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Industry analysis: the basics



2 Industry analysis: the basics 3.1 From environmental analysis to industry analysis The determinants of industry profit: Demand and competition Analysis of industry attractiveness The approach of the five competitive forces according to Porter Competition by suppliers of substitutes Market entry threat Rivalry between established competitors Bargaining power of buyers Bargaining power of suppliers The application of industry analysis Description of industry structures Forecast of industry profitability Strategies for changing the industry structure Industry segmentation: Where are the boundaries to be drawn? Sectors and markets Delimitation of markets: Substitution of demand and supply From industry attractiveness to competitive advantage: Identification of key success factors OVERVIEW 3

3 3 SECTOR ANALYSIS: THE BASICS When a management with a reputation for brilliance tackles a business with reputation for poor fundamental economics, it is the reputation of the business that remains intact. Warren Buffet, Chairman, Berkshire Hathaway The reinsurance business has the defect of being too attractive-looking to new entrants for its own good and will therefore always tend to be the opposite of, say, the old business of gathering and rendering dead horses that always tended to contain few and prosperous participants. Charles T. Munger, Chairman, Wesco Financial Corp. Learning Objectives of This Chapter In this and the next chapter, we examine the external corporate environment. In Chapter 1, we found that a thorough understanding of the competitive landscape is a critical part of a successful strategy. We also realized that a business strategy is essentially a search for profit. The primary task of this chapter is to identify sources of profit in the external corporate environment. Since the industry environment is the most relevant environmental aspect for companies, the focus of our environmental analysis will be on the industry analysis. The industry analysis is relevant both at the level of the corporate strategy and the business field strategy. Corporate strategy deals with deciding which industries the company should operate in and how it should divide its resources between them. Such decisions require the investigation of the attractiveness of different branches or industries with regard to their profit potential. The main objective of this chapter is to understand how the competitive structures of an industry determine its profitability. The business field strategy deals with the creation of competitive advantages. By analyzing customer needs and preferences and the way companies compete for customers, we identify principal sources of competitive advantage in an industry, what we call key success factors. By the time you complete this chapter you will be able to identify the key structural features of an industry that affect competition and profitability, use industry analysis to explain why some industries have more competition and lower profitability is than in other industries, 98

4 3.1 From environmental analysis to industry analysis to use indications of structure-changing industry trends in order to forecast future changes in competition and profitability, to develop strategies that are suitable for changing industry structures in such a way that the profitability of the industry is improved and the requirements of competition and analyze customers to identify opportunities to gain competitive advantage in an industry (key success factors). 3.1 From environmental analysis to industry analysis The business environment of a company is made up of all those external influencing factors that influence its decisions and its performance. The question is, given the enormous number and range of external influences, how managers can hope to monitor, let alone analyze, environmental conditions. The starting point is the creation of a system or frame of reference for structuring information. Environmental influences can, for example, be classified according to their source (e.g. into political, economic, social and technological factors) or by their proximity (the microenvironment or working environment is distinguished from more comprehensive influences that make up the macroenvironment). 1 While systematic, ongoing observation and evaluation of the full range of external influences may seem desirable, such extensive environmental analysis is certainly not cost-effective and causes information overload. The national and international economy The natural environment Technology INDUSTRY ENVIRONMENT Suppliers Competitors Customers Demographic structure State and politics Social structure Figure 3.1: From environmental analysis to industry analysis The basic requirement for an efficient environmental analysis is therefore to distinguish between the important and the less important. To do this, one has to return to basic principles. First, in order for the company to be profitable, it must create value for customers. Hence, it has to understand its customers. Second: in the context of value creation, the company acquires goods and services from suppliers. Therefore, it needs to understand its suppliers and know how to build business relationships with them. Third, the ability to generate profits from value-adding activities depends on the intensity of competition between companies seeking the same value-adding opportunities

