Michael Porter

Exit barriers intensify competitive rivalry by stopping businesses that are losing money from leaving the industry when there is little or no hope of future profitability.

The Five Forces model  from Michael Porter is an important way to understand the competitive pressures within an industry and at the centre is competitive rivalry.

What Are The Major Exit Barriers?

I’ve split the discussion of exit barriers into two sections for rational barriers backed up with economic logic and emotional barriers which create commitment beyond the level where it makes sense financially.

Rational Exit Barriers

• Specialised assets – some industries require specialised assets and capabilities which cannot create value in other markets. Assets that can be re-used elsewhere or those that are easily adapted make it easier for a business to move from one market where it is struggling to another where prospects look brighter.
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• Contractual arrangements – the business may have entered into contracts with customers and suppliers where breach of contract creates punitive damages which the business cannot afford. Even if there is nothing in writing, a business may be unwilling to break its commitments because of relationship and reputation damage that could affect other parts of the business or group.
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• Vertical integration with other business units – a group may have a number of subsidiaries connected in the industry value chain. While one may be losing money (although transfer pricing makes it difficult to get a realistic arms-length assessment), damage may be done to the other businesses.

Emotional Exit Barriers

• The business may come under political or social pressure to keep an important factory unit open because it is a key part of the local economy. Sometimes financial help may be available but more often the business fears damage through bad publicity.
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• The owner or senior managers may have an emotional commitment to the business which makes it unwilling to concede defeat even when the economic justification for exit is compelling. Perhaps the business was where it all began and therefore there are heritage reasons to keep the business going which link into the core story. Perhaps there is loyalty to employees or fear for what it means for their own personal positions.

The Impact Of Barriers To Exit

Whatever the cause of the barriers to exit, the end result is that firms stay in the market when it is better for them and their competitors that they leave in an orderly manner.

It therefore makes sense for the market leader or someone determined to win the “last man standing” strategy in a declining market to help struggling firms to leave and take out the excess capacity.

The worst that can happen is for the business to go bankrupt and to be bought for a song by an ambitious management team with an idea to shake-up the industry with a strategic innovation and the financial backing to make it happen.

More often, the existing management and shareholders find the finance to buy the business back in a pre-pack administration deal, free of the high levels of debt and contingent liabilities that stopped an effective turnaround taking place.  It may lead to a viable business or the industry economics may cause future problems.

In his book Competitive Strategy, Michael Porter introduces the idea of generic competitive strategies and says that a business must choose between differentiation and cost leadership or risk being “stuck in the middle”, missing on the high profitability that an effective strategy for one or the other.

Differentiation Or Cost Leadership

Porter argues that businesses face a choice – differentiation or cost leadership over a broad or narrow market – if the firm wants to avoid low profitability that comes from confused customers and employees from a “blurred corporate culture”.

This is because achieving cost leadership normally involves eliminating all those little bits of extra product functionality and customer service that bump up customer value in the eyes of customers looking for a differentiated product because they cost money.

This makes a lot of sense.

Business managers intuitively know that to give the customer more, it’s going to usually cost more.

But then examples started to appear which showed successful businesses which had established a cost leadership position but which were also differentiated.

Quality Is Free

Just as Michael Porter argued that cost leadership and differentiation involved trade-offs that meant you couldn’t do both, it used to be thought that businesses had to choose between low cost and good, consistent quality.

But the total quality movement popularised by Edwards Deming, Philip Crosby and Joseph Juran showed that cost of quality had an inverse relationship. As quality improves, costs didn’t increase as had been expected but reduced.

Differentiation And Cost Leadership

In Michael Porter’s next book, Competitive Advantage, he still warned about the dangers of being stuck in the middle.

“Becoming stuck in the middle is often a manifestation of a firm’s unwillingness to make choices about how to compete. It tries for competitive advantage through every means and achieved none, because achieving different types of competitive advantage usually requires inconsistent actions.” (page 17).

