ENVIRONMENT ANALYSIS – COMPETITIVE FORCES

OVERVIEW

Objective

! To explain and evaluate the competitive forces model.

COMPETITIVE
FORCES

THE ! Concept
COMPETITIVE ! Model
FORCES MODEL ! New entrants
! Barriers to entry
! Substitutes
! Buyers
! Suppliers
! Rivalry
APPLICATION
AND
EVALUATION

! Application
! Strengths
! Weaknesses
! Market structure
! Government

Copyright Accountancy Tuition Centre Ltd 2001 0401

 ENVIRONMENT ANALYSIS – COMPETITIVE FORCES

1 COMPETITIVE FORCES

1.1 Introduction

Michael Porter of the Harvard Business School engaged in extensive research into the
competitive position and threats affecting major organisations. His theory of
competitive forces, published in 1980, forced strategists to rethink their views on the
nature of competition.

1.2 The concept of competitive forces

Porter defined competition as “any activity within an industry that affects the levels of
margin earned”. As a result of extensive research, Porter concluded that most business
planners were far too “blinkered” in the way they viewed competition, focusing only
on those organisations within their industry who supplied similar products or services
to similar customers. These Porter called “rivals” and said that the term “competitors”
should be broadened to include not just rivals but also a further four types of
competitor.

Though the idea that an organisation “competes” with its customers and suppliers is
fairly radical, the competitive forces model put forward very compelling arguments,
and is now widely accepted.

Porter claimed that there are five “competitive forces” affecting every industry and
that, in most, some force other than rivalry has the greatest impact on the levels of
margin earned.

Copyright Accountancy Tuition Centre Ltd 2001 0402

 ENVIRONMENT ANALYSIS – COMPETITIVE FORCES

1.3 Competitive forces model

BARRIERS TO ENTRY
! Economic of scale GREATEST WHERE
! Which barriers exist? ! Rivals are of similar size
! Other cost advantages
! To what extent do they ! Slow growth in market
! Capital requirements
limit entry ! High fixed costs
! Access to distribution
! Are we trying to get in ! Price wars to maintain
! Patents
or keep others out? turnover
! Government policy
! Reactions of existing firms ! Lack of differentiation
! High exit barriers

THREAT
OF NEW
ENTRANTS
POWERS GREATEST WHERE
! Concentration of buyers
! Alternative sources of POWERS GREATEST WHERE
supply exist ! Few suppliers
! Cost of purchase is high BARGAINING RIVALRY BARGAINING ! Few substitutes
POWER OF POWER OF ! Switching costs are high
proportion of total cost SUPPLIERS
BUYERS ! Possibility of integrating
! Threat of backward integration
! Low switching costs forward
! Buyers have low profits ! Customers not significant
! Buyer has full information THREAT ! Supplier’s product differentiated
OF SUB-
STITUTES

! Can we find new markets

for our products?
! To what extent is there a danger?
! Can it be minimised by
differentiation or low costs?

Copyright Accountancy Tuition Centre Ltd 2000 0403

 ENVIRONMENT ANALYSIS – COMPETITIVE FORCES

1.4 Threats posed by new entrants

There are three threats posed by potential new entrants to an industry:

! They bring with them new capacity which may directly affect the pricing
structures of the industry.

! They threaten market share in a very direct way, because they enter the
industry determined to achieve “critical mass” as quickly as possible. This
will allow them to exploit any scale economies.

! The firms within the industry will face increased costs, as they collectively
erect and maintain barriers to entry in order to deter new entrants.

1.5 Barriers to entry

The concept of entry barriers will be familiar to you from economics. A barrier is any
mechanism that deters entrants.

Example 1

What do you think are the main barriers to entry that firms might use to deter new
entrants?

1.6 Threat from substitutes

A substitute is a product or service that satisfies the same set of needs but originates in
a different industry or different state of technology. The threat posed by a substitute is
that the market volume for our product or service might suddenly reduce as customers
switch.

