Michael Porter’s Five forces of the Industry Competition

Michael Porter’s work in Strategy
Profitability(Returns on Invested Capital ROIC) of selected US Industries (1992-2006)

Michael Porter made an attempt to analyze why the industries are varying between minimum of 6% and maximum of 41%. And the outcome of his analysis is the FIVE FORCES ANALYSIS.

Five forces of the Industry Competition

#1 Threat of New Entrants (aka Barriers to Entry)
All the below factors would likely push up the barriers to the entry, we will see one by one

• High Economies of Scale: MES(Minimum Efficient Scale) is pointed in the below graph. If the industry is characterized by high MES, individual players in that particular industry cannot afford to play at that cost and if they choose somewhere less than the MES point then the cost-per-unit would me more and hence subsequently they would be thrown out of markets.

So whenever economies of scale is high which is followed by high MES, it restricts more number of players entering into the market.

• High Product Differentiation/ Brand Equity: example Audi brand
• High Capital Requirements: example Airline industry
• High Switching Costs: It refers to the willingness of the customers to switch from the existing products to the new entrant products in the market. The more this cost is, the lower customers would be willing to switch.
• High cost of accessing Distribution Channels: example FMCG dist channels
• Absolute Advantages: like Experience, Technology, IPR, etc. These are irrespective of the scale of what we are operating on. ?? what is experience curve effect? first movers affect?
• High Expected Retaliation: If the industry is characterized with the behavior associated to the players fighting whenever they essentially have a threat of a new entrant coming in(sth which is seen in the past), like Airline industry because of low levels of profits
• High Level of Government Protection

Looking from an incumbents perspective, it is always good to have high barriers to entry.

Higher Barriers to Entry -> High Industry Attractiveness -> Higher Levels of Profitability

This is the only force which we need to keep up in order to have the Industry Attractiveness high. In current markets even this force is going down and business is becoming more and more difficult.

#2 Bargaining Power of Suppliers
Suppliers are likely to be powerful if:

• Few Firms Dominate Supplier Industry: for example there are only two major suppliers in Airline Industry whereas there are 100s of airlines operating on them.
• Few substitutes for Supplier Products (SP)
• Buyer(industry player) not an important customer for supplier
• Supplier is important from a (price/quality) ratio as far as the buyer is concerned
• Supplier is Highly Differentiated
• Supplier is able to induce high Switching Costs: The costs the market player in the industry has to bear in switching between the suppliers.
• High Threat of Forward Integration by Supplier: Boeing(a manufacturing company) starting an airlines
• Low Threat of Backward Integration by Buyer: Indigo(airline players) starting to manufacture airplanes
• Rivalry among Competing Firms

Lower the suppliers are fragmented, the higher power they exhibit, so make sure the suppliers are fragmented.

Higher Bargaining Power of Suppliers -> Lower Industry Attractiveness -> Lower Levels of Profitability

#3 Bargaining Power of Buyers
Buyer groups are likely to be powerful if:

• Buyer concentration is high (buyers of the industry product)
• Buyer purchase accounts for a significant fraction of supplier’s sales
• Products are undifferentiated
• Buyers face few switching costs: between two products in the same industry
• Buyer’s industry earns low profits? like walmart
• Buyer presents a credible threat of backward integration

Higher Bargaining Power of Buyers -> Low Industry Attractiveness -> Lower Levels of Profitability

#4 Threat of Substitute Products
Threat of Substitute Products is high when

• Close substitutes available
• Low Switching Cost: between the substitutes (which may not be in the same industry)
• High Price Value Performance of Substitutes
• High Profitability of Producers of substitutes

For example: A substitute in an airline industry can be video conferencing. It is very important to analyze this force keeping in mind who all can be substituted for your industry products. This is one of the reasons airline industry is declining.

Higher Threat of Substitute Products -> Low Industry Attractiveness -> Lower Levels of Profitability

#5 Rivalry Among Existing Competitors
Rivalry among competition is high when:

• Large number of competitors (aka Low Concentration Ratios)
• Many equally balanced competitors
• Slow growth industry: When the growth rate is very slow one player will try to get into another player’s market which increases rivalry among them.

Note: There should never be cost rivalry in any industry. When there is a rivalry with respect to the costs then most likely the entire industry will get commoditized and will become no longer attractive industry.