5 3 INDUSTRY ANALYSIS: THE BASICS are competing. As a result, the company needs to understand the competition. Ultimately, it follows that the core of a company's business environment is constituted by its relationships with three groups of market players: customers, suppliers and competitors. This is the company's industry environment. This is not to say that factors at the macro level, such as general economic developments, changes in demographic structure, or social and political developments, are insignificant for the strategic analysis. These factors can be critical determinants of the threats and opportunities a business will face in the future. The key question is how these general environmental factors affect a company's industry environment (Figure 3.1). For example, if one considers the dangers of global warming, it can be assumed that this is not an important strategic problem for many companies, even with a time horizon of the next 20 years. For automobile manufacturers, however, the indirect effects of global warming on vehicle taxes and restrictions on burning fossil fuels make this environmental factor an important strategic issue today. However, in order to analyze the strategic effects of global warming, automobile manufacturers must identify and assess the consequences for their industry environment: What are the consequences for demand? Will consumers prefer fuel-efficient cars or will there be a shift from fossil fuel-based drives to electric drives? Will private car traffic be substituted by public transport? Will specialist electric vehicle manufacturers enter the automotive market as new competitors? Will the substantial R&D costs associated with adapting cars to the new environmental challenges trigger a consolidation in the industry? 3.2 The Determinants of Industry Profits: Demand and Competition If the purpose of a strategy is to help a company survive and make money, then the starting point for industry analysis is a simple question: what determines the size of profit or the level of return in an industry? As stated earlier, doing business revolves around creating value for customers, either through production (converting input into output) or through trade (arbitrage). Value is created when the price that the customer is willing to pay for a product exceeds the costs incurred by the company. But the creation of value cannot be translated directly into profit. The added value exceeding the costs is divided between the customers and the producers depending on the respective competitive forces. The stronger the competition between producers, the greater the share of this added value that the customer receives in the form of consumer surplus. This consumer surplus also results from the difference between the price actually paid and the maximum price that the consumer would have been willing to pay. Conversely, in the case of high competition and a correspondingly high level of 100

6 3.3 Analysis of the attractiveness of the sector consumer surplus The surplus received by the producers, the producer surplus, turns out to be all the lower. The only bottled water supplier at a party can charge a price that takes full advantage of the dancers' thirst. As soon as there are several mineral water suppliers with constant demand from thirsty party-goers, the competition without price fixing means that the price for the water will fall close to the initial costs or the total costs of the suppliers. But the surplus that the producers earn in addition to the minimum production costs is not fully included in their profits. In industries with powerful providers, monopolistic suppliers of key components or employees who have important but scarce qualifications (e.g. IT specialists), these providers of input factors acquire a large part of the surplus. The surplus collected in this way from the value creation activity provides, for example, a profit contribution for the suppliers or an increased income for the employees. The profits that a company can potentially achieve in an industry regardless of its internal organization are therefore determined by three factors: The value of the product for the customer. The intensity of the competition. The bargaining power of producers vis-à-vis their suppliers. The industry analysis combines these three factors in an analytical frame of reference. 3.3 Analysis of Industry Attractiveness Tables 3.1 and 3.2 show the profitability of different US industries. In some sectors (such as the tobacco and pharmaceutical industries or medical equipment manufacturers) companies generate consistently high returns or profits; in others (for example iron and steel industry, airlines or construction) the companies fail on average to cover their capital costs (figures in brackets). The basic assumption on which an industry analysis is based is that the level of industry profitability is neither accidental nor the result of exclusively industry-specific influences, but that it is determined by systematic influences of the structure of this industry. The US pharmaceutical industry and the US steel industry not only supply very different products, they also have very different structures, which make one industry highly profitable and the other a nightmare of price competition and low margins. The pharmaceutical industry produces highly differentiated products for customers who are not price sensitive because their health is at stake. In addition, for various reasons, the legislature grants monopoly privileges in the form of patents with a term of 20 years to every new product approved on the market. The steel industry produces standardized mass-produced goods with, at least in the period under consideration, falling demand, strong competition from substitutes (e.g. aluminum, plastics) and massive overcapacities. The steel industry sees itself on the one hand through powerful customers and on the other hand through strong unions or raw material suppliers under 101

7 3 SECTOR ANALYSIS: THE BASICS Pressure put. Conversely, the American steel industry and the American airline industry supply very different products, but have a number of similarities in their industry structure, which means that the opportunities for making a profit in both industries are very limited. Some of the most attractive industries are those that offer niche products, as the narrow market for such products often leads to a market-dominating position of only one or two companies (see example 3.1). 1: The profitability of US industries for the period Source: Fortune 1000 by Industry. 102