On the next two pages of the book, he softens his stance by admitting that reducing costs does not always mean sacrificing differentiation because using more effective methods and technology may reduce costs and improve differentiation. He goes on to point out that reducing costs from a high position is not the same as achieving a cost leadership position. He looked at this in more detail in What Is Strategy?

Porter identifies three conditions where a business can achieve differentiation and cost leadership:

1. When competitors are stuck in the middle and don’t force the business to the point where differentiation and cost leadership are inconsistent. This may be more often than you would expect in local, fragmented markets where businesses don’t have opportunities for big differentials in input costs for materials and labour.
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   The downside is that weak competitors can make the firm complacent and leave it vulnerable to new market entrants that are better managed.
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2. When cost is strongly determined by market share or interrelationships. Large economies of scale can give the business a big enough cost advantage to allow it to spend some of its cost savings on elements to differentiate the products and still achieve cost leadership. Interrelationships may arise between elements of the industry value chain which one competitor can take advantage of and the others can’t.
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3. The business pioneers a major innovation. Innovative new process technologies may lower production costs that allow the business to invest in differentiation factors or product innovation may deliver both cost leadership and differentiation of customer value attributes. Sustaining this innovation advantage is vital because wants it gets into the general market, the business is forced into the differentiation or cost leadership trade-off. It may even find itself at a disadvantage if rival competitors improve the innovation specifically to lower costs or to create extra differentiation.

The Danger Of The Tempting Lure Of Differentiation And Cost Leadership

A business that achieves differentiation and cost leadership is in a very strong position and should be much the most profitable firm in the industry.

This is precisely why I believe that creating a strategy to achieve both is dangerous.

The lure is strong but so are the traps and being stuck in the middle remains a clear and present danger.

I agree with the conclusion Michael Porter came to in Competitive Advantage.

“A firm should always aggressively pursue all cost reduction opportunities that do not sacrifice differentiation. A firm should also pursue all differentiation opportunities that are not costly. Beyond this point, however, a firm should be prepared to choose what its ultimate competitive advantage will be and resolve the trade-offs accordingly.” (page 20 Competitive Advantage by Michael Porter)

The Value Chain And Competitive Advantage

The value chain was created to help businesses find competitive advantage and while the value chain can be criticised, the technique is very useful to look in detail at your business at the activity level and challenge each activity:

• How does this help differentiate our business from competitors in ways that matter to customers?
• How can we reduce costs in this activity without reducing customer value and service?

One of the very best known strategy models is the Five Forces Of Industry Profitability that has been developed and promoted by Professor Michael Porter.

Background To The Five Forces Analysis Model

The Five Forces Analysis model was first introduced in the Harvard Business Review in 1979 in an article by Michael Porter called “How Competitive Forces Shape Strategy.”

It was then a major element in Michael Porter’s book, Competitive Strategy.

In 2008 Michael Porter returned to the Five Forces Model with an updated article in the Harvard Business Review called “The Five Competitive Forces That Shape Strategy.”

Even Michael Porter Didn’t Believe In The Five Forces

I found this article in Forbes.

It says that Michael Porter’s own strategy consultancy firm, Monitor, had stopped using the Five Forces Analysis.

That’s a big shock when the Five Forces are still a big part of the strategy courses that are taught on many MBA courses.

Sadly I didn’t feel the article went into too much more detail about the five forces and talked more about why the strategy firm failed.

I’ve said before, criticising the ideas of Michael Porter is very popular because of his preeminence but that criticism is often made based on a misrepresentation or simplification of Porter’s basic ideas to promote the “next big thing”.

Where’s The Customer In The Five Forces?

In my article, What Is Strategy, I define strategy as

“Strategy is how you achieve your own objectives by winning the hearts, minds and business of customers by out-thinking and outmanoeuvring competitors.”

While customers aren’t entirely ignored in the Five Forces model, there is little attention given to them. In fact big customers are seen as a negative force because of their enhanced bargaining power.