• High fixed costs & high storage costs: When these costs are high every player would like sell of his products as soon as possible and thus creating rivalry.
• Changing conditions of demand and supply
• Capacity added in large increments: Since exact demand capacity cannot be calculated every big player add their capacities in big increments and when it turns out that there is glut in the market as every individual did the same thing, it creates rivalry.
• Lack of product differentiation
• Low switching costs between rivals products: between rival incumbent players in a particular industry
• High strategic stakes: in which you not only bring the focal industry but also other industries. For example, Kingfisher survived so long even while accumulating so heavy losses is not because of the economics associated with airline industry but because of economics of other industries he had (liquor business)
• High exit barriers: Companies which cannot compete based on the economics should go out of the industry. For example, AirIndia is being supported by Indian Govt even though it is operated under huge losses in which case it might create rivalry with other players as AirIndia itself is not sensitive to economics whereas other players are.
• High exit barriers are always bad.

Exit barriers are high when
· Highly specialized assets?? number of buyers
· High Fixed Cost of exit (e.g., labor agreements)
· High Strategic interrelationships
· High Emotional barriers
· High Government and social restrictions
Higher Rivalry Among Existing Competitors -> Low Industry Attractiveness -> Lower Levels of Profitability

There are two more additions to these five forces but Porter still didn’t acknowledge them into this framework.
#6 Government Actions
#7 Power of Complimentors

Industry Analysis: Putting it all together

In practical situations it would neither be on the lowest side not on the highest side but some what like this:

Note: This analysis has to be done at several stages of life cycle of a product as it varies over a period of time based on the industry.

Crux of OS&D course and learning from case studies

We got 4 case studies to understand the concept of organization structure and design, why we need it, what are the different models, and what works best for what situation. I’m presenting here the learning/takeaways from the 4 case studies we had in our class:

1.      Robin Hood Case (Strategy Formulation)

• How to formulate a strategy
• What is a sustainable competitive advantage, positional or competency based
• Why we need a strategic competitive advantage (Organizations need to create value superior to their competitors)
• Short term and long term strategy for companies
• Process model of strategy formulation: Know the purpose, assume, analyze, and formulate strategy, followed by organization structure, and keep on doing it via measuring organization efficiency/output/performance, innovating and building competencies to remain ahead of others.

Key Learning: Organizational structure follows strategy. It’s defined to maintain competitive advantage, and strategy never follows the org design.

2.      Cunningham Motors (Make Vs. Buy)

• Two ways to build organizations: Within organizations vs. markets
• Why are companies’ movies towards outsourcing? It’s not about core/non-core, or cost reduction only, it’s also about value maximization. Four main reasons, cost reduction, accessing superior competencies and privileged assets, superior resource leverage, and risk diversification.
• When can extreme outsourcing succeed: When we have modularity and standardization of outputs, I’m good in drawing and enforcing contracts, I can limit others opportunistic behavior, I can minimize uncertain conditions.
• Markets do have hidden costs such as transaction costs and strategic risks. So, it may look like that basic org costs are more for producing something, but if we see total picture, org costs may score high on cost reduction.
• Organizations get formed when markets fail
• Organizations do have principle-agent issue. It can be solved in two ways, Live with goal divergence, but use direct supervision, rules and regulations, financial incentives and penalties, etc. or Increase Goal convergence, by socializing, aligning, inspiring, motivating and mentoring.
• Outsourcing sometimes is mindset problem/core rigidities. This mindset is changing, as we are seeing outsourcing of strategic consulting, R&D, etc. by firms now, than never before.

Key Learning: Don’t be rigid when it comes to outsourcing. Now days with complicated technology, full vertical integration is almost impossible. If it fits the bill, and work is not strategic, do go for it. You can outsource even for strategic consulting. Make sure you have control over the markets from where you are buying.

3.      Old car manufacturers Vs. Henry Ford Vs. Alfred Sloan‘s way of managing things  (Craft Vs. Mass Vs. Variety)

• Old Car manufacturers: “Craft” way, Handmade, highly customized, and highly differentiated for every customer, high on innovation, low on scale. Very high on cost.
• Henry Ford: Vertical integration, assembly line, standardization, specialization, low variety, high efficiency, very low cost, mass manufacturing, economies of scale -> Totally opposite to the “craft” way of doing things.
• Alfred Sloan: Multi-divisional structure, breaking the variety-scale trade off, more variety means increase in costs but keeping other things same as Henry’s model.

Key Learning: Choose the way that fits your strategy. Never try to be on both sides, but we can have some variety without sacrificing advantages of standardization, cost reduction and economies of scale.

