1. An industry is a group of firms producing products (goods and/or services) that are similar to each other. Industry competition attracted the attention of economists, policymakers, and managers long before the rise of the strategy field. The traditional understanding is based on Adam Smith’s (1776) model of perfect competition, in which price is set by the “market,” all firms are price takers, and entries and exits are relatively easy. However, such perfect competition is rarely observed in the real world. Consequently, since the late 1930s, a more realistic branch of economics, called industrial organization (IO) economics (or industrial economics), has emerged. Its primary contribution is a structure-conduct-performance (SCP) model. Structure refers to the structural attributes of an industry (such as the costs of entry/exit). Conduct refers to the firm’s action (such as product differentiation). Performance is the result of firm conduct in response to industry structure, which can be classified as (1) average (normal), (2) below-average, and (3) above-average. The model suggests that industry structure determines firm conduct (or strategy), which, in turn, determines firm performance. <br />However, the original goal of IO economics was not to help firms compete; instead, it was to help policymakers better understand how firms compete in order to properly regulate them. In terms of the number of firms in one industry, there is a continuum ranging from thousands of small firms in perfect competition to only one firm in a monopoly (in between, there can be an oligopoly with only a few players or even a duopoly with two competitors). The numerous small firms can only hope to earn average returns at best, whereas the monopolist may earn above-average returns. Economists and regulators are usually alarmed by above-average returns (which they label “excess profit”). Monopoly is usually outlawed, and oligopoly closely scrutinized. <br />Such and intense focus on above-average firm performance is shared by IO economics and strategy. However, IO economists and policymakers and concerned with the minimization rather than the maximization of above-average profits. The name of the name, from the perspective of the profit-maximizing firm, is to try to earn above-average returns, exactly the opposite. Therefore, strategists have turned the SCP model upside down, by drawing on its insights to help firms perform better. This transformation is the heart of this chapter. <br />THE FIVE FORCE FRAMEWORK <br />The industry-based view of strategy is underpinned by the five forces framework, first advocated by Michael Porter, a Harvard strategy professor, and later extended and strengthened by numerous others. This section traces the framework’s roots, introduces its components, and draws important lessons from it. <br />From Economics to Strategy<br />In 1980, Porter “translated” and extended the SCP model for strategy audiences. The result is the well-known five forces framework. Shown in Figure 2.1, these five forces are (1) the intensity of rivalry among competitors, (2) the threat of potential entry, (3) the bargaining power of suppliers, (4) the bargaining power of buyers, and (5) the threat of substitutes. A key proposition is that firm performance critically depends on the degree of competitiveness these five forces have within an industry.<br /> Rivalry among competitors<br />IndustryCompetitiveness<br />threat of substitutesThreat of entrants <br />Bargaining power of buyers Bargaining power of suppliers <br />The stronger and more competitive these forces are, the less likely the focal firm is able to earn above-average returns, and vice versa Table 2.1). <br />Intensity of Rivalry Competitors<br />Actions that indicate a high degree of rivalry include (1) frequent price wars, (2) proliferation of new products, (3) intense advertising campaigns, and (4) high-cost competitive actions and reactions (such as honoring all competitors’ coupons). Such intense rivalry threatens firms by reducing profits. The key question is: What conditions lead to intense rivalry? <br />At least six sets of conditions emerge (Table 2.1). First, the number of competitors is crucial. The more concentrated an industry is, the fewer the competitors are, and the more likely that competitors will recognize their mutual interdependence and restrain their rivalry (see Chapter 8 for details). As shown in the Opening Case, the few luxury car competitors historically do not engage in intense competitive actions (such as deep discounts) typically found among mass-market competitors. <br />Second, competitors that have a similar size, market influence, and product offerings often vigorously compete with other. This is especially true for firms that are unable to differentiate their products, such as airlines, which have been hit especially hard recently. Hawaiian, Philippines, Sabena, Swissair, United, and US Airways have all recently flown into bankruptcy (see Video Case 2.4). In contrast, the presence of a dominant player lessens rivalry because it can set industry-wide prices and discipline those firms that deviate too much from the prices set. One example of an industry in which a dominant player sets the standards is the global petroleum industry, which is dominated by the Organization of Petroleum Exporting countries (OPEC) – eleven countries representing one-third of the global output. <br />Threats of the Five Forces <br />FIVE FORCESTHREATS INDICATIVE OF STRONG COMPETITIVE FORCES THAT CAN DEPRESS