The Five Forces Analysis Isn’t Strategy

The Five Forces are one tool that takes a supply side approach to strategy.

Its focus tends to be on the industry – the companies who supply the products to meet customer demand – and the aim is to operate in an industry where there is enough profit to avoid the pitfalls of severe competitive rivalry.

You won’t get a winning strategy from just doing your Five Forces analysis.

No matter who much time and attention you give it.

But that’s not to say that it doesn’t serve a purpose to give insights into the competitive process.

My definition of strategy recognises that you need to understand your competitors and what they want to do and can do.

I’ve seen far too many hockey-stick style financial forecasts (where profit dips in the short term and then rises quickly in the future) to know that many businesses ignore competition. You need to accept the fact that competitors also want to grow and increase profitability.

I’m not going to criticise a tool that shines a light on competitors and how the industry fits together.

The five forces exist.

It’s a huge risk to ignore them and especially if there is a developing trend.

The Problem With The Five Forces

The big problem I see with a very detailed five forces analysis is finding the answers.

It’s much better at identifying problems than coming up with solutions.

Substitutes are a growing threat – so what do I do?

Bargaining power of customers and suppliers is growing – so what do I do?

New competitors are entering the market with much lower factor costs of products – so what do I do?

The slashed profits in the industry have caused competitive rivalry to become cut-throat – so what do I do?

I find it’s a better tool for asking:

• Should I go into this product-market (industry)?
• Should I look to diversify away from this product-market?
• Should I exit this product-market?

than for answering the question:

• How do I make more money in this product-market?

Those three questions are very valid in certain situations but the fourth question is the universal question of strategy that every business wants to answer.

The truth is that sometimes you can’t expect to make good profits in a product-market.

I think it’s useful to know that so that you don’t waste precious resources trying to do the impossible.

The Five Forces analysis does help. It wouldn’t have been accepted so readily when it first came out and it wouldn’t have stood the test of time.

The Five Forces are based on industrial economics which looked to explain why all markets weren’t perfectly efficient. The economists saw perfect competition as the ideal but as I explain in my article, It’s Not Perfect If I Can’t Make A Profit, entrepreneurs and business managers took a different view.

It’s just not the panacea to all strategy questions.

What Do You Think About The Five Forces Model?

I’d like to know your thoughts about the five forces.

Have you found the model helpful or do you think it’s a waste of time?

Value Chain Analysis is the big idea in Michael Porter’s classic strategy book Competitive Advantage.

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The Advantages Of Value Chain Analysis

1. A big advantage is that the value chain is a very flexible strategy tool for looking at your business, your competitors and the respective places in the industry’s value system.
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2. The value chain can be used to diagnose and create competitive advantages on both cost and differentiation. I’ve written about this in Using The Value Chain To Create Competitive Advantage.
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3. It helps you to understand the organisation issues involved with the promise of making customer value commitments and promises because it focuses attention on the activities needed to deliver the value proposition.
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4. Comparing your business model with your competitors using the value chain can give you a much deeper understanding of your strengths and weaknesses to be included in your SWOT analysis.
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5. The value chain is well known and has been a mainstay of strategy teaching in business schools for the last 20 to 25 years. The book, Competitive Advantage was published in 1985.
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6. It can be adapted for any type of business – manufacturing, retail or service, big or small.
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7. The value chain has developed into an extra model, the industry value chain or value system which lets you get a better understanding of the much broader competitive arena. If you’re interested in this aspect of the value chain, watch the Value Chain Videos for an easy-to-understand introduction.