8 3.2: Measuring the profitability of US industries using the EVA and total return on capital for the period Source: G. Hawawini, V. Subramanian and P. Verdin, Is Firms Profitability Driven by Industry or Firm-Specific Factors? A New Look at the Evidence, Strategic Management Journal 24 (Jan 2003), S Reprinted with permission from John Wiley & Sons Limited. Notes: 1 EVA / CE measures the ratio of economic value added (estimated according to Stern Stewart) to the company's capital employed for each industry. 2 ROA measures the share of net profit in relation to total assets for each industry. 103

9 3 INDUSTRY ANALYSIS: THE BASICS Example 3.1 Chewing tobacco, sausage skins and slot machines in praise of niche markets UST Inc. (formerly US Tobacco) has been the most profitable company in the S&P 500 over the past ten years, often with a return on equity of over 100 percent. Even in 2002, when an antitrust litigation resulted in a $ 1.2 billion penalty on earnings, UST achieved a 38 percent return on investment. What is the secret of UST's success? It's simple: with brands like Skoal, Copenhagen, Long Cut and Red Seal, the company controls 78 percent of the US market for smokeless tobacco (chewing tobacco and snuff). Despite its association with the bygone era of cowboys and rural poverty, chewing tobacco has been a growth market with a surprising number of young consumers over the past two decades. UST's long-established and well-known brands, sales through tens of thousands of small retail stores and the reluctance of large tobacco companies to enter this market resulting from the poor image and lack of social recognition of the product made UST's market position almost unassailable. State controls on the advertising of smoke-free tobacco products have further supported UST's market and competitive position, as it is even more difficult for potential new entrants to establish their brands in the market. Devro plc is based in Moodiesburn, Scotland. It offers collagen sausage skins (sausage skin) worldwide. From the British Bangers to the Chinese Lap Cheong, from the French Merguez to the South American Chourizo, Devro has the right skin that fits all types of products. Although Devro was hit hard by panicky reactions to BSE and foot-and-mouth disease, thanks to a 60 percent global market share for collagen sausage skin (including 94 percent of the UK, 83 percent of the Australian and 40 percent of the US market) it was able to Successfully cope with the crisis-ridden market conditions of the late 1990s. International Game Technology (IGT) is the world's leading manufacturer of gaming machines for casinos and other institutions where gambling is permitted. With continuous use of new gaming machines (for example, the products Elvira: Mistress of the Dark, Hundred Play Draw Poker and Ms Little Green Men were launched in 2002), UGT's US market share exceeded 70 percent. At the same time the market leadership was established in several European countries including Great Britain. With a leading position in mechanical and electronic gaming technologies, a large number of patents and close ties to casino operating companies, supported by its policy of leasing rather than selling machines, UGT's market leadership seemed incontestable. So it is not surprising that UGT achieved an average return on equity of 61 percent between 1999 and 2002. Swell:

10 3.3 Analysis of industry attractiveness Perfect competition Oligopoly Duopoly Monopoly Concentration Entry and exit barriers Product differentiation Availability of information Many companies No barriers Homogeneous products Complete information Few companies Two companies Clear barriers Potential for product differentiation Incomplete information One company High barriers Table 3.3: The range of general competitive conditions of industries Industrial economics provides the underlying theory of how industry structure drives competitive behavior and determines industry profitability. The monopoly theory and the theory of complete competition characterize the two ends of a spectrum of industry structure. A single company, which is protected from new companies by market entry barriers, forms a monopoly within which it can appropriate the entire added value in the form of the resulting profit.In contrast, complete competition is established when a large number of companies deliver an identical product without barriers to entry or exit: the profit rate drops so far that ultimately only the company's cost of capital is covered. In economic life, the industries are somewhere between these two extremes. While the US chewing tobacco market is roughly monopoly, the Chicago grain markets are almost completely competitive. Most manufacturing sectors and many service sectors have the characteristics of oligopolies: they are dominated by a small number of dominant companies. Table 3.3 clarifies essential aspects of the elementary competitive conditions of industries. By examining the basic structural features and their interactions in the respective industry, it is possible to predict the type of likely competitive behavior and the resulting level of profitability.The approach of the five competitive forces according to Porter In Table 3.3 are four structural factors that determine competition and profitability affect, summarized. However, there are a number of other industry characteristics that determine the intensity of competition and the level of profitability. A useful and widely used model to classify and analyze these factors is the Five Forces Framework developed by Michael Porter of Harvard Business School 2. Porter's approach assumes that the profitability of an industry is determined by the ratio of capital returns to the cost of capital from five sources of competitive pressure. These five competitive forces include three sources of horizontal competition: competition from substitute suppliers, competition from potential new suppliers, and competition between existing rivals in 105

