Industry Forces and the Generic Strategies

Industry Forces and the Generic Strategies Chapter 2 2.0 Literature Review In this chapter, the author will review the literature concerning Michael Porters Five Competitive Industry Forces and the Generic Strategies. This study centres on the housing industry and draws parallels to studies done by others. The author will critically evaluate the strengths and weaknesses of the model. 2.1 Background Numerous studies have been done around the world to develop and market housing projects suitable for different demographic segments. The studies on the Sri Lankan housing market are mostly policy papers/reports, leaving a void in regard to studies pertaining to market strategies and competition. Countries like Singapore and Malaysia have well structured strategies resulting in a vibrant housing market available to all this research will focus on drawing parallels on this subject. (Jones Lang LaSalle, Research Report). The California State has used Porters Five Forces Model to understand the industrys attractiveness and competitiveness. The main trend seems to be the increasing rivalry among firms and the consolidation of capital in the industry (William, Mack, 2005). The author intends to draw parallels to the Sri Lankan context. The literature on gaining competitive advantage at business unit level has been growing over the years and the author has attempted to relate academic theory and the tools and concepts of Porters Five Competitive Forces and the Generic Strategies to finding a winning market strategy for the housing industry in Sri Lanka. Although in the international arena the above models have been used extensively in research on housing industry, no such work exists on Sri Lanka. 2.3 Michael Porters Five Forces Model The Five Competitive Forces and the Generic Strategies model was developed by Michael E. Porter in his book ‘Competitive Strategy: Techniques for Analyzing Industries and Competitors in 1980. Since then it has become an important tool for analyzing an organizations structure and strategic processes. Porters models are based on the need for a corporate strategy to meet the opportunities and threats in the organizations external environment. Competitive strategy should be based on an understanding of industry structures and the way they change (Porter, 1980). The ultimate aim of a competitive strategy is to enable a business to defend against competitive forces or in the alternative influence such forces in its favour. The key is to go below the surface and analyse the resources of each competitor. Analysis of such underlying forces will show the critical strength of firms and clarify areas that yield greater profits and highlight areas that show promise of either opportunities or threats (Porter, 1980). As explained in Figure 3, Porter has identified five competitive forces that shape every industry and market, which determine the intensity of competition and the profitability and attractiveness of an industry (Porter, Michael. E, 1979: 137- 145). The author will use the model to deal with the issues below to develop a winning market strategy for the housing business in Sri Lanka. (i) The need to evaluate the suppliers to understand bargaining power and supplier/seller collaboration. (ii) The need to study the pressures of buyers bargaining power and buyer/seller collaboration. (iii) The need to consider the threat of new entrants and the possibilities of new players entering the market. (iv) The awareness of the threat of substitutes and attention to attempts by outsiders to win buyers over to their respective products. (v) Investigating the competitiveness within the industry to keep abreast of market position, increased sales and market share, to have a competitive edge over rivals. A classic example of competitive rivalry is the battle between Coca Cola and Pepsi (Draft, 1988: 251). To understand the strengths and weakness of the model each of these industry forces must be evaluated. 2.3.1 Bargaining Power of Suppliers Supplier bargaining power is likely to be high when the market is dominated by a few large suppliers, when there are no substitutes for their product, the suppliers and customers are fragmented and customer bargaining power is low and switching costs from one supplier to another are high (Porter, 1980). The supplier integrating forward to obtain higher prices and margins is a possibility. This threat is especially high when, the buying industry has a higher profitability than the supplying industry, forward integration provides economies of scale for the supplier, the buying industry hinders the supplying industry in their development, for example, reluctance to accept new releases of products and the buying industry has low barriers of entry. In such situations, the buying industry often experiences high pressure on margins from their suppliers. The relationship to powerful suppliers can potentially reduce strategic options for the organization. 2.3.2 Bargaining Power of Customers Similarly, the bargaining power of customers determines how much customers can impose pressure on margins and volumes. Customers bargaining power is likely to be high when they buy large volumes and there is a concentration of buyers, the supplying industry comprises a large number of small operators, the supplying industry operates with high fixed costs, the product is undifferentiated and can be replaced by substitutes, switching to an alternative product is relatively simple and is not costly, customers have low margins and are price sensitive, customers could produce the product themselves, the product is not of strategic importance to the customer, the customer knows about production costs and the possibility of the customer integrating backwards. 2.3.3 Threat of New Entrants When the competition in an industry is high it is easier for other companies to enter the industry. In such situations, new entrants could change major determinants of the market environment (e.g. market shares, prices, customer loyalty) at any time. There is always a latent pressure for reaction and adjustment for existing players. The threat of new entrants will depend on the extent to which there are barriers to entry. These are typically economies of scale, high initial investments and fixed costs. Cost advantages of existing players are usually due to the experience curve effects of operation with fully depreciated assets, brand loyalty of customers, protected intellectual property like patents, licenses etc., scarcity of important resources, e.g. qualified expert staff, access to raw materials controlled by existing players, distribution channels are controlled by existing players existing players have close customer relations, e.g. from long-term service contracts and the high switching costs for customers, legislation and government action. 