The Disadvantages Of Value Chain Analysis

1. It’s very strengths of flexibility mean that it has to be adapted to a particular business situation and that can be a disadvantage since, to get the best from the value chain, it’s not “plug and play”.
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2. The format of the value chain laid out in Porter’s book Competitive Advantage, is heavily oriented to a manufacturing business and the language can be off-putting for other types of business.
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3. The scale and scope of a value chain analysis can be intimidating. It can take a lot of work to finish a full value chain analysis for your company and for your main competitors so that you can identify and understand the key differences and strategy drivers.
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4. Many people are familiar with the value chain but few are experts in its use.
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5. Michael Porter’s book is excellent but it is a tough read. It’s also dated in its examples which can make some ideas more difficult to relate to and understand how things fit together in the Internet age.
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6. The value chain idea has been adopted by supply chain and operations experts and therefore its strategic impact for understanding, analysing and creating competitive advantage has been reduced.
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7. Business information systems are often not structured in a way to make it easy to get information for value chain analysis.

A Partial Analysis Of The Value Chain

A full value chain analysis can make the strategy process long, time-consuming and complex.

I don’t believe it’s necessary in many cases.

Strategy is about finding insight to create competitive advantage and then taking the actions necessary to put the ideas into action.

It can be very effective to identify the business processes and the individual roles they can play – positive and negative – for implementing a particular strategy.

Using the Value Chain To Find Value Destroying Activities

Sometimes stopping a value destroying activity is more important than strengthen a value creating process. These happen because the use of individual goals, targets and incentives can lead to actions that harm the bigger business goals.

A great example is the buyer in a steel company who is targeted with getting the lowest cost when the business has an overall differentiation strategy of fast lead times and reliable due date supply to customers. Something has to give – it may be the service promise or  inventory levels are forced to rise and may create as many costs as the buyer hopes to save.

Using the Value Chain For Focused Improvement Of Processes

The most critical processes can then be broken down into value activities for more detailed analysis of what the business is trying to achieve and how it is currently operating. That opens the opportunity for focused process improvement on the areas of constraint which offer most leverage.

Yes the belt and braces approach of doing the full value chain analysis can be comforting because you know everything has been looked at, analysed and considered.

But often, resources and time aren’t available.

My view is that some value chain analysis is better than none. Focus on the important stuff that really matters.

The Value Chain And The Six Step Profit Formula

I use a Six Step Profit Formula to help keep strategic management grounded in what can help you to increase profits in the short and long term.

The value chain is useful in a number of steps. In particular, it has a role to play in helping you to develop your irresistible promise and making sure that you deliver it consistently. It also helps you to think through how you continue to get revenue and profit from the relationship.

What Do You Think Are the Advantages & Disadvantages of Value Chain Analysis?

I’d welcome comments based on your own experience or knowledge of the value chain.

What advantages or disadvantages do you think I have missed?

What should be emphasised more?

I encourage you to contribute to the debate on the value chain as a way to develop your own understanding on it and to help others.

Using the concept of the industry value chain analysis is an important part of gaining an appreciation for the wider competitive factors that can impact on your business.

Background To The Industry Value Chain Or Value System

The idea of the value chain was introduced in the classic strategy book Competitive Advantage by Michael Porter as a way to understand and develop competitive advantage.

While much of the book looks at the value chain within a business, Michael Porter stresses the importance of linkages between the business and its suppliers and customers which gives rise to the analysis of the industry value chain or what Michael Porter called the Value System.

For more details of the value chain within a business please see:

Using the Value Chain For Competitive Advantage

The Advantages & Disadvantages Of The Value Chain

Videos About The Value Chain

What is Industry Value Chain Analysis

A business takes some form of input and creates an output product or service that a customer is willing to pay for.

Most businesses therefore buy products from suppliers and sell to customers who then either sell the product as it is or use it to create another product or service to sell.

This creates a value chain (or a value system) of suppliers and customers in an industry.

For example, a cheese company buys milk from farmers, turns it into cheese and sells it to a distributor who then sells it to the supermarkets who sell it to the consumer. That’s an industry value chain as each step in the process creates an element of value that the customer is willing to pay for in the final price.

Value chains can also branch out into different distribution channels so staying with the cheese company example,as well as the supermarket route to the consumer, the distributor also sells to food processing companies who use the cheese to create ready-made meals to sell to the supermarkets.

The supermarkets sell to local restaurants who use the cheese in their menus and the local sandwich businesses that provide your lunch.

