Copyright © 2012 Pearson Canada Inc. 0 Chapter 4 Exploring the External Environment: Macro and Industry Dynamics

Copyright © 2012 Pearson Canada Inc. 1 LEARNING OBJECTIVES 1. Explain the importance of the external environment for strategy and company performance…often called the Structure Conduct Performance (SCP) Model. Contrasted with Ch 3 and the Resource Based View of the Firm (RBV). Together these two approaches satisfy what we used to call our SWOT. 2. Use PESTEL to identify the macro characteristics of the external environment. 3. Identify the major features of an industry and the forces that affect industry profitability – especially issues to do with competition. 4. Understand the dynamic characteristics of the external environment. 5. Show how industry dynamics may redefine industries. 6. Overall, why are some industries more attractive than others?

Copyright © 2012 Pearson Canada Inc. 2 Trading Punches Coca-Cola Coca-Cola invented “Kick Pepsi's can” Diet Coke New Coke Repair Coke and restore stock price Diversify product line Pepsi “Beat Coke” “Pepsi Generation” “Pepsi Challenge” Foster entrepreneurial spirit of Pepsi’s people Jettison slow-growing businesses Diversify beyond soft-drinks

Copyright © 2012 Pearson Canada Inc. 3 The External Environment of Strategy An internal analysis is just half of what is needed to build strategy More complicated frameworks help us understand the full picture Internal Strengths Weaknesses Resources Capabilities Relationships Etc.

Copyright © 2012 Pearson Canada Inc. 4 The External Environment of Strategy Macro Environment Political, Economic, Sociocultural, Technological, Environmental, Legal Industry Environment Strategic Group The Organization

Copyright © 2012 Pearson Canada Inc. 5 The External Environment of Strategy - KEY QUESTIONS TO ASK What macro environmental conditions will have a material effect on our ability to implement our strategy successfully? How stable are these characteristics? What is our firm’s industry? What are the characteristics of the industry?

Copyright © 2012 Pearson Canada Inc. 6 Macro Environment PESTEL analysis is used widely to structure analysis of a company’s external environment. PESTEL is an acronym for the political, economic, sociocultural, technological, environmental, and legal context(s) in which a company operates.

Copyright © 2012 Pearson Canada Inc. 7 Macro Environment – PESTEL analysis Political How stable is the political environment? What are local taxation policies and how do these affect your business? Is the government involved in trading agreements such as EU, NAFTA, ASEAN, or others? What are the foreign-trade regulations? What are the social-welfare policies?

Copyright © 2012 Pearson Canada Inc. 8 Macro Environment – PESTEL analysis Economic What are current and projected interest rates? What is the level of inflation, what is it projected to be, and how does this projection reflect the growth of your market? What are local employment levels per capita and how are they changing? What are the long-term prospects for gross domestic product (GDP) per capita and so on? What are exchange rates between critical markets and how will they affect production and distribution of your goods?

Copyright © 2012 Pearson Canada Inc. 9 Macro Environment – PESTEL analysis Sociocultural What are local lifestyle trends? What are the current demographics and how are they changing? What is the level and distribution of education and income? What are the dominant local religions and what influence do they have on consumer attitudes and opinions? What is the level of consumerism and what are popular attitudes toward it? What pending legislation affects corporate social policies (e.g., domestic-partner benefits or maternity/paternity leave)? What are the attitudes toward work and leisure?

Copyright © 2012 Pearson Canada Inc. 10 Macro Environment – PESTEL analysis Technological What is the level of research funding in government and industry and are those levels changing? What is the government and industry’s level of interest and focus on technology? How mature is the technology? What is the status of intellectual-property issues in the local environment? Are potentially disruptive technologies in adjacent industries creeping in at the edges of the focal industry?

Copyright © 2012 Pearson Canada Inc. 11 Macro Environment – PESTEL analysis Environmental What are local environmental issues? Are there any pending ecological or environmental issues relevant to your industry? How do the activities of international pressure groups (e.g., Greenpeace, Earth First, PETA) affect your business? Are there environmental-protection laws? What are the regulations regarding waste disposal and energy consumption?

Copyright © 2012 Pearson Canada Inc. 12 Macro Environment – PESTEL analysis Legal What are the regulations regarding monopolies and private property? Does intellectual property have legal protections? Are there relevant consumer laws? What is the status of employment, health and safety, and product-safety laws?