2.3.4 Threat of Substitutes Threats from substitutes exists if there are alternative products with lower prices and better performance parameters which can potentially attract a significant proportion of the market, thus reducing potential sales volume for existing players. This category also relates to complementary products. Similar to the threat of new entrants, the threat of substitutes is determined by factors like brand loyalty of customers, close customer relationships, switching costs for customers, the relative price for performance of substitutes and the current trends. 2.3.5 Competitive Rivalry between Existing Players This force describes the intensity of competition between existing players in an industry. High competitive pressure, results in pressure on prices, margins and hence on profitability of every single player. Competition between existing players is likely to be high when, there are many players of about the same size with similar strategies, there is not much differentiation between players and their products resulting in high price competition, market growth rate of a player is possible only at the expense of a competitor and the barriers for exit are high. 2.4 Five Forces Analysis The Five Forces Analysis can provide valuable information for three aspects of corporate planning described below. 2.4.1 Statistic Analysis The Five Forces Analysis enables determining the attractiveness of an industry. It provides insights on profitability. Thus, it supports decisions about entry to or exit from an industry or a market segment. Moreover, the model can be used to compare the impact of competitive forces on ones own organization against that on competitors. Competitors may have different options to react to changes in competitive forces from their different resources and competencies. This may influence the structure of the whole industry. 2.4.2 Dynamical Analysis In combination with a PEST Analysis, which reveals drivers for change in an industry, Five Forces Analysis can reveal insights into the potential future attractiveness of the industry. Expected political, economical, socio-demographical and technological changes can influence the five competitive forces and thus have impact on industry structures. 2.4.3 Analysis of Options With the knowledge about intensity and power of competitive forces, organizations can develop options to influence them in a way that improves their own competitiveness. The result could be a new strategic direction, for example, a new positioning and differentiation for competitive products and strategic partnerships. Thus, the model allows a systematic and structured analysis of market structure and competitive situation and can be applied to particular companies, market segments, industries or regions. 2.4.4 Influence of Five Forces After the analysis of current and potential future state of the five competitive forces, managers can search for options to influence these forces in their organizations interest. Although industry-specific business models will limit options, ones own strategy can change the impact of competitive forces on the organization. The objective is to reduce the power of competitive forces. 2.5 Michael Porters Generic Strategies Model According to Michael Porter a companys strengths ultimately fall into one of two headings; cost advantage and differentiation. Applying these strengths in a broad or narrow scope can result in effective cost leadership, differentiation and focus (Porter Michael. E, 1980: 35-40). Each of these strategies runs its own risk. In reference to a low cost strategy, other companies too may lower their costs to be competitive. In the case of differentiation too, competitors may change customer profiles to latch onto the market segment. With regard to the focus strategy, competitors may try to make changes to the target segment to attract a greater market. (Thompson Arthur. A., Strickland A. J., Gamble John. E. and Jain Arun. K., 2009: 115 138). In this study the focus group is the middle income market segment. Competitive strategies focus on ways in which a company can achieve the most advantageous position (Pearson, 1999). Therefore high profitability can be achieved through achieving the lowest costs or the highest prices vis-Ã  -vis the competition, called ‘cost leadership by Porter and ‘differentiation, is the way in which companies can earn a price premium (Porter, 1980). As explained in Figure 4, there are three generic strategies available to companies to attain competitive advantage, namely overall cost leadership, differentiation and focus (Porter, 1980). These three strategies require a total commitment and organizational arrangements which could be diluted if there is more than one primary target. The basic generic strategy is to outperform competitions, which means a firm could earn high returns. Success of one of the generic strategies will help a firm obtain a just return (Porter, 1980). Companies can achieve competitive advantage essentially by differentiating their products and services from those of competitors and through low costs. Firms can target their products by a broad target, thereby covering most of the marketplace, or they can focus on a narrow target in the market (Lynch, 2003). Each competitive strategy will be evaluated to understand the strengths and weakness of the model. 2.5.1 Cost Leadership Companies using cost leadership strategy attempt to become the lowest-cost producers in an industry. Lowest costs would earn the highest profits where competing products are essentially undifferentiated and sell at a standard market price. In certain instances, the company can charge an average price while following low cost leadership strategy and reinvest the extra profits into the business. Companies like Ryan Air and Easy Jet and ASDA and Tesco adopt a cost leadership strategy (Lynch, 2003). 