11 3 INDUSTRY ANALYSIS: THE FUNDAMENTALS of the industry; and two sources of vertical competition: the bargaining power of suppliers and buyers (see Figure 3.2). Potential new competitors The extent of each of these competitive forces is determined by several key structural factors, which are summarized in Figure 3.3. 3: The structural factors of the five competitive forces 106

12 3.3 Analysis of the attractiveness of the industry Competition from suppliers of substitutes The price that customers are willing to pay for a product or service depends at least in part on the availability of substitutes, i.e. products or services that have a similar benefit to a provide a comparable price. The lack of adequate substitutes with a similar price-benefit ratio, as in the case of gasoline or cigarettes, means that customers are comparatively less price-conscious, that is, the demand is inelastic in relation to the price. The presence of adequate substitutes means that the customer will react to price increases for the product by switching to substitutes, i.e. the demand is elastic in relation to the price. For example, electronic commerce represents a new source of competition from substitution providers, which has turned out to be a tremendous increase in competitive pressure for some established industries. For example, the travel agency industry, especially in Europe and North America, has been brought to the brink of ruin by the growing number of online reservation systems operated by specialist providers such as Expedia or Travelocity as well as directly by airlines. The extent to which prices or profits are limited by substitutes depends on the propensity of buyers to switch between alternatives. This in turn is determined by the respective price-performance ratio. If a journey from Munich to Hamburg by plane is 50 minutes faster than by train, and the average traveler rates an hour at 30, this means that the train is competitive if the fare for train 25 is less than that of the price charged by the airlines. However, we all know that other decision-making factors such as the possibility to work while traveling, customer loyalty offers, fear of flying or an ecological awareness must basically be included in the calculation. In general, the more complex the needs that are satisfied by the product and the more difficult it is to recognize differences in performance, the lower the risk that customers will choose the substitute offer because of price differences. The fact that inexpensive imitations of prestigious perfumes have never achieved significant market shares can be attributed, at least in part, to the difficulties normal customers have in ascertaining the quality characteristics of various fragrances - they therefore rely on the quality signals of the brand's threat to market entry if an average within an industry If a return on capital is achieved that is well above the average cost of capital, then it acts like a magnet on companies outside this industry. Unless the entry of new companies into the market is blocked, profitability will fall close to the level of competition. The US bagel industry, for example, faced a flood of new entrants in 1996 that severely reduced its profit prospects. 3 Not only the actual market access, but the potential market entry threat should be sufficient to ensure that the companies already established in the industry do not set their prices far from the competitive price. An example of this is American Airlines (AA), which is listed as 107