Our only defences against substitutes are:

! to produce and control them ourselves

! to buy them up

! to differentiate our product to such an extent that customers perceive that

there is “no substitute”

Copyright Accountancy Tuition Centre Ltd 2001 0404

 ENVIRONMENT ANALYSIS – COMPETITIVE FORCES

Example 2

Give examples of industry and technology substitutes for air travel:

! Industry -

! Technology -

1.7 Bargaining power of buyers

Porter suggests that buyers are most powerful when:

! They are relatively large when compared to us

! We represent a significant part of their product cost

! We provide an undifferentiated or standard supply, so they have alternative

suppliers on hand

! There are few switching costs to prevent them buying elsewhere

! They earn low margins, so they want to force our prices down

! The customer threatens backward integration

! They are not quality-sensitive

! They have full information about our cost structure and margins

Example 3

Give examples of powerful buyers in your industry.

1.8 Bargaining power of suppliers

Suppliers are powerful when:

! There are relatively few suppliers of the product or service

! Few or no substitutes exist
! They perceive you to be small or unimportant
! The supplier’s product is an important component in your product or service
! They provide a differentiated or unique product
! They threaten forward integration

Copyright Accountancy Tuition Centre Ltd 2001 0405

 ENVIRONMENT ANALYSIS – COMPETITIVE FORCES

Example 4

Give examples of common powerful suppliers.

1.9 Rivalry

Porter suggests that rivalry is more powerful where:

! Firms are equally balanced

! Industry growth is slow

! Storage costs are high

! There is little product differentiation and therefore little brand loyalty

! Large capacity increments exist due to high stepped fixed costs or large batch
sizes

! High strategic stakes (such as investment in factory or retail premises) exist

! There are high exit barriers, such as redundancy costs

Copyright Accountancy Tuition Centre Ltd 2001 0406

 ENVIRONMENT ANALYSIS – COMPETITIVE FORCES

2 APPLICATION AND EVALUATION

2.1 Introduction

It is not sufficient that you are able to describe and explain the model. You may be
asked to apply it to a specific scenario, or to argue its strengths and weaknesses.

2.2 Applying the competitive forces model

Example 5

Prepare a competitive forces analysis based on the following scenario (3 sides in

total):

Lumber is a UK based drinks company whose origins are in cider manufacture. It has
well-established brand names and cider-making remains at the core of its business.
Over the years the company has expanded its operations, first in products closely
associated with cider and its by-product pectin, then into apple juices, and more
recently into other non-alcoholic drinks. The company has also expanded abroad by
acquisition.

Structure

The company is structured along divisional lines of responsibility split into three key
operating sections.

! The UK drinks division, responsible for the production and sale of cider and
apple juice in the UK, and the wholesale distribution of wines, spirits and
other drinks in the UK.

! The Overseas drinks division, responsible for cider and fruit juice operations
in Australia and the USA, and cider, apple juice and associated exports from
the UK.

! The Pectin division, responsible for the citrus and apple pectin production
and their sales in the UK and overseas, and also responsible for pectin
operations in Brazil and the Bahamas.

Each division of the company has a divisional board with its own managing director,
financial director and other functional directors. The three divisions report to the main
board of the company based in Hereford.

The company is an independent drinks company with more than half the equity
controlled by the Lumber family. Lumber is a firm advocate of industrial participation
and has a central corporate aim “the satisfaction of the needs of the shareholders,
customers and employees”. The stated strategic aim of the group is to achieve
sustained growth through the progressive development of the business and its brands,
and to maintain leadership in all of its key activities. A further aim is to stay
independent from the large drinks groups that dominate the market. Lumber believes
that success can only be achieved if every employee understands and supports the
objectives that the company strives to achieve, and through consultation with its
employees it hopes to build co-operative team spirit.