Each activity within the industry value chain has its own needs and preferences and plays some role in shaping the product and the value the ultimate consumers gets from the product. Each activity has its own cost dynamics and the way the activities link together can either add value or create unnecessary costs.

Industry value chain analysis allows you to look at the way the entire system works together to help you to find ways to create competitive advantage so your business earns higher profits.

The Industry Value Chain Analysis System

The diagram below shows five different activities within the industry value chain or value system.

The Industry Value Chain shows the alternative ways of competing, each with advantages and disadvantages

I’d like you to imagine that you are the business highlighted in yellow, a provider of the third activity in the value chain which links various independent suppliers.

You analyse the industry value chain and whilst there are many independents like you, you notice that there are some competitors that are set up differently.

• One competitor who is vertically integrated backwards i.e. they have a business that combines what you do with your immediate supplier. This gives them an advantage over control of the incoming supplies and means that supply priorities can be much clearer, However there is a balancing act for scale efficiencies since the two processes are linked.
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• Another competitor is part of a group which has three business units, the first deals with the first two stages of production, the second does what you do and the next stage and the third sells the product to the final consumer.
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• The final competitor in the industry value chain is a fully integrated business that does all five steps.

Industry Value Chain Analysis – A Look At What Is

Once you’ve sketched out the industry value chain or value system, you’ll have a broader view of how you fit into the market since you’ll see yourself as part of a value delivery system which competes with alternative value delivery systems.

You can start looking at the implications of each.

• What causes cost and value to accumulate within an activity?
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• How some value chains create advantage for those who use them and how you can respond or react?
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• How profit accumulates in particular sections of the industry value chain? The classic example is the portable computer industry where Intel and Microsoft have created strong strategic positions which capture a high proportion of the overall profits made in the industry value chain, leaving other component manufacturers, PC assemblers and PC distributors trailing.

Understanding what is currently happening in your industry can help you to look at

• Business definition issues – what activities in the industry value chain should you be doing? Should you vertically integrate backwards or forwards? Or should you focus on building up your core competences in a tightly defined area and establish a strategic control position, just like Intel and Microsoft?
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• How you can create competitive advantage and where it is futile to try because the business design of your competitors has major strengths and weaknesses?
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• Where your own business model is vulnerable to competitive attack and what you can do about it?

Industry Value Chain Analysis – A Look At What Might Be

The book Profit Patterns by Adrian Slywotzky and David Morrison makes it clear that industry value chains used to be stable over the long term but over the last twenty years there has been much more movement which creates profound impact on the businesses operating within them.

Unfortunately many businesses miss the changes that are happening around them until it is too late and they are trapped in a no profit zone and business system. This is a significant threat which should be identified and included in your SWOT Analysis.

They identify a number of profit patterns to look out for:

• Value Chain Convergence – competitors from previously distinct industries start to compete against each other as their products compete to meet the consumers’ underlying needs. As an example, think about how Skype and the other voice over the Internet providers have damaged traditional telephone service providers like British Telecom. Or how the development of smartphones impact on laptop PC providers and how touchpad products like the iPad make the dividing line between products much fuzzier. Slywotzky and Morrison identify three levels of convergence – supplier convergence, product convergence and complementor convergence.
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• Value Chain De-integration – businesses focused on one value activity have created strategic control positions that capture a high share of the profits created by the entire value chain – this is the Microsoft or Intel example.
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• Value Chain Squeeze – how growing strength of operators in the activities either side of a particular value in the industry chain can apply the buyer power and supplier power from Porter’s Five Forces to create a no profit zone.
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• Value Chain Strengthening The Weak Link – one activity in the industry value chain may be systematically destroying value for the entire chain through high costs and poor quality and service. Strengthening this weak link can put a business in a very powerful position to exert influence and capture profit from the entire chain.
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• Value Chain Reintegration – while disintegration can create value, so can reintegration. Apple was once a struggling business that was losing the PC operating system against Microsoft because of its refusal to let others use its operating system. Now look at it and the control it has over many stages in the industry value system, outsourcing when appropriate but keeping control over key elements including close links with consumers through the Apple stores.

