Treat of new entrants. Bargaining power of customers. Bargaining power of suppliers. Treat of substitute. products LECTURE 8:GROWTH STRATEGIES PT 2

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1 LECTURE 8:GROWTH STRATEGIES PT 2 THE PORTER S FIVE FORCE ANALYSIS Porter five forces analysis is a framework for industry analysis and business strategy development formed by Michael E. Porter of Harvard Business School in It draws upon industrial organization (IO) economics to derive five forces that determine the competitive intensity and therefore attractiveness of a market. Attractiveness in this context refers to the overall industry profitability. An "unattractive" industry is one in which the combination of these five forces acts to drive down overall profitability. A very unattractive industry would be one approaching "pure competition", in which available profits for all firms are driven to normal profit. Below is a graphical representation of Porter s five forces analysis. Bargaining power of customers Treat of new entrants Bargaining power of suppliers Competitive rivalry Within an industry Treat of substitute products

2 Three of Porter's five forces refer to competition from external sources. The remainder are internal threats. Porter referred to these forces as the micro environment, to contrast it with the more general term macro environment. They consist of those forces close to a company that affect its ability to serve its customers and make a profit. A change in any of the forces normally requires a business unit to re-assess the marketplace given the overall change in industry information. The overall industry attractiveness does not imply that every firm in the industry will return the same profitability. Firms are able to apply their core competencies, business model or network to achieve a profit above the industry average. A clear example of this is the airline industry. As an industry, profitability is low and yet individual companies, by applying unique business models, have been able to make a return in excess of the industry average. Porter's five forces include - three forces from 'horizontal' competition: the threat of substitute products or services, the threat of established rivals, and the threat of new entrants; and two forces from 'vertical' competition: the bargaining power of suppliers and the bargaining power of customers. This five forces analysis, is just one part of the complete Porter strategic models. The other elements are the value chain and the generic strategies. Porter developed his Five Forces analysis in reaction to the then-popular SWOT analysis, which he found unrigorous and ad hoc. Porter's five forces is based on the Structure-Conduct-Performance paradigm in industrial organizational economics. It has been applied to a diverse range of problems, from helping businesses become more profitable to helping governments stabilize industries. Five forces: Threat of new entrants Profitable markets that yield high returns will attract new firms. This results in many new entrants, which eventually will decrease profitability for all firms in the industry. Unless the entry of new firms can be blocked by incumbents, the abnormal profit rate will trend towards zero (perfect competition). The existence of barriers to entry (patents, rights, etc.) The most attractive segment is one in which entry barriers are high and exit barriers are low. Few new firms can enter and non-performing firms can exit easily.

3 Economies of product differences Brand equity Switching costs or sunk costs Capital requirements Access to distribution Customer loyalty to established brands Absolute cost Industry profitability; the more profitable the industry the more attractive it will be to new competitors. Threat of substitute products or services The existence of products outside of the realm of the common product boundaries increases the propensity of customers to switch to alternatives. Note that this should not be confused with competitors' similar products but entirely different ones instead. For example, tap water might be considered a substitute for Coke, whereas Pepsi is a competitor's similar product. Increased marketing for drinking tap water might "shrink the pie" for both Coke and Pepsi, whereas increased Pepsi advertising would likely "grow the pie" (increase consumption of all soft drinks), albeit while giving Pepsi a larger slice at Coke's expense. Buyer propensity to substitute Relative price performance of substitute Buyer switching costs Perceived level of product differentiation Number of substitute products available in the market Ease of substitution. Information-based products are more prone to substitution, as online product can easily replace material product. Substandard product Quality depreciation

4 Bargaining power of customers (buyers): The bargaining power of customers is also described as the market of outputs: the ability of customers to put the firm under pressure, which also affects the customer's sensitivity to price changes. Buyer concentration to firm concentration ratio Degree of dependency upon existing channels of distribution Bargaining leverage, particularly in industries with high fixed costs Buyer switching costs relative to firm switching costs Buyer information availability Availability of existing substitute products Buyer price sensitivity Differential advantage (uniqueness) of industry products RFM Analysis Bargaining power of suppliers: The bargaining power of suppliers is also described as the market of inputs. Suppliers of raw materials, components, labor, and services (such as expertise) to the firm can be a source of power over the firm, when there are few substitutes. Suppliers may refuse to work with the firm, or, e.g., charge excessively high prices for unique resources. Supplier switching costs relative to firm switching costs Degree of differentiation of inputs Impact of inputs on cost or differentiation