13 3 INDUSTRY ANALYSIS: THE BASICS only airline offers a direct flight between Dallas-Fort Worth, Texas, and Santa Barbara, California. As a quasi-monopoly, AA could now generate a high producer surplus through high ticket prices. Due to the lack of market entry barriers, AA has refrained from exploiting its monopoly position in order not to encourage any other airline to offer the same city connection. An industry in which there are no or very low barriers to entry or exit is arguable: the prices and profits in this industry are close to the competitive level regardless of the current number of providers in the industry. 4 Disputability depends particularly on the absence of so-called sunk costs (past costs). This is understood to mean special costs that arise when market entry requires industry-specific investments (e.g. acquisition of non-transferable licenses, specific production facilities), the value or costs of which cannot be recovered or can only be partially recovered if the market leaves the market. If there are no or only low sunk costs for an industry (e.g. parts of the software industry), then an industry is always susceptible to profit-skimming raid-like market entries and exits as soon as the established companies raise their prices above the competitive level. In most industries, however, new entrants cannot enter on the same terms as the incumbents own. The extent to which established companies have an advantage over newly added companies in terms of unit costs can be described as the level of market entry barriers. Barriers to market entry determine the extent of the profit skimming above the level of competition that can be maintained in an industry in the long term. The main triggers of market entry barriers are capital requirements, economies of scale, cost advantages, the extent of product differentiation, access to sales channels, governmental and legal barriers and retaliatory measures. Capital requirements The capital requirements that are necessary for a successful establishment in a certain industry can be so high that only the largest companies can enter the market. Boeing and Airbus' duopoly on large passenger aircraft is protected by the immense capital cost of building and maintaining the research and development, production and maintenance for the supply of such aircraft. The same is true of the industry that puts commercial satellites into orbit: the cost of developing a rocket and launch equipment, as well as the military interests of individual nations, make it very unlikely that new competitors will enter the market. In other industries, the costs associated with entering the market can be moderate. One reason the e-commerce boom ended in financial disaster for most market participants in the late 1990s is that the initial set-up costs for new internet-based businesses were typically very low. In general, start-up costs in many service industries are still within a framework that enables individual, self-financed entrepreneurs to enter the market. For example, in the fast food chain, the franchise cost for a restaurant at Wendy's is about $ and at Burger King about $ 1 million

14 3.3 Analysis of the attractiveness of the sector Economies of scale In capital, research or advertising-intensive sectors, large-scale production is a prerequisite for efficiency. The problem for potential new entrants is that they are faced with the choice of either starting with small quantities and accepting high unit costs, or starting with large quantities and running the risk of their capacities being underutilized as long as the corresponding sales figures still need to be built up. It is well known in the automotive industry that you have to sell over four million vehicles a year in order to achieve a cost structure on the basis of which you can compete in the mass market. These economies of scale have largely prevented market entry into the industry, so that only two groups of companies have managed to enter the market in the last few decades: on the one hand, state-subsidized companies (e.g. Proton from Malaysia and Maruti from India) and, on the other hand, companies that rely on them that low production costs (preliminary products, personnel) would compensate for their economies of scale (e.g. Sangyong from Korea, which however could not prevail). A major source of economies of scale are product development costs. For example, a new car model typically costs over $ 1.5 billion to develop and bring to market. It is the same with passenger aircraft. Airbus anticipates over $ 20 billion in development costs for the A380 wide-body aircraft means that over 800 aircraft will have to be sold to break even. Taking into account market forecasts for such wide-body aircraft, a further consequence was that Boeing was effectively excluded from the segment of extra-large jumbo jets at the moment that Airbus had committed itself to the project. Corresponding development projects were dropped in favor of a further development of the successful type 747. Absolute cost advantages In addition to economies of scale, established companies can also have a cost advantage over potential new competitors because they were simply earlier in the market. For example, absolute cost advantages are often based on the acquisition of inexpensive raw material sources. Saudi Aramco's access to the world's largest and easiest-to-reach oil reserves gives the company an unassailable cost advantage over Shell, Exxon Mobil and other western oil multinationals, whose production costs per barrel are nearly three times that of Saudi Aramco. Absolute cost advantages can also result from learning effects. Sharp's cost advantage for flat screen televisions is the consequence of early market entry and the resulting ability to learn faster than Sony or Philips. Extent of product differentiation In every industry in which the differentiation of products (e.g. technical properties, quality features) is an essential competitive criterion, established companies have the advantage of brand awareness and customer loyalty. The number of American customers who are loyal to a single brand varies from under 30 percent for batteries, canned vegetables and trash bags to up to 61 percent for toothpaste, 65 percent for mayonnaise and 71 percent 109