Changes to the industry value chain are a little like the analogy of the boiled frog who doesn’t notice that the water is gradually getting hotter until it is too late, by which time it’s too sleepy to do anything.

The way to look out for industry value chain movements and what might be happening is through competitive analysis to keep track of changes each year. This way you can get an early warning of the patterns that might be developing in your industry and have the time to either decide to participate or to create defensive strategies.

Industry Value Chain Analysis – A Look At What Could Be

The third element of industry value chain analysis is to use it pro-actively to think about how you can configure it to your advantage over the long term.

You don’t have to wait for the profit patterns to happen based on the actions of competitors, if you see the opportunity you can start the process yourself.

Opportunities arise from:

• Deregulation of previously regulated activities
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• Changing customer needs and priorities
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• Technology changes

Your competitors, who may not use industry value chain analysis, might not notice what you are doing or might not realise the significance of your actions until you’ve established a long-lasting advantage.

Industry Value Chain Videos

I found these value chain videos from Professor Andrew Fearne which focus on the industry value chain or value system.

Have You Used Industry Value Chain Analysis?

Have you used industry value chain analysis and found it helpful to:

• Understand what is happening in your wider competitive space?
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• Identified potential threats early?
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• Identified opportunities?

Please leave a comment and share your experience or any tips you’ve found that makes doing the industry value chain analysis easier.

My thinking on strategy is heavily influenced by Michael Porter and his classic book Competitive Advantage introduced the concept of the value chain analysis.

The value chain is an original Porter concept although he built on the idea of the business system from strategy consultants McKinsey and its main purpose is to help you to find, create or develop competitive advantages.

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Types of Competitive Advantage

Michael Porter argues that there are only two types of competitive advantage:

• competitive advantage that comes from differentiation – providing some kind of unique value to particular customers
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• competitive advantage that comes from having the cost leadership position

While it would be nice to have both, under normal conditions, the two forms of competitive advantage are mutually exclusive and, if businesses fail to choose, they get stuck in the middle.

Michael Porter believes that these competitive advantages derive from the activities the business does which are:

• done better than competitors;
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• done differently than competitors;
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• that create unique benefits; or
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• done at a lower cost than competitors.

To understand the source of competitive advantage then you need to perform a value chain analysis which identifies the separate value activities.

The Formal Elements of Value Chain Analysis

Porter built his value chain analysis model on a manufacturing business – back in 1985 there were many more around in the United States.

He split the value chain into two parts:

• Primary value activities
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• Support value activities

Primary value activities included:

• Inbound logistics
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• Operations
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• Outbound logistics
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• Marketing & sales
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• Customer service

Support value activities include:

• Procurement
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• Technology
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• Human resources
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• Firm infrastructure

This is a very general, helicopter view of a business and when you’re carrying out your value chain analysis you are supposed to go much more specific and detailed for your business.

You keep analysing activities which give a differentiation advantage (or have the potential to do so)  or disadvantage and which have a cost advantage or disadvantage.

The idea of value chain analysis is that you understand how your business compares with competitors at a detailed level. You can go into a lot of detail for your own business but you’ll be surprised at what you can learn about your competitors by talking to ex-employees (who may already work for you), suppliers, customers and being the customer yourself.

The value chain has been criticised as too prescriptive because the value chain elements don’t fit all types of businesses. This is missing the point entirely.

You don’t have to follow Michael Porter’s categorisation – and I suspect that he’d be astonished if you did – but if you want to understand the sources of your competitive advantages in terms of differentiation and cost, you do need to perform a value chain analysis which fits your business/industry.

It does take some thought and effort but that can be more of a reason to do it. Your lazy, superficial competitors either won’t understand the value chain or will look at what’s involved and think “That’s too difficult”.