2.5.2 Differentiation Porter (1980) argues that companies employing differentiation strategy will incur extra costs . These costs may include high advertising to promote a differentiated brand image for the product, which is both a cost and an investment. McDonalds for example is differentiated by its very brand name and brand images of Big Mac and Ronald McDonald. While differentiation has many advantages some problematic areas include the difficulty in ascertaining whether the extra costs entailed in differentiation can actually be recovered from the customer through premium pricing. Moreover, successful differentiation strategy of a firm may attract competitors to enter the companys market segment and copy the differentiated product (Lynch, 2003). 2.5.3 Focus Porter initially presented focus as one of the three generic strategies, but later identified focus as a moderator of the two strategies. Companies employ this strategy by focusing on areas with the least amount of competition (Pearson, 1999). This strategy can be applied by focusing on a specific niche in the market and offering specialised products, hence the name ‘niche strategy (Lynch, 2003). This strategy provides companies the possibility to charge a premium price for superior quality, known as ‘differentiation focus or by offering a low price product to a small and specialised group of buyers, termed ‘cost focus. Ferrari and Rolls-Royce are classic examples of niche players. Both have a niche of premium products available at a premium price. 2.6 Analysis of Porters Generic Strategies Firms can choose from one of the three generic strategies to compete in the marketplace, regardless of the context of industry (Porter, 1980). Kay (1993) and Miller (1992) have cited empirical examples of successful companies like Toyota and Benetton, which have adopted more than one generic strategy. Both these companies used generic strategies of differentiation and low cost simultaneously, which led to their success. Companies that are successful at making use of the cost leadership strategy are often positioned to capitalize on a value proposition which emerges from their low cost emphasis, like the classic success story of Tesco in the UK. Interestingly, an emphasis on cost leadership in this sense can act as a form of differentiation. Successful implementation of a cost leadership strategy would benefit from process engineering skills, products designed for ease of manufacture, access to inexpensive capital, tight cost control and incentives based largely on quantitative targets. McDonalds for example, achieves low costs through standardised products and centralised buying of supplies, etc. Unlike cost leadership strategy, there is empirical evidence to support the differentiation strategy (Pearson, 1999). Hall (1980) investigated sixty-four American companies and the findings of the study revealed that companies following a differentiation strategy had superior performance compared to those companies that were not following the same. The focal point for the company pursuing a differentiation strategy should be the customer, and not per se the competitors. Note that for a differentiation strategy to be successful, the point of differentiation perceived by customers as valuable should coincide with the distinctive competence of the company (Pearson, 1999). For example, Orange succeeded by providing the most basic requirements for mobile phone communication, bettered the competition and created a differentiation in the minds of the consumers. (Barwise et al, 2004). Notably, only a number of small and medium sized companies use the niche strategy (Lynch, 2003). Application of Porters generic strategies to the Portuguese Crystal Glass, the Mould and Porcelain showed that organizations following differentiation strategy tended to achieve higher performance relative to organizations which did not show the presence of a non-classical differentiation based on a time based tendency. (Strategic Orientations of Manufacturing Organisations in the European Market: Evidence from Portugal; Available Online). Notably, most successful firms exhibit one or more forms of differentiation, along with forms that are directly associated with cost leadership and focus orientation. This is one of the grey areas in the analysis of generic strategies that reality can be different and more subtle than the stark contrasts that are highlighted by Porter (1980). Kim et al (2004) have argued that Porters generic strategies of differentiation and cost leadership will be applicable to e-business firms in a broad sense, while the focus/niche strategy will not be as viable for e-business firms, compared to their traditional counterparts. 2.7 Exploration of information for Porters Generic Strategies Analysis The information necessary for conducting the generic strategies analysis can be found in company and competitor websites. Annual reports of companies can be used to analyse the relationships between costs and profitability and how a particular strategy is affecting the firms overall performance. Marketing communication tools used by the company and competitors may also reflect the generic strategies. Advertisements can be a useful source of information to analyse the strategy that is being pursued by the company, and how that differs from that of the competition. Journal articles, trade publications and reputable magazine articles are useful sources of information to analyse industry trends, customer preferences in a given market and the strategies that are being pursued by the companies in a particular industry. 2.8 Relationship between Porters Generic Strategies Analysis and the Five Forces Model The three generic strategies suggested by Porter (1980, 1985) can be effectively utilised to defend against competition in the business environment. The industry forces take the form of competitive rivalry, barriers to entry, threat of substitutes, buyer power and supplier power, explained below (Lynch, 2003). 2.8.1 Competitive Rivalry If the competition in the industry is fierce, the advantage of a cost leadership strategy would be that competitiveness in price. However, cost leadership strategy is not the most desirable, as competitors may put intense price pressures, forcing all players to reduce their prices drastically. Differentiation may be a better strategy as loyal customers may stay with the company. It would also be hard for competitors to cope with specialised needs of customers who are part of a niche segment in the market. 