15 3 SECTOR ANALYSIS: THE BASICS for cigarettes. 6 In such markets, new entrants have to invest an above-average amount in advertising and sales promotion in order to achieve the same level of brand awareness and brand value as established companies. A study that examined the relationship between the time of market entry and the costs incurred for advertising and promotion in the consumer goods market found that companies added later accept additional costs of 2.12 percent of sales compared to companies that entered the market early had to. 7 As an alternative, new entrants to the market can either accept a niche position in the market or try to compete by offering discounts. Both are at the expense of profits or profit expectations and thus act as a market entry barrier. Access to sales channels While in the consumer goods sector a high level of brand awareness among customers acts as a market entry barrier for new providers, access to sales channels is a more immediate and far more difficult barrier for new market participants. Limited capacities within distribution channels (such as shelf space), risk aversion among retailers and the fixed costs associated with offering additional products mean that retailers are very reluctant to add products from a new manufacturer to their range. The struggle of the large food manufacturers for shelf space in supermarkets, which is also reflected in the fact that the reservation of regular space is typically associated with flat-rate payments to retail chains, has the consequence that new market participants hardly find any entry into this area. State and Legal Barriers Some economists, particularly those of the Chicago School, claim that the only real barriers to market entry can only be created by the state. In taxi companies, banks, the telecommunications industry and television broadcasters, access to the market usually requires the acquisition of a license from a public authority. Since ancient times, corporations and preferred individuals have benefited from governments granting them exclusive rights to operate a particular business or offer a particular service. In knowledge-intensive industries, patents, copyrights and other legally protected forms of intellectual property represent an important barrier to market entry. Xerox's monopoly in the copier industry, which was maintained until the late 1970s, was secured by a protective wall of over patents, which cover individual components of the copying process based. After all, regulatory requirements as well as environmental and safety standards often put new market participants in a disadvantageous position in relation to established companies. It has been found that the monitoring costs for new market entrants are comparatively higher than for established companies. Retaliation Barriers to entry also depend on new entrants' expectations of possible retaliation by established firms. Retaliation against new entrants can take the form of aggressive discounts, 110

16 3.3 Analysis of the attractiveness of the industry if increased advertising, sales promotion or legal disputes arise. For example, the major airlines have a long history of various forms of retaliation against new low-cost competitors. Southwest and other low-cost airlines have argued that the selective discounts offered by American Airlines and other major airlines are tantamount to predatory pricing designed to prevent low-cost carriers from accessing previously profitable routes. 8 In order to avoid retaliation by the long-established companies, new market participants can initially seek limited access to neglected market segments. When Toyota, Nissan and Honda first entered the North American automobile market, one of the reasons they focused on the small car segment was that the three big Detroit manufacturers wrote off this segment as inherently unprofitable. 9 The effectiveness of barriers to market entry Empirical studies show that industries protected by high barriers to market entry often have above-average profitability 10 and that capital requirements and advertising are particularly effective barriers to accessing sources of increased profitability. 11 Whether barriers to market entry prove effective in deterring potential entrants depends on the potential entrant's resources and skills.Barriers that are effective against start-ups may be ineffective against established companies that want to diversify out of another industry. George Yip found no evidence that barriers to market entry deter companies from entering the market. 12 Some new entrants had resources that allowed them to break down barriers and use similar strategies to compete with long-established companies. For example, Mars managed to leverage its strong position in confectionery to enter the ice cream market, while Virgin used its well-established brand name to enter a wide range of industries from airlines to telecommunications. Other companies circumvented barriers to market entry by using innovation strategies. Thus, in the late 1990s, a multitude of established consumer goods companies from banks to booksellers had to grapple with the new competitors of the e-commerce start-ups who used the internet to bypass conventional sales channels and the rivalry between the established competitors in most Industries, the competition between companies within an industry is the main influencing factor on the intensity of competition and the general level of profitability. In some industries, there is aggressive competition among companies, which occasionally goes so far that prices are pushed below costs and thus industry-wide Losses are caused. In other industries, price competition is more moderate and competition is focused on advertising, innovation and other non-price dimensions. Six factors play a decisive role in determining the form and intensity of competition between established companies: the degree of concentration, the heterogeneity of the competing companies, the extent of product differentiation, overcapacities, market exit barriers and cost characteristics. 111