4.      Acme and Omega (Organizational structured, Input based and Output based)

• Org structures: Functional, Divisional, Hybrid and Matrix based
• Functional: Input based, Advantages: Specialized within functions, good repo between managers and subordinates, efficient, feedback is taken positively, Disadvantages: lack the vision of overall goal, functional silos, and bureaucracy and communication issues within divisions. -> Good for medium/big enterprise working with defined output and less uncertainty. Mass production, like Acme. -> Cost Leader
• Divisional:  Advantages: Output based, business units based on geographies, products, customers, etc., gets the overall vision of product, Disadvantages: Product silos, Redundancy, non-communicating product divisions, lower in depth specialization. -> Good for small/medium enterprise working with lots of uncertainty, complicated requirements, and complex solutions: R&D efforts, like Omega -> can charge premium for product specialization and customization.
• Hybrid structure: This is combination of functional and divisional but they don’t interfere with each other, for ex. where divisions can be Finance, HR, etc. nonfunctional roles, and then we can have purchase, sales, development, production come under different business units.
• Matrix structure: One employee, multiple bosses, both functions existing and simultaneously too, Product and functional managers have equal responsibilities and authorities. Advantages: Caters to highly changing environment, innovation driven by in depth specialization, not as redundant as divisional model, Disadvantages: Confusing, Can create politics if not implemented properly, Pseudo bosses, need high degree of coordination
• Matrix structure looks very confusing, but is being implemented by organizations successfully. Here are the roles people play in this:

i.            Matrix Leader: Power balancing, dual evaluation, bring out conflicts in open, timely resolution, open debates, and provide directions, stretch and challenge.

ii.            Matrix Boss: Source of power is superior customer knowledge and not just hierarchy, treat the same level boss as customer, keeps in mind the bigger goal that is common to both bosses.

iii.            Two Boss Manager: Should not develop affiliations for favors from either of the boss, resolves conflicts involving both bosses

Key Learning: Structure should be such that it helps people to collaborate, rather than restrict any activity. It should render temporariness, so that processes and behavior matters, and not the structure, should prevent power bases so that changes are accepted, develop orientation towards learning and adapting. Matrix structure has got able characteristics, and is good for very large organizations, if implemented properly.

5.      VFM Solutions (Restructuring)

• Three dimensions to consider while restructuring, strategic objective, job content and human dimension.
• If size of proposed business is huge, it’s better to create it as a Business unit under upper management/CEO.
• Also, need to check if new business is one off or strategic aligned with the objective.
• Can new job be done with existing skill sets? Is there need for training?
• Have I taken my current important colleagues into confidence and was there enough communication with them?

Key Learning: Restructuring is an important aspect, and where exactly to restructure should be determined after carefully accessing the attributes of the new business, skill set required and aspirations of the existing employees.

 

 

Competitive Strategy and role of Organization Structure

What is Competitive Advantage: In simple words, it’s the “edge” a particular firm/company is having over it’s rivals and is able to generate more value for it’s stakeholders (customers, employees, suppliers,shareholders, etc)

Competitive Strategy is a strategy to maintain this advantage over rivals. The more sustainable the competitive advantage, the more difficult it is for competitors to neutralize the advantage.

There are two ways to sustain competitive advantage:

1. Privileged Position: This is just by virtue of you position, and is not sustainable. For example, India is an IT Hub, because of privileged position(low cost, English speaking, good IQ and skilled workforce). Can India or Indian IT companies depend on this position based advantage forever. Time to “think”.
2. Superior skills and competencies : This is a great way to keep you advantage intact by building on rare and non fungible skills required for a leader. Some examples are quality, brand loyalty, innovation, etc.

Important questions:

• What is your source of competitive advantage ?
• Are these based on privileged position or are these based on competencies ?
• Is your competitive advantage sustainable ?
• What must we do in the short run and in the long run to maintain / develop sustainable competitive advantage ?

(Refer Robin hood’s case)

Process model of strategy formulation:

• 3 layered process
• Step 1: What is the organization goal/purpose? What assumptions are we backing up? What does the analysis of the data available tell us? Do I have a competitive advantage, if yes, is that based on my privileged position or competencies.
• Step 2:  Design competitive strategy based on your org goal, assumptions and analysis.What should be done to maintain my advantage, or get to my advantage over others.
• Step 3: Form your organization design to achieve that strategy. Pls note that Org Design should follow Strategy and not other way around.
• Step 4: Keep on innovating on the skills and processes, measure organization performance and build competencies.

