faster in the top-ranking firms, creating a steeper power curve. This greater openness seems to create a more level playing field at first, but greater differentiation and consolidation tend to occur over time.

Figure 4.2 Common shape of a power curve

Power curves are also promoted by intangible assets such as software and biotech, which generate increasing returns to scale and economies of scope. By contrast, more labor- or capital-intensive sectors, such as chemicals and machinery, have flatter curves. In industries that display a power curve, including insurance, machinery, and U.S. banks and savings institutions, the intriguing strategic implication is that strategic thrusts rather than incremental strategies are required to improve a company’s position significantly. 

Product Life Cycle Analysis

The product life cycle model—based on the theory of diffusion of innovations and its logical counterpart, the pattern of acceptance of new ideas—is perhaps the best-known model of industry evolution. It holds that an industry passes through a number of stages: introduction, growth, maturity, and decline. The different stages are defined by changes in the rate of growth of industry sales, generally thought to follow an S-shaped curve, reflecting the cumulative result of first and repeat adoptions of a product or service over time.

The service life cycle can be a useful analytic tool for strategy development. Research has shown that the evolution of an industry or product class depends on the interaction of a number of factors, including the competitive strategies of rival firms, changes in customer behavior, and legal and social influences. Figure 4.3 shows typical competitive responses to the changes that accompany the transition from a market’s introduction stage to growth to maturity and, ultimately, to decline.

A high level of uncertainty characterizes the introductory or emerging stage of a product or industry life cycle. Competitors are often unsure which segments to target and how. Potential customers are unfamiliar with the new product or service, the benefits it offers, where to buy it, or how much to pay. Consequently, a substantial amount of experimentation is a hallmark of emerging industries.

Figure 4.3 Conditions over the life cycle of a service firm¹

Growth environments are less uncertain and competitively more intense. At this stage of an industry’s evolution, the number of rivals is usually largest. Therefore, competitive shakeouts are common toward the end of the growth phase.

Mature industries, although the most competitively stable, are relatively stagnant in terms of sales growth. However, product development can give rise to new spurts of growth in specific segments, technological breakthroughs can alter the course of market development and upset the competitive order, and global opportunities can open avenues for further growth.

Declining industries are typically regarded as unattractive, but clever strategies can produce substantial profits. We will return to these different scenarios in Chapter 7 when we consider specific strategies for each life cycle stage.

Although useful as a general construct for understanding how the principle of diffusion can shape industry sales over time, the product life cycle concept has little predictive value. Empirical studies have shown that industry growth does not always follow an S-shaped pattern. In some instances, stages are very brief. More important, the product life cycle concept does not explicitly acknowledge the possibility that companies can affect the shape of the growth curve through strategic actions such as increasing the pace of innovation or repositioning their offerings. Taking an industry growth curve as a given, therefore, can unnecessarily become a self-fulfilling prophecy. 

New Patterns

Many new industries evolve through some convergence in technological standards. Competition for standards or formats is frequently waged within a group of companies between the developer of one standard and another group of companies favoring a different standard. Competition for standard or format share is important, because the winning standard will garner for its adopters a substantial share of future profits. Battles for cell phone technologies and set-top box standards, for example, decide the winners in market share.

For industries in which competition for standards is an important determinant of strategic success, C. K. Prahalad has proposed a model that describes industry evolution in three phases.¹⁰ In the first phase, competition is mostly focused on ideas, product concepts, technology choices, and the building of a competency base. The primary goal at this stage is to learn more about the potential of the industry and about the key factors that will determine future success or failure. In the second phase, competition is more about building a viable coalition of partners that will support a standard against competing formats. Companies cooperating at this stage may compete vigorously in phase three of the process—the battle for market share for end products and profits.

As competition becomes more global, industries consolidate, technology becomes more pervasive, and the lines between customers, suppliers, competitors, and partners are increasingly becoming blurred. With greater frequency, companies that compete in one market collaborate with others. At times, they can be each other’s customers or suppliers. This complex juxtaposition of roles makes accurately forecasting an industry’s future structure extremely difficult and relying on simple, stylized models of industry evolution very dangerous.

As industry boundaries become more permeable, structural changes in adjacent industries (industries serving the same customer base with different products or services, or industries using similar technologies and production processes) or related industries (industries supplying components, technologies, or complementary services) increasingly influence an industry’s outlook for the future. Finally, change sometimes is simply a function of experience. Buyers generally become more discriminating as they become more familiar with a product and its substitutes and, consequently, they are likely to be more explicit in their demands for improvements.

Methods for Analyzing an Industry

Analyzing an industry is typically done based on a method of strategic segmentation that focuses on a subset of the total customer market, a competitor analysis that concentrates on individual corporations or their major units, or a strategic group analysis of all firms that face similar threats and opportunities.

Segmentation

Strategic segmentation is the process of dividing an industry into relatively homogeneous, minimally overlapping segments that benefit from distinct competitive strategies. Strategic segmentation is the process of identifying segments that offer the best prospects for long term, sustainable results. It considers the long-term defensibility of different segments by analyzing barriers to entry such as capital investment intensity, proprietary technologies and patents, geographical location, tariffs, and other trade barriers.