2.8.2 Barriers to Entry A company employing any one of the three strategies would find it easy to create barriers for new entrants. The learning curve of cost leaders in an industry, along with the economies of scale through experience curve effects, would often make it impossible for potential entrants to compete on price, as the more mature firm can further lower prices without comprising its profitability. High customer loyalty towards a companys brands, which is true for the differentiation strategy, can play a vital role in discouraging potential entrants. Customers often choose to be with a niche player because of a certain core competence that only that particular player is providing in the market. Also companies that make use of the focus strategy over time often develop a thorough understanding of their customers needs, which is a very difficult task for a potential entrant. In this way, focus can act as an entry barrier too. 2.8.3 Threat of substitutes It is the differentiation and differentiation-focused strategies that effectively reduce the threat of substitutes. Threat of substitutes is reduced in case of the differentiation strategy due to customer loyalty to the unique aspects of a particular product or service, which no substitute product can offer in the customers mind. In case of the later strategy, the very nature of the companys products and core competence of the firm reduce the threat of substitutes. 2.8.4 Buyer Power The power of buyers changes in accordance with the three generic strategies. Cost leaders have the unique ability to offer lower price options to large and powerful buyers. However, the scenario differs for companies making use of the differentiation and focus strategies. Buyers in case of these two strategies would have less power as there are few alternatives available to them. 2.8.5 Supplier Power Suppliers can exercise their power primarily in case of differentiation and focus/niche strategies. Companies making use of these strategies have the ability to pass the price increases of suppliers to their final customers, through the premium pricing strategy. 2.9 Strengths and Weaknesses of Porters Models Porters model of Five Competitive Forces allows a systematic and structured analysis of market structure and competitive situation. The model can be applied to particular companies, market segments, industries or regions. The strength of competitive forces determines the inflow of investment and drives the returns to free market levels. The five competitive forces such as entry, threat of substitutes, bargaining power of buyers, bargaining power of suppliers and intense competition among rivals reflecting that competition in industry goes beyond established players. Porter identified that these five competitive forces shapes every industry and every market. These forces determine the intensity of competition and hence the profitability and attractiveness of an industry. The objective of corporate strategy should be to modify these competitive forces in a way that improves the position of the organization. Porters model supports analysis of the driving forces in an industry. Based on the information derived from the Five Forces Analysis, management can decide how to influence or to exploit particular characteristics of their industry. Therefore, it is necessary to determine the scope of the market to be analyzed in a first step. Following, all relevant forces for this market are identified and analyzed. Hence, it is not necessary to analyze all elements of all competitive forces with the same depth. The Five Forces Model is based on microeconomics. It takes into account supply and demand, complementary products and substitutes, the relationship between volume of production and cost of production and market structures like monopoly, oligopoly or perfect competition. After the analysis of current and potential future state of the five competitive forces, managers can search for options to influence these forces in their organizations interest. Although industry-specific business models will limit options, the own strategy can change the impact of competitive forces on the organization. The objective is to reduce the power of competitive forces. The model is based on the idea of competition. It assumes that companies try to achieve competitive advantages over other players in the markets as well as over suppliers or customers. With this focus, it dos not really take into consideration strategies like strategic alliances, electronic linking of information systems of all companies along a value chain, virtual enterprise-networks or others. As for the limitations part, nothing in this world is in itself PERFECT, so is this five forces model. Sometimes, it is better if some new player enter the market. It gives way to fresh thinking and catches the attention of the customers, in addition to benefits like infrastructure development. Again, it is better if a decent number of substitutes are valuable in the market, as it makes one think how to better his product and win the hearts of the clients. In reference to the generic strategies it became clear over time that in reality there were some shades of grey in the distinction between differentiation and cost, compared to the black and white that is projected in theory. It is very difficult for most companies to completely ignore cost, no matter how different their product offering is. Similarly, most companies will not admit that their product is essentially the same as that of others (Macmillan et al, 2000). It is important for analysts to bear in mind that Porters generic strategies should be considered as a part of a broader strategic analysis. The generic strategies only provide a good starting point for exploring the concepts of cost leadership and differentiation and may not provide relevant strategic routes in the case of fast growing markets (Lynch, 2003). It is important to conduct other analyses like PESTEL analysis to analyse how the generic strategy being employed by a company should change in accordance with external factors. Other useful analyses would include SWOT analysis of the key success factors etc.