17 3 SECTOR ANALYSIS: THE BASICS The degree of concentration The degree of concentration of the providers relates to the number and size distribution of companies that compete in a market. It is usually measured in terms of the concentration ratio, i.e. the aggregated market share of the leading producers. A concentration ratio of 4, also known as the four-firm concentration ratio (CR4) in the Anglo-American language area, shows, for example, the market share of the four largest producers. A market that is dominated by a single company (e.g. Microsoft for PC operating systems or UST in the US market for smoke-free tobacco products) shows little competition and the dominant company can, all things being equal, make use of considerable discretion in pricing. Where a market is dominated by a small group of leading companies (oligopoly), price competition can also only be effective to a limited extent, due to secret price agreements or even more frequently due to the parallelization of price decisions. 13 As a result, prices tend to be very close in markets that are only dominated by two companies, such as alkaline batteries (Duracell and Eveready), color film (Kodak and Fuji) and soft drinks (Coke and Pepsi) to lie and the competition will focus on advertising, sales promotion and product development. As the number of companies supplying a market increases, the conscious or automatic coordination of prices becomes more difficult and the likelihood increases that a company will start with discounts in order to curb its sales and / or to force weaker competitors out of the market. Apart from the general observation that the displacement of a competitor from the market usually reduces price competition, while the entry of a new competitor typically stimulates it, the systematic evidence of the influence of seller concentration on profitability is surprisingly weak. Richard Schmalensee stated that: The relation, if any, between seller concentration and profitability is weak statistically and the estimated effect is usually small. 14 Competitor heterogeneity The extent to which a group of companies can avoid price competition and engage in secret price fixing depends on how similar the companies are in terms of their origins, goals, production and service programs, cost structures and corporate strategy. The cozy and comfortable atmosphere that prevailed in the American automotive industry until the beginning of the import competition was largely promoted by the homogeneity of the large manufacturers in terms of their cost structures, strategies and the way of thinking of top management. The intense competition that can now be observed on the European and especially the North American automotive market is, conversely, at least partly due to the different national origins, costs, strategies and management styles of the competing companies. Likewise, the difficult task of OPEC to agree on production quotas among the member states and to enforce them is also due to their great heterogeneity in terms of national goals, production conditions and costs as well as political and religious framework conditions. 112

18 3.3 Analysis of the attractiveness of the industry Product differentiation The more similar the offerings of the competing companies in an industry, the more willing customers are to switch and the greater the incentive for companies to lower prices in order to increase sales. Wherever the products are practically indistinguishable from competitors, the product becomes a standardized commodity and the price becomes the sole basis of competition. Typical commodity markets such as agriculture (wheat, cattle), mining (iron, gold) and the petrochemical industry (oil, gas) are, as the special commodity futures exchanges illustrate, very price-sensitive. The individual providers within the industry therefore see themselves exposed to an intense, sometimes ruinous price war, regardless of the general price level, which is very much determined by demand. It is not for nothing that these markets are often characterized by consolidation and a high degree of concentration. In contrast, pure price competition in sectors in which the products are highly differentiated (perfumes, pharmaceutical industry, restaurants, management consultancies) is rather weak, even if there are many competing companies on the market. Overcapacity and Exit Barriers Why does an industry's profitability tend to drop so drastically during a recession? The answer lies in the balance of demand and capacity. Unused capacities cause companies to lower prices in order to be able to conclude new deals and thus spread the fixed costs over a larger volume of sales. Overcapacity can occur cyclically, such as with the alternating boom and recession phases in the semiconductor industry, or it can also be part of a structural problem resulting from previous overinvestment and falling demand. In the latter case, the key question is whether the overcapacities will be reduced again by companies leaving the market. Market exit barriers are the costs associated with reducing capacities in an industry. In cases where resources are long-lasting and specific (e.g. rigid protection against dismissal for employees), there may be significant market exit barriers. 15 For example, a few years ago, high market exit barriers in the European oil refining industry, resulting from the high costs of dismantling refineries, meeting stringent environmental regulations and laying off employees, resulted in persistent excess capacity, which led to profits very low level. Conversely, rapid growth in demand through high utilization of existing production facilities leads to production bottlenecks, which in unregulated markets push profits up in the short term. For example, in the second half of 2003, bulk shipping profits quadrupled as a result of China's increased demand for iron ore. Another example is the sharp rise in global demand for solar cells against the background of the massive rise in prices for fossil fuels, which among other things led to the fact that the production capacity of 2006 was completely sold at the end of 2005 and the manufacturers' profits and share prices rose sharply. 113