Segmentation is complex because there are many ways to divide an industry or market. The most widely used categories of segmentation variables are customer characteristics and product- or service-related variables. Customer descriptors range from geography, size of customer firm, customer type, and customer lifestyle to personal descriptive variables, such as age, income, or sex. Product- or service-related segmentation schemes divide the market based on variables such as user type, level of use, benefits sought, competing offerings, purchase frequency and loyalty, and price sensitivity. After a strategic business unit’s (SBU’s) preferred segments have been identified, the process of analysis concludes with the strategic targeting of the particular segment and the positioning the firm for competitive advantage within that segment.

Competitor Analysis

Because industry structures and patterns of evolution are becoming more complex, traditional business assumptions are often not tenable. Many markets are no longer distinct nor are their boundaries well defined; competition is not mainly about capturing market share; customer and competitor profiles are constantly shifting; and competition occurs simultaneously at the business unit and corporate levels.

These new realities call for executives to adopt a broader perspective on strategy and for them to ask new questions. Do consumer companies compete at the business unit level, at the corporate level, or both? Do companies compete as stand-alone entities or as extended families that include their supplier bases? When a firm defines its competition, should executives focus on the corporate portfolio of which the SBU is a part? What are the competitive advantages of a portfolio of businesses against stand-alone businesses? Which is more important to sustainable competitive advantage: access to money or information technology?

As these questions suggest, competitive analysis should be paired with an analysis of the drivers of industry evolution. Consequently, strategies cannot be neatly compartmentalized at the SBU or corporate level. A principal rationale behind the concept of the diversified corporation is that the benefits of a portfolio transcend financial strength. A portfolio of related businesses reflects an integrated set of resources—core competencies that transcend business units—and has the potential for developing a sustainable corporate advantage that must be considered along with competitive factors at the business unit level.

To analyze immediate competitors, five key questions are useful:

Developing a solid understanding of who a firm’s immediate competitors are and what motivates their competitive behavior is important for strategy formulation. An analysis of key competitors’ major strengths and weaknesses and their past behavior, for example, may suggest attractive competitive opportunities or imminent threats. Understanding why a competitor behaves a certain way helps to make a determination of how likely it is to expect a major strategic or retaliatory initiative. Assessing competitors’ successes and failures assists in predicting their future behavior. Finally, an analysis of a competitor’s organizational structure and culture can be insightful; a cost-driven, highly structured competitor is unlikely to mount a successful challenge with an innovation-driven, market-oriented strategy.

In analyzing competitive patterns, it is often useful to assign roles to particular competitors. In many markets, it is possible to identify a leader, one or more challengers, and a number of followers and nichers. Although labeling competitors can be dangerously simplistic, such an analysis can provide insight into the competitive dynamics of the industry.

Leaders tend to focus on expanding total demand by attracting new users, developing new uses for their products or services, and encouraging more use of existing products and services. Defending market share is important to them, but they might not want to be aggressive in taking share from their immediate rivals because to do so can be more costly than expanding the market, or because they want to avoid scrutiny by regulatory agencies. Coca-Cola, for example, focuses more on developing new markets overseas than on taking market share from Pepsi Cola in the domestic market.

Challengers typically concentrate on a single target—the leader. Sometimes they do so directly, as in the case of Fuji’s challenge to Kodak. At other times, they use indirect strategies. Computer Associates, for example, acquired a number of smaller competitors before embarking on directly competitive attacks against larger rivals.

Followers and nichers compete with more modest strategic objectives. Some followers use a strategy of innovative imitation, whereas others elect to compete selectively in a few segments or with a more limited product or service offering. Nichers typically focus on a narrow slice of the market by concentrating, for example, on specific end users and geographic areas, or offering specialty products or services.

The identification of potential competitors is more difficult. Firms that are currently not in the industry but can enter at relatively low cost should be considered. So should companies for whom there is obvious synergy by being in the industry. Customers or suppliers who can integrate backward or forward comprise another category of potential competitors.

Strategic Groups

Many industries have numerous competitors, far more than can be analyzed individually. In such cases, the application of the concept of strategic groups makes the task of competitor analysis more manageable. A strategic group is a set of firms that face similar threats and opportunities, which are different from the threats and opportunities faced by other sets of companies in the same industry.

Rivalry is usually more intense within strategic groups than between them, because members of the same strategic group focus on the same market segments with similar strategies and resources. In the fast food industry, for example, hamburger chains tend to compete more directly with other hamburger chains than with chicken or pizza restaurants. Similarly, in pharmaceuticals, strategic groups can be defined in terms of the disease categories on which companies focus.

Analysis of strategic groups helps to reveal how competition evolves between competitors with a similar strategic focus. Strategic groups can be mapped by using price, product-line breadth, the degree of vertical integration, and other variables that differentiate competitors within an industry.