5 Presence of substitute inputs Strength of distribution channel Supplier concentration to firm concentration ratio Employee solidarity (e.g. labor unions) Supplier competition - ability to forward vertically integrate and cut out the BUYER Ex.: If you are making biscuits and there is only one person who sells flour, you have no alternative but to buy it from him. Intensity of competitive rivalry: For most industries, the intensity of competitive rivalry is the major determinant of the competitiveness of the industry. Sustainable competitive advantage through innovation Competition between online and offline companies Level of advertising expense Powerful competitive strategy Firm concentration ratio NB: 6th force = Often the model is adjusted with a 6th force, the public authorities. This is important because the law and the norms can influence each of Porter s 5 forces. Key factors for success = The key success factors of the environment have to be identified. To have a competitive advantage some strategic elements should be controlled.

6 Usage Strategy consultants occasionally use Porter's five forces framework when making a qualitative evaluation of a firm's strategic position. However, for most consultants, the framework is only a starting point or "checklist." They might use "Value Chain" afterward. Like all general frameworks, an analysis that uses it to the exclusion of specifics about a particular situation is considered naїve. According to Porter, the five forces model should be used at the line-of-business industry level; it is not designed to be used at the industry group or industry sector level. An industry is defined at a lower, more basic level: a market in which similar or closely related products and/or services are sold to buyers. (See industry information.) A firm that competes in a single industry should develop, at a minimum, one five forces analysis for its industry. Porter makes clear that for diversified companies, the first fundamental issue in corporate strategy is the selection of industries (lines of business) in which the company should compete; and each line of business should develop its own, industry-specific, five forces analysis. The average Global 1,000 company competes in approximately 52 industries (lines of business). Criticisms Porter's framework has been challenged by other academics and strategists such as Stewart Neill. Similarly, the likes of ABC, Kevin P. Coyne and Somu Subramaniam have stated that three dubious assumptions underlie the five forces: That buyers, competitors, and suppliers are unrelated and do not interact and collude. That the source of value is structural advantage (creating barriers to entry). That uncertainty is low, allowing participants in a market to plan for and respond to competitive behavior.

7 An important extension to Porter was found in the work of Adam Brandenburger and Barry Nalebuff of Yale School of Management in the mid-1990s. Using game theory, they added the concept of complementors (also called "the 6th force"), helping to explain the reasoning behind strategic alliances. The idea that complementors are the sixth force has often been credited to Andrew Grove, former CEO of Intel Corporation. According to most references, the sixth force is government or the public. Martyn Richard Jones, whilst consulting at Groupe Bull, developed an augmented 5 forces model in Scotland in It is based on Porter's model and includes Government (national and regional) as well as Pressure Groups as the notional 6th force. This model was the result of work carried out as part of Groupe Bull's Knowledge Asset Management Organisation initiative. Porter indirectly rebutted the assertions of other forces, by referring to innovation, government, and complementary products and services as "factors" that affect the five forces. It is also perhaps not feasible to evaluate the attractiveness of an industry independent of the resources a firm brings to that industry. It is thus argued that this theory be coupled with the Resource-Based View (RBV) in order for the firm to develop a much more sound strategy. It provides a simple perspective for accessing and analyzing the competitive strength and position of a corporation, business or organization. USING THE COMPANY SHELL AS AN ILLUSTRATION OF THE PORTER S FIVE FORCES MODEL ANAYLSIS

8 External environmental analysis for shell : Good business strategic planning will only take place if the organization has detailed knowledge of both the internal and external environments in which it operates in. The PERMADELTS framework together with PORTER S FIVE FORCES model provides a checklist of the most important and major factors that affect an organization. The external environment can be split into three layers with the organization as the core. This diagram shows the various aspects of the external environment and how all the different functions and business aspects are interrelated and have an impact on each other. The PERMADELTS factors can be identified and illustrates why the organization has to conduct an environmental analysis and take the findings into consideration. Each component shall be examine in more analysis and take