Copyright Accountancy Tuition Centre Ltd 2001 0407

 ENVIRONMENT ANALYSIS – COMPETITIVE FORCES

Lumber’s trading divisions

The UK drinks division

In order to halt a recent decline in the sales of cider, the company has launched a
number of new brands, namely Special VAT for the premium end of the market
catering for the off-trade (home consumption), and Woodbow 1080, a premium brand
to be distributed through the pub trade. Both of these have been extensively supported
by promotion and advertising. The keg trade in cider is believed to have reached its
optimum level. Lumber still believes in the cider market and has plans to expand its
extraction capacity in Hereford using more locally-grown English fruit.

Soft drinks

Lumber has developed a range of soft drinks to cater for the non-alcoholic market.
Most of the Lumber brands are in the premium sector and are based around apple juice.
More recently Lumber has been developing other juices to increase its range, orange
and grape being the two most important. Carbonated and still juice markets are
growing and Lumber has an agency in the UK for the Perrier range of mineral waters
and these brands play an important role in the Lumber business.

Wines, spirits and other drinks

The wines and spirits business made progress in 20X5/X6 after a slow start. The
market is very competitive and in some cases showing signs of decline. Lumber is
represented by agency businesses in whisky, French brandy, French champagne and
other liqueurs. Lumber is also the marketing company for Domecq sherry. The sherry
market showed a decline of 2 per cent last year and margins are under severe pressure.
Lumber imports a Caribbean beer under the brand Red Stripe. This brand is slowly
making progress, using London as the first area to be covered.

Overseas drinks division

Australia

Lumber has expanded into Australia by a series of acquisitions starting in 20X2 and
continuing into 20X6. The acquisitions have all been in areas closely related to
Lumber’s business. There are plans to import into the country Lumber’s UK cider
brand Woodbow. Tests are being conducted in New South Wales to assess this
decision. The Australian market is new for Lumber and has not been without its
problems. Management has been strengthened with the appointment of a new
management team. The aim is to develop market share in what is a growing market.

United States of America

Lumber has taken an important decision to go into the American market. In 20X4 it
acquired the Red Cheek company, one of the foremost producers of apple juice whose
markets were essentially along the US East Coast. The company believed that by
taking over Red Cheek it would allow Lumber to have an important presence in the US
market where the apple juice market is considered to be a growing one.

Lumber had a number of problems with the Red Cheek acquisition. Severe price
competition meant a squeeze on margins, to which Lumber responded by introducing a
new range of blended fruit juices. The American acquisition cost £18.1 million, a large
sum for a company such as Lumber, and much of this was borrowed.

Copyright Accountancy Tuition Centre Ltd 2001 0408

 ENVIRONMENT ANALYSIS – COMPETITIVE FORCES

This put up gearing, and finance charges on the loan had a depressing effect on profit in
20X4/X5. Further investment was needed in the Red Cheek business in the last
financial year until April 20X6. More work is needed on the Red Cheek acquisition
before it can be claimed to be a resounding success.
Direct exports

The expansion of the European Community has allowed the company to sell its UK
brands in the tourist areas of Spain and Portugal without suffering import duties.
Canada also appears to show promise, particularly the English-speaking areas such as
British Columbia.

The Pectin division

Lumber is the sole manufacturer of this product in the UK and is one of its main
producers in the world.

The pectin operation is based both in the UK and in plants abroad in Brazil and the
Caribbean. Lumber has an agency arrangement with Sunkist Growers Inc of the USA
to market world-wide the “Exchange” brand of pectin it controls. Overseas sales
amount to around 60 per cent of the division’s turnover. Currency movements play a
vital role in the division’s operations.

Outlook

Lumber is still trying to build its business back to the position it held in 20X3/X4.
Slowly the company is being turned around but much work has yet to be done. The
firm is investing substantially in its business and is attempting to reduce the level of its
borrowings. It aims for a complete recovery in the years to come.