INDUSTRY PROFITABILITY Rivalry among competitors Threat of potential entryBargaining power of suppliersBargaining power of buyers Threat of substitutes A large number of competing firms Rivals are similar in size, influence, and product offerings High-price, low-frequency purchases Capacity is added in large increments Slow industry growth and decline High exit costs Little scale-based low-cost advantages (economies of scale) Little non-scale-based low-cost advantages Insufficient product differentiation Little fear of retaliation No government policy banning or discouraging entry A small number of suppliers Suppliers provides unique, differentiated products Focal firm is not an important customer of suppliers Suppliers are willing and able to vertically integrate forward A small number of buyers Products provide little cost savings or quality of life enhancement Buyers purchase standard, undifferentiated products from focal firm Buyers are having economic difficultiesBuyers are willing and able to vertically integrate backward Substitutes superior to existing products in quality and function Switching costs to use substitutes are low <br />Big Tickets versus Staple Goods<br /> <br />Product Us Market Leader Leader’s Market share Leader’s Share Among Top-4 Firms Big tickets: High-price, less-frequently purchased products Athletic footwearReebok25%40%Automobile General Motors35%46%Mattresses Sealy 25%46%Men’s jeans VF Corporation 26%40%MotorcyclesHonda 33%42%Refrigerators General Electric 34%38%Staple goods: Low-price, more-frequently purchased products BeerAnheuser Busch (Budweiser)44%52%Facial tissues Kimberly-Clark (Kleenex)47%56%Laundry detergents Procter & Gamble 53%59%Light bulbs General Electric 59%62%Photographic film Kodak 76%81%Processed cheese Kraft54%71%<br />Third, intense rivalry also occurs in industries that produce “big ticket items” that are purchased infrequently (such as mattresses and motorcycles). This is because it can be difficult to establish dominance in such industries (that is, the market leader has a very large market share). In contrast, it can be relatively easier for leading firms to dominate in “staple goods” industries with low-price, more-frequently purchased products. Examples include beers, facial tissues, and photographic film, which are dominated by Anheuser Bush (Budweiser), Kimberly-Clark (Kleenex), and Kodak, respectively (see Table 2.2). Consumers for “staple goods” are not likely to spend much time on their purchase decisions, and find it convenient to stick with well-known brands. On the other hand, consumers for “big ticket” items are more interested in searching for a good deal every time they buy, and may not automatically rely on the reputation of leading firms. <br />Fourth, in some industries, new capacity has to be added in large increments, thus fueling intense rivalry. If three shipping companies, each with one ship of equal size, currently serve the route between two seaports, any existing company’s – or new entrant’s – addition of merely one ship, adds to the new capacity by one third. In addition to shipping, hotel, petrochemical, semiconductor, and steel industries periodically experience over-capacity, which leads to price-cutting as a primary coping mechanism. <br />Fifth, slow industry growth or decline makes competitors more desperate, often unleashing competitive actions not used previously. For instance, when facing declining consumer interest in fast food, McDonald’s launched its $1 menu featuring the Big N’ Tasty burger, which costs $1.07 to make in some restaurants. This action, designed to wear out McDonald’s chief competitors, Burger King and Wendy’s, squeezed industry-wide margins as a result (see Video Case 1.3).<br />Finally, industries experiencing high exit costs are like to see firms continue to operate at a loss. Investments in specialized assets such as specific machines, equipment, and facilities that are of little or no alternative use or cannot be sold off pose as exit barriers. In additions, emotional, personal, and career costs, especially on the part of executives admitting failure, can be high. In Japan and Germany, for example, executives may be legally prosecuted if their firms file for bankruptcy. Thus, it is not surprising that these executives try everything before admitting failure and taking their firms out of the industry. <br />Overall, if only a small number of rivals are led by a few dominant firms, new capacity is added incrementally, industry growth is strong, and exit costs are reasonable, the degree of rivalry is likely to be moderate and industry profits more stable. Conditions opposite from those may unleash intense rivalry. Chapter 8 discusses more about interfirm rivalry. <br />Threat of Potential entry<br />In addition to keeping an eye on existing rivals, established firms in an industry, known as incumbents, also have a vested interest in keeping potential new entrants out. New entrants are motivated to enter an industry because of the lucrative, above average returns some incumbents earn. For example, EMC dominated the global data-strong industry, with gross margins reaching a peak of percent during the booming 1990s. One competitor joked that EMC stood for “Excessive Margin Company.” As a result, a powerful pack of heavyweights, led by IBM, HP, and Cisco, have entered this industry to “eat EMC’s lunch. <br />The incumbents’ primary weapons are entry barriers, defined as the industry structures that increase the costs of entry. For instance, it took Boeing $5 billion to develop the 777, and Airbus spent an estimated $10-$15 billion on its A380.Boeing needs to sell more than 2000 aircraft (approximately 15 percent of the global market share) just to break even. This means losing money for at least ten to fourteen years. It probably will take much longer for Airbus to recover its investment on the A380. It is not surprising that currently these are the only two competitors in the large commercial aircraft industry, and that all potential entrants, including those backed by the Japanese, Korean, and Chinese governments, have decided to quit (Airbus itself entered the industry in the 1960s with heavy subsidies from the British, French, German, and Spanish governments). The key question is: What conditions have created such high entry barriers? <br />Shown in Table 2.1, at least five structural attributes are associated with high entry barriers. The first is whether incumbents enjoy scale-based low cost advantages. The key concept is economies of scale, which refers to reductions in per unit costs by increasing the scale of production. This makes sense, because, in general, the more companies perform a certain task, the more efficient they become. Economies of scale can be shown by experience curves, namely, the curves on which firms can drive down unit costs based on their experience with expanding scale. New entrants able to ride down the experience curves faster than incumbents are likely to overcome entry barriers based on economies of scale. For example, Galanz, a Chinese microwave producer, produced 200,000 units in 1999. In 2002, it manufactured 15 million microwave ovens for more than 200 brands all over the world. Galanz has become the world’s volume leader (although not always using its own brand). Such as high output has enabled Galanz to rapidly ride down the experience curve. Consequently; the Chinese giant launched its own brands in Europe, where it held a 40 percent share of the market in 2002.<br />Another set of low-cost advantages that incumbents may enjoy is independent of scale. These are four potential sources for non-scale-based low cost advantages. First, proprietary technological (such as patents) is helpful. When entrants have to “invent around.” The outcome is costly and uncertain. Entrants can also directly copy proprietary technology, which can trigger lawsuits by incumbents for patent violations. This happened to Nexgen, a computer chip maker, when Intel filed such lawsuits. Nexgen paid a heavy price by being forced out of the industry. A second source of such low-cost advantages in know-how, the intricate knowledge of how to make products and serve customers that takes years, sometimes decades, to accumulate. New entrants often struggle to duplicate such know-how. A third source is favorable access to raw materials and distribution channels. Because of a long history of dealing with each other, suppliers may be willing to offer incumbents volume discounts and (corporate) buyers happy to provide incumbents with the best distribution channels. Suppliers and buyers are less likely to offer new entrants with little or no track record such good deals, thereby effectively jacking up the cost structure for new entrants. Finally, given that real estate prices tend to rise (in most cases), in incumbents occupy favorable locations for their operations, new entrants are forced to buy or rent at high prices in similar locations or look for lower-cost, but less-than-desirable locations. <br />In addition to scale-and non-scale-based low-cost advantages, another entry barrier is product differentiation, which refers to the uniqueness of the incumbent’s products that customer’s value. Two underlying sources of differentiation include brand identification and customer loyalty. Incumbents, often through intense advertising, want customers to identify their brands with some unique attributes. For example, BMW brags about its cars being the “ultimate driving machines.” Champagne makers in the French region of Champagne argue that competing products made elsewhere are not really worthy of the name, Champagne.<br />Another source of product differentiation is customer loyalty, especially when switching costs for new products are substantial. Many high-tech industries are characterized by network externalizes, in which the value a user derives from a product increases with the number (or the network) of other users of the same product. These industries have a “winner take all” property, in which winners (incumbents) whose technology standard is embraced by the market (such as the Microsoft Office package of Word, Excel, and PowerPoint, which has approximately 93 percent global market share as of this writing) are essentially locking out potential entrants. In other words, these industries have an interesting “increasing returns” characteristic, as opposed to “diminishing returns” taught in basic economics. In the earlier days of the personal computer (PC) standards war, Microsoft’s DOS was not technically superior to Apple’s Macintosh (Mac). However, through a deal with IBM, Microsoft dramatically increased its installed base and encouraged more software developers to wire DOS-based software. After DOS locked in the market, Microsoft was able to spread its costs over a larger base of users, thus reaping increasing returns. Apple, on the hand, chose a “go alone” strategy suffered from a low installed base, which eventually led even many Mac lovers to switch to DOS. <br />Another entry barrier is possible retaliation