9 the findings into consideration. Each component shall be examine in more detail and extract information that is important and relevant to Shell. PERMADELTS : Political and Legal factors can have an impact on business strategy. The political and the legal aspects are placed in the 2nd layer because political and legal policies and laws will affect how the organization operates with its suppliers, laborers, capital customers, investors and other component mentioned in the 3rd layer/ Government European Union, International laws, trade legislation all affect the way the company conduct business. For example the US, UK and Europe placed embargo on trade with certain countries such as IRAQ which is rich in oil supplies. Therefore Shell is unable to extract, supply, or operate any kind of business operations in Iraq. Should Shell have any intentions to develop market growth strategies into this region such restrictions would impact the company s business plan and Shell should neglect this as a possible objective. Employment law varies from country to country differences such as wages, health and safety standards, redundancy policies etc. More recent legislation on CO2 emission is an important factor and should be taken seriously by Shell; this will have an immediate and direct effect on their core business. In countries such as the UK, Italy, France, Germany, Holland and others, government have placed congestion and toll charges for two reasons, first to encourage the general public to use the public transport system to reduce pollution levels and second to encourage the use of alternative engines such as battery operated cars. Where vehicles are battery operated they are omitted from the congestion and toll charges. Therefore the demand for diesel will increase and petroleum to decrease. In 1997, 176 governments from around the world gathered to set and agree target for reducing emission of harmful gasses. Competition law affecting business decisions such as mergers, acquisition or the reduction on restricting competition can open up opportunities for an organization. For example; as airline tickets were subjects to more competitive

10 practices and ticket prices reduced, airline travel increased and the demand for the supply of fuel also increased. Social and Cultural factors : Social and cultural factors include population, lifestyle, values, education, demographics, population rates and social trends. Factors that are likely to affect shell are: Population changes, the more population that exist and population increases the more likely the demand for petrol consumption will increase Lifestyle for example in the US they possess are more luxury lifestyle and require car which have larger engine sizes and therefore consume more petrol. In third world countries and developing countries public transport If a countries population consists of a large number being educated they will have different preferences towards a more healthy society and ethical environment issues will determine their requirement. For example in Japan it is estimated that 75% of the population are university graduates. Hence there strategic positioning on the worlds technological advances. A country such as Japan will require and raise standards in vehicle production to become more fuel efficient and economical. Thus affecting the demand for alternative sources of fuel and reducing the demand in the supply of petroleum. Technological environment : Technological environment have proved to be a vital source for the success, growth, cost-reduction of business. Computers and I.T network have assisted with the improvement towards machinery, logistics, stock-ordering, supplies, communication etc. It also helps in the delivering of organizations hierarchical structures. Improvement in manufacturing has benefited from such technological advances. Cost savings on labor, storage, payments and time

11 Time being a crucial element in business terms, for example communication improvement. One office in Amsterdam can have a virtual meeting with another office in China. Sales and stocks are easily monitored, recorded and reported faster and easier. Economic environment: Third world economies where unemployment is high and income levels are low private vehicles are not high demand which will affect the demand for fuel. Developing economies are important indicators and should be closely monitored as petrol demand is likely to increase. Government fiscal and monetary policies will also affect Shell s operation for capital investment, should interest rates fall investors will spend and not invest in share ventures. High exchange rates will affect product prices. Taxation also affecting wages, profit levels, suppliers prices, tariffs on imported goods etc. Currency and exchange rates need to be addressed as Shell s competitors are also global organizations and petrol prices are affected by the dollar, Euro etc. Physical environment and Ecology : It s a major concern for company like Shell since their business is reliant on natural resources. Materials such as oil cannot be replaced once used up. These materials are of limited supply. The burning of oil cannot be replaced once used up. These materials are of limited supply. The burning of oil gives off harmful emissions and damages the environment. Main areas that will affect Shell are: Natural conditions such as weather, floods, earth quakes, volcanic eruptions. The limited resources caused extraction of raw materials. Logistical issues such as transportation how quickly can Shell supply fuel to their customer (customers being the countries that they sell to)

12 The infrastructures of countries also affect how efficiently they can reach their customers and end-users, third world countries have less advanced transportation systems. Environmental legislation and government permission and licenses. Shell must follow the bureaucratic procedures and apply for licenses and permission from the government s authorities before they can perform any drilling in the search for natural resources, such as fossil fuels.

Porter s Five Forces Model Strategy framework

Porter s Five Forces Model Strategy framework by Martin on August 18, 2014 The five forces model was developed by Michael E. Porter to help companies assess the nature of an industry s competitiveness