Copyright © 2012 Pearson Canada Inc. Globalization See page 78….WTO has been remarkably successful…but ‘sticky’ issues remain Globalization is not always good. Many companies are without oversight as the firm is bigger than the country, the country is bankrupt and without infrastructure, and the IMF and WTO impose rules that make sovereignty impossible. If you’re interested, see the documentary “Life and Debt” on Jamaica’s experience. Even within Canada, there are issues (pharmacists, accountants) 13

Copyright © 2012 Pearson Canada Inc. 14 Macro Environment - PRESSURES FAVOURING INDUSTRY GLOBALIZATION Interdependent countries Homogeneous customer needs Favourable trade policies Large scale and scope economies Global competitors Global customer needs Common technological standards Learning and experience Global channels Common manufacturing and marketing regulations Sourcing efficiencies Competition Markets Governments Costs Favourable logistics Arbitrage opportunities High R&D costs Transferable marketing approaches Source:Adapted from M.E. Porter, Competition in Global industries (Boston: Harvard Business School Press, 1986); G. Yip, “Global Strategy in a World of Nations, “ Sloan Management Review 31:1 (1989), 29-40

Copyright © 2012 Pearson Canada Inc. 15 Value System Analysis The company’s value chain is embedded in a larger system that Michael Porter calls the “value system.” The system is a chain of companies, each with its own value chain. That part of the system that creates and delivers the inputs used by the company is “upstream,” while that part of the system that takes the company’s output to the final consumer is “downstream.”

Copyright © 2012 Pearson Canada Inc. Deconstructing agendas Page 80. “In this book, we are pursuing the goal of managers and shareholders.” See the text for the rest of this paragraph. What do you think? History of the origins of the 5 Forces Model – efforts to increase competition and reduce market imperfections. Research is now used to create and/or perpetuate market imperfections. Responsibilities must accompany this power. Originally, capitalism worked (for society) at the micro level. Managerial and global capitalism raises new issues that haven’t yet been addressed. KSFs (valuable but perhaps not rare. Could be expensive to imitate, though) If industry forces (Porter’s Model) are more important and dynamic on issues related to KSFs then we would be more sensitive to them. 16

Copyright © 2012 Pearson Canada Inc. 17 Industry Analysis – THE FIVES FORCES MODEL (Very important) Buyer Power (Channel and End Consumer) Buyer concentration Importance of volume to customers Differentiation of inputs Impact of outputs on cost of differentiation Switching costs of customers Presence of substitute products Threat of backward integration Costs relative to total purchases in industry Supplier Power Supplier concentration Importance of volume to supplier Differentiation of inputs Impact of inputs on cost or differentiation Switching costs of firms in the industry Presence of substitute inputs Threat of forward integration Cost relative to total purchases in industry Threat of New Entrants (and Entry Barriers) Absolute cost advantages Proprietary learning curve Access to inputs Government policy Economies of scale Capital requirements Brand identity Switching costs Access to distribution Expected retaliation Proprietary products Threat of Substitutes Switching costs Buyer inclination to substitute Price-performance tradeoff of substitutes Varity of substitutes Necessity of product or service Degree of Rivalry Exit barriers Industry concentration Fixed costs/value added Industry growth Intermittent overcapacity Product differences Switching costs Brand identity Diversity of rivals Corporate stakes Source:Adapted from M.E. Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: Free Press, 1980) Industry value chain – from raw materials and other inputs, to channel, to end consumer Complementors Number of complements Relative value added Barriers to complement entry Difficulty of engaging complements Buyer perception of complements Complement exclusivity

Copyright © 2012 Pearson Canada Inc. 18 Industry Analysis - CAUSES OF RIVARLY Barriers to Entry Strong brands Proprietary technology Start-up costs Etc. Barriers to Exit Few other opportunities Sunk investments Etc. In addition to entry and exit barriers, many factors drive rivalry History of price wars Level of fixed costs Industry concentration Market growth Etc.