by incumbents. Incumbents often maintain some excess capacity, which is designed to punish new entrants (see also Chapter 8). To think slightly outside the box, perhaps the best example is the armed forces maintained by practically every country. They cost taxpayers huge sums of money and do not create much value in peace time. But the armed forces exist for one reason: To deter entry by invading foreign armies. For this reason, no country has even decided to unilaterally disband its armed forces, and the worst punishment for defeated countries (such as Germany and Japan in 1945 and Iraq in 2003) is to have their military dismantled. In general, new entrants are more likely to be deterred if the threat of retaliation is credible and predictable. For example, Coca-Cola is known to retaliate by slashing prices if any competitor (other than Pepsi) crosses the threshold of 10 percent share in any local market. Facing such a determined incumbent, potential entrants often think twice before making a move.<br />Finally, government policy banning or discouraging entries can serve as another entry barrier. For example, the US government does not allow foreign entrants to invest in the defense industry and only allows up to 25 percent equity injection from foreign carriers in the airline industry. In many countries, governments practice protectionist policies to ban or discourage foreign entrants, enabling large, established incumbents to carve up domestic markets (see Integrative Case 1.2). In almost every case, lowering government-imposed entry barriers leads to a proliferation of new entrants, threatening the profit margins of incumbents – as illustrated by the Chinese telecommunications service industry (see Strategy in Action 2.1). <br />Overall, if incumbents can leverage the scale- and/or non-scale-based advantages, provide sufficient differentiation, maintain a credible threat of retaliation, or enjoy regulatory protection, the threat of potential entry becomes weak and incumbents can enjoy higher profits. <br />Bargaining Power of Suppliers<br />Suppliers are organizations that provide materials, services, and manpower to firms in the focal industry. The bargaining power of suppliers refers to their ability to raise prices and/or reduce quality of goods and services. Four conditions lead to strong bargaining power for suppliers (Table 2.1). First, if a few firms dominate the supply industry, they may gain an upper hand. For example, in the PC industry, the most profitable players are not Dell, IBM, or Sony, but their two suppliers, Microsoft (operating systems) and Intel (microprocessors), virtually possess monopolies in these two crucial areas. Conversely, numerous individual coffee growers in Africa and Latin America posses little bargaining power when dealing with multinationals such as Nestle and Starbucks.<br />Second, the bargaining power of suppliers can become substantial if they provide unique, differentiated products with few or no substitutes. For instance, for a Coca-Cola bottler, there is only one supplier for Coke syrup. If Coca-Cola hikes up the syrup price, bottlers, which actually bottle, market, and distribute the soda, have to swallow these increases, even if they are unable to pass the price increases to consumers. It is hardly surprising that Coca-Cola’s return on equity is substantially higher than that of bottlers (for example, 38 percent versus 6 percent in 2002). <br />Third, suppliers can exercise strong bargaining power if the focal firm is not an important customer. Boeing and Airbus, for example, are not too concerned with losing the business of small airlines, which can only purchase one or two aircraft at a time. Consequently, they often refuse to lower prices. In contrast, they are intensely concerned about losing large airlines, such as American, British, Japan, and Singapore Airlines, which typically buy dozens of aircraft at a time. As a result, lower prices and increased services are often offered to those larger airlines.<br />Finally, suppliers can enhance their bargaining power if they are willing and able to enter the focal industry by forward integration. In other words, suppliers can threaten to become both suppliers and rivals. For example, in addition to supplying shoes to traditional department and footwear stores. Nike has established a number of Nike Towns in major cities to directly hawk shoes and sportswear. <br />In summary, powerful suppliers can squeeze profit out of firms in the focal industry. Firms in the focal industry, thus, have an incentive to strength their own bargaining power by reducing their dependence on certain suppliers. For example, Wal-Mart has implemented a policy of not allowing any supplier to account for more than 3 percent of its total purchases.