19 3 SECTOR ANALYSIS: THE BASICS It follows from this that companies in growing sectors can obviously generate higher profits than companies in slowly growing or shrinking sectors, which is proven by relevant studies (see Figure 3.4). Return on Investment ROI (in%)% MARKET GROWTH Less than -5% -5% to 0 0 to 5% 5 to 10% over 10% 5 0 Return on sales Return on investment Cash flow / investment Figure 3.4: The influence of company growth on profitability Source: RD Buzzell and B.T. Gale, The PIMS Principles (New York: Free Press, 1987) Cost Structures: Economies of Scale and the Relation of Fixed Costs to Variable Costs If overcapacity leads to price competition, how far will prices fall? The answer to this question is provided by the analysis of cost structures. Where the fixed costs are relatively high in relation to the variable costs, companies will also enter into marginal deals at any price that at least covers the variable costs. However, the impact of doing so on profitability can be catastrophic. Between 2001 and 2003, the total losses of American airlines exceeded the cumulative profits that have been made in all years since the industry was created. The willingness of airlines to offer heavily discounted tickets on low-capacity flights is a result of the very low variable costs associated with the occupancy of empty seats. This problem arises in many infrastructure-based industries, such as the hotel industry, parts of the telecommunications industry or the paper industry. The devastating influence of overcapacities on profitability in the petrochemical industry, at tire manufacturers and in the steel and semiconductor industries also has two causes: On the one hand, the high fixed costs in these industries and, on the other, the willingness of companies to do additional business at any price accept that covers the variable costs. Economies of scale can also be a reason why companies enter into aggressive price competition in order to generate cost advantages from higher sales volumes. If, as already mentioned, the necessary economies of scale in the automotive industry presuppose the production of four million vehicles per year, a figure that only six of the 19 international automakers 114

20 3.3 Analysis of the industry's attractiveness, the result is a bitter battle for market share, as every company tries to reach the critical volume. 16 In this respect, the year 2005 represented the high point so far on the North American automobile market. The mutual undercutting by means of special promotions, ruinous financing offers and regular price reductions led to an extreme erosion of prices and high losses, especially for US manufacturers (e.g. General Motors, Ford), which are particularly dependent on their home market. Buyers' bargaining power. Companies typically operate in two types of markets: the market for input goods and the market for output goods. On the market for input goods, companies buy raw materials, components and other intermediate services as well as financial and personnel services. In the market for output goods, companies sell their goods and services to customers (trading companies, consumers or processing producers). In both markets, transactions create value for both buyers and sellers. How this value is divided between them in terms of the resulting profit depends on their relative economic power. First, let's look at the market for output goods. The degree of buyer power a company is exposed to depends on two factors: the buyers' price sensitivity and their relative bargaining power. The price sensitivity of buyers Four important factors determine the sensitivity of potential buyers with regard to the price setting of the companies in an industry: The higher the share of the respective product or service in the total costs of the buyer, the more price sensitive the buyer will be. For example, beverage manufacturers are very sensitive to the cost of tin cans, as this represents one of the largest cost blocks. Conversely, most companies are not very sensitive to the fees charged by their auditors, as the inherently high auditing costs make up a very small proportion of the company's total costs. The less differentiated the products that a certain industry offers, the greater the willingness of buyers to change suppliers due to price considerations, as we have already discussed elsewhere. The manufacturers of T-shirts, light bulbs, empty video cassettes or toys fear the buying power of Wal-Mart or Karstadt much more than the suppliers of perfumes or yacht equipment. The more intense the competition between buyers, the more eagerly they try to force price reductions from suppliers, that is in many cases from suppliers. The increasing competition in the global automotive industry put component suppliers such as Webasto, Brose and Delphi under pressure to lower their prices, increase quality and shorten delivery times. The same goes for the telecommunications equipment industry or airlines. 115