Adapting Value Chain Analysis For Differentiation Or Cost Leadership

In his book Competitive Advantage (a must-read for any strategy professional), there are long chapters for how you can use value chain analysis to create cost or differentiation competitive advantages.

You’ll have guessed from the title of my blog, I’m not a huge fan of the cost leadership. That’s because I think there’s always someone who can come along and product whatever [product or service you sell a bit cheaper. For a cost leadership strategy to work, you have to have a significant cost differential which competitors recognise. Otherwise, you’re caught in a commodity trap selling an undifferentiated product at lower and lower prices.

But you can’t ignore costs if you follow the differentiation advantage path.

If your main differentiators are in marketing and customer service then you must keep a focus on costs in the logistics and operations activities and all the support activities. Your differentiation advantage only excuses you incurring extra costs in the activities which create a competitive advantage and only then if the advantage outweighs the extra costs.

How To Do Value Chain Analysis: Identify Your Value Activities

Use Michael Porter’s model if you find it helpful but otherwise create your own high level process map for your business which can also be used for your competitors.

Then drill down to identify the individual activities which create a differentiation advantage or which incur significant costs. Group minor activities together in categories like “other marketing activities”.

It helps if there are several people working on the value chain analysis. Functional specialists who know what’s happening and others who can provide an outsider’s perspective and ask the “dumb questions” which can challenge conventional wisdom and provide significant insight.

How To Do Value Chain Analysis: Allocate Costs To The Value Chain Activities

You can spend a lot of time trying to allocate costs precisely but it’s a false exercise.

It’s much better to be approximately right than precisely wrong.

Activities will incur some costs directly while other costs need to be apportioned based on various assumptions. Don’t confuse the two since you can draw very different conclusions if you change the underlying assumptions.

How To Do Value Chain Analysis: Identify Sources Of Differentiation Advantage

Differentiation comes from:

• the way individual activities are performed
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• the way related activities link together
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• the way the entire value chain is structured

I recommend you work both ways:

From your current or desired key success factors and differentiation factors through to your value activities in a deliberate challenge to see what you can do to support your differentiation advantages.

Then from your individual activities back out to your customers by asking “is there anything in the way we do this activity (or could do the activity) which creates special value for the customer?”

Differentiation & Your Customer’s Value Chain

You can learn a lot from applying value chain analysis to your own business and thinking through how all the parts fit together to support your customer value proposition.

You may get even more insights by looking at the value chain of your typical customer (or different groups of customers) and identifying ways that you can add value or reduce costs to their business by better understanding:

• What your customers are trying to do.
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• How they operate.
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• Their problems and frustrations.

Having a better understanding of your market and the customers who make it up is potentially a big competitive advantage since it lets you develop better products and to respond to changing needs faster than your competitors.

Is The Value Chain Analysis Only For Big Businesses?

No I don’t think so.

Small businesses are often simpler to understand so it means a value chain analysis can be put together quicker.

There’s no getting away from the idea that competitive advantages and disadvantages flow from the activities you do in your business but you can only understand them and how they link together by doing value chain analysis.

The Value Chain And The Six Step Profit Formula

I use a Six Step Profit Formula to help keep strategic management grounded in what can help you to increase profits in the short and long term.

The value chain is useful in a number of steps. In particular, it has a role to play in helping you to develop your irresistible promise and making sure that you deliver it consistently. It also helps you to think through how you continue to get revenue and profit from the relationship.

The Value Chain Is A Strategic Planning Model

The Value Chain is one of the frameworks included in my Strategic Planning Models guide.

Click the link to fined out what other models could help you to develop a winning business strategy.

What Do You Think About Value Chain Analysis?

Do you find Michael Porter’s ideas for value chain analysis a useful technique for creating competitive advantage, analysing the advantages of competitors and spotting opportunities for advantage?

I’d like to know what you think so please leave a comment.

In particular, do you believe that value chain analysis is a suitable technique for SMEs and businesses that don’t have strategic planning specialists.