<br />Bargaining Power of Buyers<br />From the perspective of buyers (individual or corporate), firms in the focal industry are essentially suppliers. Therefore, the previous discussion on suppliers is relevant here (Table 2.1). Four conditions lead to strong bargaining power of buyers. First, a small number of buyers lead to strong bargaining power. For example, around the world, thousands of automobile component suppliers try to sell to a small number of automakers, such as BMW, GM, and Honda. These buyers frequently extract price concessions and quality improvements by playing off suppliers against each other. When these automakers invest abroad, they often suggest, encourage, or coerce suppliers to invest with them and demand that supplier factories be sited next to the assembly plants – at the suppliers’ expense. Not surprisingly, many suppliers comply. <br />Second, buyers can enhance their bargaining power if products of an industry do not clearly produce cost savings or add value for buyers. For example, repeated and frequent upgrades in software packages are causing a buyer fatigue. Heads of information technology (IT) departments at many buyer companies are increasingly suspicious about whether the costly new systems are really able to help them save money. In consumer electronic (especially wireless communications), the industry has recently unleashed a bewildering array of new products such as cellular phones, personal digital assistants (PDA), and e-mail pagers. For some consumers who already invested in these gadgets only a few years ago, the rationale to replace them with an expensive new device such as Handspring’s Treo is not compelling (see Video Cases 1.1 and 1.2). The upshot is that reluctant buyers can either refuse to buy or extract significant discounts. <br />Third, buyers can have strong bargaining power if they purchase standard, undifferentiated commodity products from suppliers. Although automobile components suppliers as a group possess less bargaining power relative to automakers, suppliers are not equally powerless. There are usually several tiers of suppliers. The top tier suppliers are the most crucial, often supplying nonstandard, differentiated key components such as electrical systems, steering wheels, and car seats. The bottom tier consists of suppliers making standard, undifferentiated commodity products such as seat belt buckles, cup holders, or simply nuts and bolts. Not surprisingly, top-tier suppliers possess more bargaining power than bottom-tier suppliers. <br />Fourth, buyers can increase their bargaining power when they have economic difficulties. During the early-2000s, individual and corporate consumers in much of the world were reluctant to spend when confronted with the global economic recession and uncertainty. Repeated interest rate cuts by American, European, Japanese, and other authorities did not seem to boost consumption. The upshot is that many goods and services were on sale. <br />Finally, like suppliers may enhance their bargaining power by entering the focal industry through backward integration. For instance, Qualcomm had a 90 percent market share of code division multiple access (CDMA) chips, which power most of the world’s cellular phones. Unfortunately, its two largest buyers, Samsung and Nokia, began making their own CDMA chips, which cut Qualcomm’s share to 80 percent by 2004. Many department stores and grocery chains, in addition to buying merchandise from national-brand producers, also procure store-brand products (such as Kroger, Meijer, Kenmore [Sears], and Safeway brands), which compete side-by-side with national brands for shelf space. Store-brand products currently command approximately 39 percent of grocery sales in Britain, 21 percent in France, and 16 percent in the United States. <br />In summary, powerful or desperate buyers can enhance their bargaining power. Buyers’ bargaining power may be minimized if firms can sell to numerous buyers, clearly add value, provide differentiated products, help buyers with difficulties, and enhance entry barriers.<br />Threat of Substitutes <br />Substitutes are products of different industries that satisfy customer needs currently met by the focal industry. For example instance, while Pepsi is not a substitute for Coke (Pepsi is a rival the same industry), tea, coffee, juice, and water are – that is, they are still beverages, but are in a different product category. Two areas of substitutes are particularly threatening (Table 2.1). First, if substitutes have superior quality and function when compared to existing products, they may rapidly emerge to attract a large number of customers. For example, the emergence of online brokerage houses – such as E* Trade, Ameritrade, and Scot trade, which allow investors more convenient, 24/7 online access at much lower transaction costs – has threatened traditional brokerage houses such as Merrill Lynch. Similarly, digital payment start-ups such as Viewpointe and Net Deposit have significantly jeopardized the business of paper check printing companies such as Deluxe Corporation. Conversely, inferior substitutes have little chance of succeeding. For instance, Eurotunnel threatened to replace ferry services between England and France. Yet, it has not only failed to outcompete ferries, but also been substituted by cut-rate airlines such as Ryan air (see opening Case in Chapter 3) and easy Jet. <br />Second, substitutes pose significant threats if switching costs are low. For example, consumers incur virtually no costs when switching from sugar to a sugar substitute, NutraSweet. Both are readily available in restaurant and grocery stores. On the other hand, no substitutes exist for large passenger jets, especially for transoceanic transportation. Given the disappearance of ship-based transoceanic passenger service since the days of the movie Titanic, the only other way to go to Hawaii or New Zealand seems to be by swimming (!). As a result, Boeing and Airbus can charge higher prices than if there were substitutes for their products. <br />Overall, the possible threat of substitutes requires firms to vigilantly scan the larger environment, as opposed to the narrowly defined focal industry. Enhancing customer value (such as price, quality, utility, and