2.3 Strengths

The competitive forces model, as you have hopefully found from having to apply it,
certainly changes our view of competition. The specific strengths when compared to
other environment analysis techniques are:

! The structure of the model is very rigorous and formalised

! There is a lot of detail given to support the model and suggest examples to
look for

! The model even suggests or implies some possible responses

2.4 Weaknesses

The competitive forces model does, however, have some weaknesses or difficulties in
application. These include:

! The model is very rigid, and it is sometimes difficult to decide which

category a particular example should go in

Copyright Accountancy Tuition Centre Ltd 2001 0409

 ENVIRONMENT ANALYSIS – COMPETITIVE FORCES

! It is important to be very precise in the definition of what “our” industry is.

This will help to differentiate between, for example, rivals and substitutes.

! If an organisation operates in several industry segments, it is better to do a

separate analysis for each segment. Often the organisation’s products are
“substitutes” for one another.

2.5 Competitive forces and market structure

There is widespread debate as to whether the structure of the industry determines the
competitive forces that act on it, or vice-versa. This is very much a “chicken and egg”
situation, as the two are so closely related it is difficult to distinguish between them.

2.6 The role of government and legislation

Government has a diverse role in the nature of competitive forces acting on an industry.
It appears that each of the forces can be influenced, for example:

! Rivalry may be affected by competition legislation

! Substitutes may be encouraged or protected by government legislation

! Customer and supplier relationships may be affected by import and export

controls or subsidies

! Legal entry barriers such as patents or trademarks may protect the industry

FOCUS

You should now be able to

! understand the general competitive forces model

! discuss the intensity of rivalry among existing competitors

! discuss the bargaining power of suppliers

! discuss the bargaining power of buyers

! discuss the threat of new entrants

! discuss the threat of substitutes

! evaluate the weaknesses of the model

! understand the connection with market structure

! discuss the role of government and regulation.

Copyright Accountancy Tuition Centre Ltd 2001 0410

 ENVIRONMENT ANALYSIS – COMPETITIVE FORCES

EXAMPLE SOLUTIONS

Solution 1 – Barriers to entry

Porter identifies the following entry barriers:

! Economies of scale
! Product differentiation
! Capital requirements such as investment in plant and machinery or marketing
! Cost advantages independent of size (the experience curve effect)
! Access to distribution channels such as retail outlets or “prime sites”
! Government policy
! The expected hostile and aggressive reaction of the firms within the industry

Solution 2 – Substitutes to air travel

! Industry - Rail or cruise

! Technology - Videoconferencing or e-mail

Solution 3 – Powerful buyers

This will obviously depend on your industry, but you might consider any customer or
client that represents a large percentage of your turnover, or perhaps a government
department.

Solution 4 – Powerful suppliers

You might include:

! Electricity or telephone suppliers

! Banks
! Suppliers of scarce raw materials
! Staff (if they have skills that are scarce they can demand high salaries)

Solution 5 – Lumber

This is a very detailed answer, but it does give you some idea of the volume of points
available from the scenario.

Within its drinks operations Lumber is involved in several products and markets.
These can be categorised as cider, soft drinks and other alcoholic drinks, for home and
overseas sales. This report will analyse the competitive nature of Lumber’s industry,
first within the cider market and then its other business activities.

CIDER OPERATIONS

Cider is Lumber’s core business, the firm being involved in manufacture and
distribution on an international basis.

Copyright Accountancy Tuition Centre Ltd 2001 0411

 ENVIRONMENT ANALYSIS – COMPETITIVE FORCES

Suppliers

Industry profitability can be threatened by the presence of powerful suppliers.

Although little information is available on suppliers to the cider business, the following
points should be noted.

! Apple growers in the Hereford region are likely to be the most important
suppliers.
! Suppliers are likely to be small in relation to Lumber plc.
! Within the EC alternative sources of supply are likely to exist.

In conclusion, powerful suppliers are unlikely to prove a threat.