Copyright © 2012 Pearson Canada Inc. 19 Industry Analysis - SUPPLIER POWER When firms in the supply industry can dictate terms, they can extract greater profits Diamond supply Percent DeBeers Others 50 Diamond Retailers 50

Copyright © 2012 Pearson Canada Inc. 20 Industry Analysis - BUYER POWER SuppliersBuyers Profits I In industries characterized with many suppliers and few buyers, buyers often capture a greater share of profits Industry A SuppliersBuyers Industry B Profits

Copyright © 2012 Pearson Canada Inc. 21 Industry Analysis - THREAT OF SUBSTITUTES Soft drinks CokePepsi Movie rentals Blockbuster Hollywood video Bottled waterCable TV

Copyright © 2012 Pearson Canada Inc. Issues with this Model Industry structure has profound impact, but doesn’t explain total variability (RBV) Depiction of Model suggests a zero sum equation. Increasingly, at least for many firms, we are witnessing alliances and partnerships in recognition of mutual benefits. Win-win is now a possibility for at least some players. Relationships matter more than transactions (within limits) Model, as depicted, is most relevant for ‘some industries’ at ‘some’ time. Its utility is otherwise limited. Model also, to be useful, has to have accurate understanding of ‘business definition’ Page 88 (must be typo) “The pressure on industry operating margins will be significantly GREATER in industries…” Pages Using average scores is problematic. Model needs analyst to “weight” the importance of the factor and then score it, not just treat them all as equally weighted. Average score is not helpful. In depth research is needed (and judgment). 22

Copyright © 2012 Pearson Canada Inc. 23 Industry Analysis - IMPACT OF COMPLEMENTOR Any factor that makes it more attractive for suppliers to supply an industry on favourable terms or that makes it more attractive for buyers to purchase products or services from an industry at prices higher than it would pay absent the complementor OR in greater quantities Some firms create their own complementors (Apple, Amazon) In ‘corporate strategy’ we will discuss what business are you in? Horizontal and vertical integration are possible. Complementor: Hot dogs + Buns More sales Three Examples Music + MP3 player More attractive offering Westjet plane orders + Air Canada plane orders Lower costs from Boeing

Copyright © 2012 Pearson Canada Inc. 5 Forces Plus Complementors (Model for evaluating industry structure and its implications on firm performance (SCP) Increases in 5 Forces leads to decreases in profitability Increases in complementors (normally) leads to increases in profitability 24

Copyright © 2012 Pearson Canada Inc. Uses of Industry Structure Model Use to assess fit and alignment of strategy and to identify needed changes Use to query future conditions Hi Q strategies will help firms Min buyer power Min supplier power Min rivalry Min substitutes Increase barriers to entry for focal firm Next Step: Delve even deeper into competitor analysis 25

Copyright © 2012 Pearson Canada Inc. 26 Competitor Analysis Mapping Competitors Strategic Groups (what are they? Who is in, which ones might we join?) Value curve helps with this. The Value Curve (pages 92-93) Predicting Competitors’ Behaviours

Copyright © 2012 Pearson Canada Inc. Competitor Analysis With an accurate understanding of industry definition, and with an accurate understanding of KSFs, and within each group… What are industry structure issues? (see page 96 and how might that affect competitors?) Who? Strategy? Assumptions? Objectives? Performance? Potential for retaliation? 27

Copyright © 2012 Pearson Canada Inc. 28 Dynamic Characteristics of the External Environment - INDUSTRY LIFE CYCLE Market Size Time Embryonic Technological uncertainty Niche market – selected products for selected markets Participants emphasize problem solving – product as “solution” Growing Customers become better informed Market expands beyond niche More competitors enter Mature Aggressive customers Proliferation of products and markets served Market volatility and beginnings of industry consolidation In Decline Product/market contraction Further consolidation and industry regeneration

Copyright © 2012 Pearson Canada Inc. Evolution and Change Commoditization Reinvigoration Information Tactics 29

Copyright © 2012 Pearson Canada Inc. 30 Dynamic Characteristics of the External Environment - TECHNOLOGICAL DISCONTINUITIES Discontinuities Process-related Product-related Southwest Airlines radically changed the airline business model by adopting new processes (e.g., a point-to-point model) In disk-drive industry, virtually every new generation of technology led to demise of market leader Example

Copyright © 2012 Pearson Canada Inc. Incumbents vs Entrants and the “Innovator’s Dilemna” Competency Enhancing Innovations Disruptive innovations One option is for incumbents to use ‘real’ options 31