location) may reduce the attractiveness of substitutes. <br />Lessons from the Five Forces Framework <br />Taken together, the five force framework provides three significant lessons. First, it reinforces the important point that not all industries are equal in terms of their potential profitability. It sheds light on why, for example, the pharmaceutical industry is always more profitable than the grocery store industry around the world. The upshot is that when firms have the luxury to choose (such as diversified companies contemplating entry into new industries or entrepreneurial start-ups scanning new opportunities), they are better off choosing an industry whose five forces are weak. Michael Dell, the founder of Dell Computer, confessed that he probably would have avoided the PC industry had he known how competitive it could become. Second, the task for strategists is to assess the opportunities (O) and threats (T) underlying each competitive force affecting an industry, and then estimate the likely profit potential of the industry. Finally, according to Porter, the key is “to stake out a position that is less vulnerable to attack from head-to-head opponents, whether established or new, and less vulnerable to erosion from the direction of buyers, suppliers, and substitutes.” Consequently, the five force framework is also known as the industry positioning school. <br />Although Porter put forward the thrust of this framework more than twenty years ago, it has continued to assert strong influence in strategy practice and research today. While it has been debated and modified (as introduced later), its core features remain remarkably insightful when analyzing new phenomena such as e-commerce. Table 2.3 (p. 52) suggests that despite the myth that the Internet may completely rewrite the rules of competition, the contrary may be true. The so-called “New economy” “appears less like a new economy than like an old economy that has access to a new technology. Unfortunately, from the perspective of the five forces, the benefits of the internet, such as making information widely available and linking buyers and sellers together, tend to threaten profit margins of the focal firms that try to capture these benefits.<br />THE FIVE FORCES AND THE INTERNET <br />FIVE FORCES THREAT REPRESENTED BY THE INTERNET Rivalry among competitors Threat of potential entry Bargaining power of suppliersBargaining power of buyers Threat of substitutes Reduce differentiation among competitors.Drives the basis of competition to price.Increases the number of competitors, which despite having some online presence may be outside the region/country. Reduces entry barriers such as the need for sales forces and brick-and-mortar channels.Internet applications are difficult to keep proprietary from new entrants.Incumbents do not have sufficient advantage to deter entry. More convenient for suppliers to reach end users, reducing the leverage of the focal firm. Internet procurement and digital marketplace may give all companies equal access to suppliers, reducing the value of “special relationships.” Buyers possess greater information on the products of the focal firm and of competitors, facilitating comparison shopping. Buyers can reach producers (suppliers more easily, reducing the focal firm’s bargaining power in distribution industries.The proliferation of internet applications may create new substitutes, making the focal firm’s products (goods and services) obsolete. <br />THREE GENERIC COMPETITIVE STRATEGIES<br />Product Differentiation Market Segmentation Key Functional Areas Cost leadershipDifferentiationFocus Low (mainly by price)High (mainly by uniqueness)Low (mainly by price) or high (mainly by uniqueness)Low (mass-market)High (many market segments)Low (one or a few segments)Manufacturing and materials management Research and development, marketing and sales Any kind of functional area<br />THREE GENERIC STRATEGIES <br />Having identified the five forces underlying industry competition, the next challenge is how to make strategic choices. In 1985, porter suggested three generic strategies, (1) cost leadership, (2) differentiation, and (3) focus, all of which are intended to strengthen the focal firm’s position relative to the five competitive forces. <br />Cost Leadership <br />Recall that our definition of strategy (see Chapter 1) is a firm’s theory of how to compete successfully. A cost leadership strategy basically indicates that a firm’s theory of how to compete successfully centers on low costs and prices. Offering the same product value at a lower price- in other words, better value – tends to attract many more customers. A cost leader often positions its products to target the “average” customers for the mass-market with little differentiation. The key functional areas of cost leaders are manufacturing and materials management, which need to continually ride down the experience curve to keep lowering costs. The hallmark of this strategy is a high-volume, low-margin approach. <br />A great advantage for a leader, such as Wal-Mart, is to minimize the threats from the five forces. First, the cost leader is able to charge lower prices and market better profits than higher cost rivals. Second, its low cost advantage is a significant entry barrier that keeps other rivals out. Third, because the cost leader typically buys a large volume from suppliers, it reduces the bargaining power of suppliers. Fourth, the cost leader would be less negatively affected if strong suppliers increase prices or powerful buyers force prices down. Finally, the cost leader challenges substitutes to not only outcompete the utility its products, but also its prices, a very difficult proposition. Therefore, a true cost leader is relatively safe from these threats. This enviable position is the main reason so many companies try to become cost leaders. However, only a few succeed. For example, Nissan, for decades, has tried, but failed, to outcompete Toyota on a model-by-model basis. This is because Toyota, the cost leader, has a bigger market share, it factories have greater economies of scale for each model, and therefore, its unit costs are usually lower.