Buyers

Powerful buyers can also pressurise industry profit margins. The major buyers of
Lumber’s cider appear to be the UK pub trade (dominated by UK brewers),
supermarkets and off-sales chains. Details on cider sales overseas are sketchy but sales
are likely to be made to similar businesses. The following points should be noted.

! Some purchasers will be much larger than Lumber.

! Few switching costs exist.
! Buyers’ profit margins are likely to be low.
! Backward integration by public house chains is possible.

There does appear to be a threat from powerful buyers. Lumber’s major protection
here is the strength of its brand names, which could dissuade buyers from switching.

Substitutes

Cider is a traditional product and substitutes could come in many forms. These include
the following.

! Non-alcoholic drinks, particularly in view of health awareness.

! Other alcoholic drinks, for example lagers.
! Home-brewing sales in periods of recession.

The recent decline in cider sales is of concern and more details are required as to
whether this is a market trend, representing a switch away from cider drinking. If the
switch is towards non-alcoholic drinks Lumber has some protection due to its other
operations.

New entrants

New entrants to an industry can make that industry more competitive by price cutting,
promotional activities to build market share and bidding-up the costs of factors of
production. Barriers to entry to an industry protect against new entrants. Barriers to
entry to cider manufacturing and distribution include the following.

! Economies of scale – Lumber believes it is operating at an optimal level in

the production of keg cider; this could be high enough to deter new entrants.
! Product differentiation – through its existing brand names.
! Access to distribution channels – Lumber has established relationships with
the pub trade and off-sales; it is also building up a world-wide distribution
network.

Copyright Accountancy Tuition Centre Ltd 2001 0412

 ENVIRONMENT ANALYSIS – COMPETITIVE FORCES

Whether these barriers would be sufficient to deter a new entrant is open to question.
The industry has a low technology level and capital requirements are likely to be small.
However, if cider consumption is falling the existence of excess capacity might deter
new entrants because of the fear of a price war with existing producers.

Rivals

Little information is available on Lumber’s rivals. However, the company appears

relatively small as compared to the large drinks groups that dominate the market. A
thorough analysis of other cider manufacturers is therefore required. The following
points are worthy of note.

! Decline in cider sales is likely to increase competition.

! Current advertising campaigns by Lumber and innovation in cider production
could be a sign of increased rivalry.
! If Lumber is trying to break into overseas cider markets, the reverse could
also occur and foreign manufacturers could attempt to import into the UK.

OTHER DRINKS

Many of the comments on competitive forces made above could apply equally to
Lumber’s other products. The following additional points should be noted.

Suppliers

! Apple juice operations are likely to have a similar supplier relationship to

cider. This could enhance Lumber’s power over suppliers.
! Perrier agency plays an important role in Lumber’s business and the threat of
forward integration or pressure on margins should be considered.
! Similar comments could be made on wine and spirits supply.
! Suppliers of finance could have great potential influence on the US
subsidiary due to high gearing levels.

Buyers

! Relationships are likely to be similar to cider, but with more emphasis on

supermarket trade for distribution of soft drinks.
! More information is needed on buyers in the USA and other foreign markets.

Substitutes

Decline in wine and spirits sales needs investigation. To which products are consumers
moving?

New entrants

New entrants could be deterred by

! Lumber’s brand names

! the highly competitive nature of the drinks industry
! access to distribution channels: Lumber’s traditional strength in cider
distribution will help here.

However, as many of the wine, spirit and soft drink brands are not owned by Lumber,
this position could be undermined.

Copyright Accountancy Tuition Centre Ltd 2001 0413

 ENVIRONMENT ANALYSIS – COMPETITIVE FORCES

Rivals

! Soft drinks, wines and spirits markets all appear highly competitive.
! More information is needed on rivals in all markets.
! As margins are under pressure in some markets, direct sales by Lumber’s
suppliers could be a threat.

Copyright Accountancy Tuition Centre Ltd 2001 0414