This is an ongoing process, and companies keep on working on this aggresively to maintain supremacy.

[This blog is captured from “Organization Structure and Design” class notes (by Prof Sourav Mukherji  Some information referred from Wikipedia/other listed sites.]

 

Repo Rate and Reverse Repo Rate

Repurchase Agreement(REPO Rate): It is the interest rate that central bank controls is called Repo Rate. It is the interest at which commercial banks can borrow from RBI up to a certain limit. This type of transaction is a collateralized transaction. In other words if the bank wants to borrow from RBI, it gives to the RBI a govt’s security. After certain period of time it purchases that same security at lower price. The difference in price is implicit interest rate which is termed as Repo Rate. Technically it is the rate at which liquidity is provided.

Reverse Repo Rate is the rate at which banks could lend to RBI.

Currently RBI sets only Repo Rate and RRR will be 100 basis points (1% less) less than the repo rate. RRR sets the floor for interest rates in the economy. (it means I cannot lend at less than RRR rate)

In between RR and RRR is Marginal Spending Facility Rate, this is 1% above RR and it is non collateralized transaction. Through this RBI has created a corridor for interest rates so that it will fluctuate within these boundaries.

Monetary Policy Implementation

Monetary policy is operated in several channels. Most important are

• banking systems
• financial markets
• exchange rates

In India major monetary policy channel is banking channel, that is why India often regulates Cash Reserve Ratio(CRR).

In banking systems, leverage ratios play prominent role. More on leverage ratios is blogged under financial accounting

leverage ratio = (debt/assets)/(capital/equity)

When a bank’s equity is very low, even a small shock/recession will make the banks bankrupt.

We will discuss more about exchange rates in further posts.

Money Supply, Monetary Base, CRR and Money Multiplier

Money supply in any economy is given as ‘Currency + Deposits’

Currency is the amount of money holding by the individuals. Deposits is the money holding by the bank. Holding 100% funds in currency form by the individuals OR in deposits form in the bank is unrealistic.

In reality we use fractional banking system.

what is fractional banking system? A bank is not required to hold all the money in form of reserves, it is under the assumption that not every account holder will show up at the bank for their cash at one time.

What is Cash Reserve Ratio?: Rule is set by the central bank that at any given point of time commercial banks should hold only a certain amount(20%) of deposits as reserves.

Example:
If say, 1000 Rs is deposited into the bank, then it should keep only 200 Rs with it and lend 800 Rs to others. This will create potential transactions of worth 1800 (1000 Rs which is initially deposited and 800 Rs which is newly created), so it could create economic activity of worth 1800 Rupees. And the remaining 20% (200 Rs) is CRR Cash Reserve Ratio. Others who have received 800 Rs will now deposit that money into another bank in which again 160 Rs (20%) is retained by the bank and remaining 640 Rs is lent to others and this goes on till the deposits reach 5000 Rs. How to arrive at this deposit level of 5000 rupees? is given by CRR itself.

What is Reserve Level?: Initial amount of deposit, i.e, 1000 in above example is called reserve level.

How to compute deposit level from CRR?: Deposit Level = (Reserve Level)/CRR

Reserve level of 1000 will be able to support a deposit level of 1000/0.2 = 5000

What is Monetary Base(MB): is the initial ‘amount of capital’/’Reserve Level’ that is injected into the economy (In above example it is 1000 Rs) It is defined as ‘Currency + Reserves’

The actual amount of money supply in the economy is much higher than the monetary base (In above example it is 5000 Rs). So the Actual Money Supply is a multiple of monetary base, this multiple is called Money Multiplier  (In above example it is 5)

What determines Money Multiplier(MM)? its CRR, the higher the CRR, the lower the MM because the banks cannot indulge in multiple deposit creation.

Now if the Central Bank (CB) wants to decrease the money supply in the economy, it should raise the CRR. This is one instrument CB uses to control liquidity in the economy.

It also depends on the individual on how much to hold the money in his hands in from of currency and how much to put in bank, so central bank has only partial role to control the liquidity through CRR.

Note: CB just sets the floor of CRR but it is up to the commercial banks to decide on the maximum cap of CRR, there is no limit.

During post crisis USA federal reserve’s problem: It can increase the MB as much as it wants. When it is increased by humongous amounts then prices should go up but it is not, because banks are not lending, and instead excess reserves are going up, money multipliers are falling down and hence it is not translating into higher availability of money in the market.