<br />However, at least two drawbacks come with being the cost leader. First, the danger of being outcompeted on costs always exists. This forces the leader to continuously search for lower costs. For example, a majority of Wall-mart’s nongrocery products are currently produced in low-cost countries such as China, Indonesia, Mexico, and Vietnam. However, twenty years ago, most of them were made in Hong Kong, Singapore, South Korea, and Taiwan, collectively known as the four Tigers. As the Four Tigers gradually lost their low-cost edge, Wal-Mart switched to even lower-cost countries. The managerial task of replacing hundreds of suppliers in the Four Tigers with an equal or larger number of suppliers in a different set of less economically developed countries is simply mind-boggling. Second, in the relentless drive to cut costs, a cost leader may make trade-offs that compromise the value that customers perceive. A case in point is Toyota’s attempt to market a car in Japan with unpainted bumpers. Consumers quickly noticed and rebelled, forcing this model to be withdrawn. The lesson from this experience is not to cut too many corners.<br />Overall, most companies pursue a cost leadership strategy because they find little alternative basis for distinction. However, a number of other firms have decided to be different by embracing the second generic strategy discussed next.<br />Differentiation<br />A differentiation strategy focuses on how to deliver products that customers perceive as valuable and different (Table 2.4). While cost leaders serve “typical” customers, differentiators target customers in smaller, well-defined segments who are willing to pay premium prices. The key is a low-volume, high-margin approach. The ability to charge higher prices enables differentiators to outperform competitors that are unable to do the same. A Lexus car or a Sony TV is not significantly more expensive to produce than a Chrysler car or a Samsung TV. Yet, customers always pay more to get a Lexus or a Sony, enabling these companies to earn healthy profits. To attract customers willing to pay premiums, differentiated products must have some truly or perceived unique attributes, such as quality, sophistication, prestige, and luxury. The challenge is to identify these attributes and deliver value centered on them for each market segment. Therefore, in addition to maintaining a strong lineup for its 3-, 5-, and 7-series, BMW is now filling the “gaps” by adding new 1- and 6-series as well as the revamped Mini and Rolls – Royce brands. For differentiators, research and development (R&D) is an important functional area through which new features can be experimented with and introduced. Another key function is marketing and sales, focusing on both capturing customers’ psychological desires, which lure them to buy, and satisfying their needs after sales through excellent service.<br />According to the five forces framework, the less a differentiator resembles its rivals, the more protected its products are. For instance, Disney theme parks advertise the unique experience associated with Disney movie characters, whereas Kings Island and Six Flags theme parks brag about how fast and tall their roller coasters are. In cosmetics, while L’Oreal stresses how many patents it has filed, Shiseido makes more concrete claims: Its new Body Creator skin gel can melt 1.1 kilograms (2.4 pounds) of body fat a month without any need to diet or exercise (see Closing Case). The bargaining power of suppliers is relatively less of a problem because differentiators may be better able (as compared to cost leaders) to pass on some (but not unlimited) price increases to customers. Similarly, the bargaining power of buyers is less problematic because differentiators tend to enjoy relatively strong brand loyalty. <br />On the other hand, a differentiation strategy has two drawbacks. First, the differentiator may have difficulty sustaining the basis of differentiation in the long run. There is always the danger that customers may decide that the price differential between the differentiator’s and cost leader’s products is not worth paying for. For example, because Mercedes and Chrysler cars increasingly share common parts, Mercedes customers may increasingly wonder why they pay Mercedes prices to get Chrysler material. Second, the differentiator has to confront relentless efforts of competitive imitation. As the overall quality of the industry goes up, brand loyalty in favor of the leading differentiators may decline, for example, IBM’s PCs used to command a premium in the 1980s, but not anymore. The upshot is that differentiators must watch out for imitators and avoid pricing their products out of the market. <br />Overall, a differentiation strategy requires more creativity and capability than a single-minded drive to lower costs. Successful differentiators are able to earn healthy returns.<br />Focus <br />A focus strategy serves the needs of a particular segment or niche of an industry (Table 2.4.). The segment can be defined by geographical market, by type of customer, or by product line. While the breath of the focus is a matter of degree, focused firms usually serve the needs of a segment so unique that broad-based competitors choose not to serve that same segment. As shown in the Opening Case, a small number of focused competitors the ultra luxury segment of the car industry. During negotiations for such cars, price is usually not much of an issue. They key is to provide “meticulous, ‘Wow! Service,” according to one Bentley dealer.<br />In essence, a focused firm is a specialized differentiator or a specialized cost leader. Although it sounds like a tongue twister, a specialized differentiator (such as Bentley) is basically more differentiated than the large differentiator (such as BMW). This approach can be successful when a focused firm possesses intimate knowledge about a particular segment. The logic of how a traditional differentiator can dominate the five forces, discussed before, applies here, the only exception being a much smaller, narrower, but sharper focus. The two drawbacks of differentiation, namely, the difficulty to sustain such expensive differentiation and the challenge of defending against ambitious imitation, also apply here. <br />A focused firm can also be a specialized cost leader. For example, India’s focused IT firms, such as Infosys, Wipro, and TCS, have successfully competed with US giants many times their size, such as Accenture, EDS, and IBM. Indian firms have developed an excellent reputation for providing high-quality service at low costs (see Opening Case in Chapter 1) their programmers earn approximately $5,000 to $10,000 a year, doing the same (or sometimes better) work performed by their Us and European colleagues who are paid five to ten times more. Again, the same rationale for a traditional cost leader to dominate the five forces, described earlier, applies here. The key difference is that a focused cost leader deals with a narrower segment. The two drawbacks, the danger of being outcompeted on costs and of cutting too many corners, are also relevant in the focus strategy. <br />Lessons from the Three Generic Strategies<br />The essence of the three strategic choices is whether to perform activities differently or to perform different activities relative to competitors. Two lessons emerge. First, cost and differentiation are two fundamental strategy dimensions. The key is to choose one dimension and focus on it consistently. Second, companies that are stuck in the middle, that is, neither have the lowest costs nor sufficient differentiation (or focus), can indicate either the lack of a clear strategy or a drifting strategy. Their performance can suffer as a consequence.<br />DEBATES AND EXTENSIONS <br />Although the industry-based view is a powerful strategic tool, it is not without controversies. Therefore, as a new generation of strategists, you need to understand some of the debates and extensions, and avoid uncritical acceptance of the traditional view. This section introduces eight leading debates: (1) clear versus blurred boundaries of industry, (2) threats versus opportunities, (3) five forces versus a sixth force, (4) industry rivalry versus strategic groups, (5) integrating versus outsourcing, (6) being “stuck in the middle” versus being “all-round,” (7) positioning versus hyper competition, and (8) industry – versus firm- and institution-specific determinants of firm performance. <br />Clear versus Blurred Boundaries of Industries<br />The heart of the industry-basedf view is the identification of a clearly demarcated industry. However, this concept of an industry may be increaseingly elusive. For example, consider the relevision broadcasting industry. The emergence of cable, stellite, and telecommunications techonologies has blurred the industry’s boundaries. A television in the future may control houasehold security systems, play interactive games, and place online orders – essentially blending with the functions of a computer. To jocky for advantageous positions in preparation for such a future, a large number of mergers and alliances have involved relevision, telecommunications, cable, soft ware, and movie companies in recent years. In other words, ABC’s competitors not only include CBS, NBC, CNN, and Fox, but also AT&T, Sky TV, Microsoft, Apple, Sony, and others. “so what exactly is this “industry”? <br />Threats versus Opportunities<br />Even assuming the industry boundaries can be clearly identified, the assumption that all five forces are (at least potential)threats seems simplistic and has been challenged on two accounts. Firstm, strategic alliance are on the rise, and even competitorts are increasingly collaborating with each other. GM and Toyota manufacture cars together. Samsung provides computer chips to Sony.MiG and Sukhoi, two of Russia’s leading aircraft and arms rivals collaborate on marketing and avionics (see Strategy in Actions 7.1 in Chapter 7). In other qords, even if these rivals don’t love each other, they don’t hate each other either. Although distrust will continue, some trust in one’s compatitors seems imperative for collaboration to work. For example, on any given day, Motorola may find AT&T to be a competitor and a partner (as well as a supplier and a buyer). Compared with the traditional, black-and-white view, this more complicated, but more realistic <br />