Today both Europe and USA facing similar banking crisis.

In 1929 crisis analysis, pattern observed was currency holdings went up and CRR also went up and as a result credit availability in the economy decreased.

Alternative Dispute Resolution Mechanism [ADR]

As we know that court of law is a process of “expense” and “suspense”, with so many cases lingering around, and taking loads of time, there exists a good alternative for commercial contracts.

In cases of conflict in commercial contracts, there exists a mechanism called alternative dispute resolution mechanism(ADR). Following are the steps involved:

1. Negotiations :Negotiation is a dialogue between two or more people or parties, intended to reach an understanding and resolve point of difference.
2. Mediation: In case bilateral negotiations fail, then mediation comes in. Typically, a third party, the mediator, assists the parties to negotiate a settlement.
3. Conciliation: Conciliation is an alternative dispute resolution (ADR) process whereby the parties to a dispute use a conciliator, who meets with the parties separately in an attempt to resolve their differences.In conciliation the parties seldom, if ever, actually face each other across the table in the presence of the conciliator.
4. Arbitration: Arbitration is a proceeding in which a dispute is resolved by an impartial adjudicator whose decision the parties to the dispute have agreed, or legislation has decreed, will be final and binding. There are limited rights of review and appeal of arbitration awards.

Advantages of arbitration over courts:

• Parties can choose their own judges
• Judges are always uneven, both parties selecting same number of judges, and all judges selecting the final and neutral judge
• Panel can be well versed with the domain
• Anyone can be the arbitrator
• The results are not open in public domain, until and unless both parties agree
• It can be carried out anywhere and anytime
• An arbitration can’t be challenged in the court after award is announced.

It can be challenged in courts only under two scenarios:

1. Very conclusively prove that judges are biased
2. In cases where Arbitration panel questions the law (Why is tax 30% or so.)

This comes under Indian Arbitration and Conciliation Act, 1996, which is exact copy of the International Law, and is universally acceptable.

Is a party doesn’t pay Arbitration Award, then the other party can go to the court. Court will not reopen the case, but will take the award as final, and get other party to pay.

Cost of arbitration can be shared by both parties, or final panel can award the cost to one party.

Lok Adalat is a form of arbitration.

[This blog is captured from “Managing Commercial contracts” class notes (by Prof S. Shankar . Some information referred from Wikipedia/other listed sites.]

Employment Contracts- Valid restrictions on the employees

– Disclosure of company confidential information.

– Starting a competing business

– Double employment

– Solicitation of company customers

– It is said that when Phaneesh Murthy was asked to leave Infosys, he was asked to sign a non-Solicitation bond. This was done so that he do not use his existing relations with the customers to pouch them. As a part of this bond, he was not allowed to setup his own first for one year. In that period, Infosys worked to strengthen the relationship with customers.

[This blog is captured from “Managing Commercial contracts” class notes (by Prof S. Shankar . Some information referred from Wikipedia/other listed sites.]

Salient features of a Bond

– A Bond is a form of contract.

– A Bond is never oral, its always in writing.

– A Bond has an obligation and the condition attached to an obligation.

– Obligation and its related conditions always rest with one person.

– If an obligation is not performed then the condition attached to it is executed.

– A Bond can be considered as a One sided contract (though there is no such legal term as one sided contract).

– A Bond will always be expressed in money terms, it is never in kind.

– A debenture is also sometimes called as Bond.

– Indemnity is for indefinite period e.g. Defence agreements but bonds are for definite period.

– Indemnity arises only after the event happens. Bonds are void if conditions are fulfilled.

[This blog is captured from “Managing Commercial contracts” class notes (by Prof S. Shankar . Some information referred from Wikipedia/other listed sites.]

Key questions to ask when getting into contract

– What is the risk i am getting into by getting into an agreement ?

– It is not possible to cover all the risks in the contract.

– It is considered practical to list all the risks in the table and see how best to address these in the contract.

– The key question becomes- How do i cover the listed risks ? How can the contract help me to cover the risks ?

– Break-up a contract into table containing 2 columns- Essence and Collaterals

– Essence covers the conditions based on which other party and claim the damages.

– Collateral covers the basis on which contract can be cancelled.

[This blog is captured from “Managing Commercial contracts” class notes (by Prof S. Shankar . Some information referred from Wikipedia/other listed sites.]