I’m ending my look at Michael Porter’s Five Forces Analysis with a look at competitive rivalry, perhaps the most powerful and destructive of the five forces as competitors carelessly compete away any profits and even create price wars that cause long term damage to industry profitability.

Competitive Rivalry Or Rivalry Amongst Existing Firms

Michael Porter introduced the Five Forces model in his book Competitive Strategy and it has since become the standard way to examine the existing industry structure and how it might change in the foreseeable future.

It’s not a coincidence that Michael Porter placed competitive rivalry in the centre of his famous Five Forces diagram.

The 5 Levels of Competition

It’s easy to falls into the trap of thinking that all competition is bad but without competitors, you’ve got no one to look good against. It’s been established that it is easier to make a decision between A and B because the brain can compare and contrast than it is to decide to buy A on its own.

I recently wrote about the 5 Levels Of Business Competition which is an important framework for assessing the intensity of competitive rivalry and what you can do to move it in the right direction.

The Symptoms of Competitive Rivalry

Competitive rivalry become intense when one or more competitors either sees an opportunity to grow and acquire the customers of competitors or feels the need to attract more customers because of low profitability.

Industries where competitive rivalry is a major issue will usually have many competitors who are struggling to make an adequate return on investment so profitability will generally be low. A few competitors – those that have established competitive advantage – will make a treasonable profit but more many, intense competitive rivalry means a fight to break even and generate enough cash to survive.

Competitive rivalry intensifies through retaliation as competitors react to aggressive strategies with their own aggressive or defensive strategies.

This rivalry often comes through in terms of lower prices, as competitors use marginal costing to justify a contribution to overheads. However, competitive rivalry can also come through in advertising, product introductions and customer service battles.

Much of the competitive rivalry is damaging to long term profitability in the industry since it raises customer expectations of value for money although advertising can expand the market or establish differentiation through branding.

Richard D’Aveni came up with the term hypercompetition to describe situations where rivals fight hard against each other. The danger is that the firms head toward the model economists call perfect competition.

The Factors That Determine Competitive Rivalry

Competitive rivalry arises from a number of factors that work together to either give competing firms an incentive to try to break ranks or a vulnerability to the other Five Forces.

Moving from the growth to the maturity stage of the product life cycle and then into decline can increase rivalry. In the growth stage, firms get used to the business growing as more customers come into the market. However new demand eventually reaches saturation point and replacement demand isn’t sufficient to continue to provide growth opportunities. Firms will therefore look to grow through taking existing customers away from competitors.

It gets worse if the industry moves into the decline stage of the product life cycle or if the wider economy goes into recession, especially if the industry is cyclical and exaggerates the effect. Competitors will see their own sales volumes go down and in the absence of industry-wide  information, assume that their rivals are cutting prices.

High fixed costs, low variable costs and low capacity utilisation provide the economic rationale for trying to increase market share because a small increment of extra volume has a disproportionate effect on profitability. Unfortunately the reverse is also true, lost volumes in this situation has a significant downward impact on competitors’ profitability making a response the natural reaction. Price wars can develop very quickly and especially if competitors are manipulated by big customers into believing short term offers are bigger and more long term than they really are.

Competitive rivalry increases with commodity products and reduces if there is effective differentiation or switching costs. Customers have an incentive to stay loyal rather than shop around for the lowest prices.

Competitive rivalry is also a function of the competitors in the market. The most orderly markets tend to be where one has established a clear leadership position and the others are tucked in behind, taking advantage of the price umbrella established by the leader. These firms can coexist if they know their place in the market and stick to it.

However, if two or more firms are competing for market leadership and market share offers economies of scale and experience curve savings (see the Competitive Advantage matrix) then rivalry intensifies. It gets worse if competitors don’t understand each other and find it difficult to interpret the intentions of each other because of different goals. Competitors from different countries and cultures can make the existing firms particularly sensitive because of fears over low-cost competition.

Competition makes it difficult for the weak firms to make a profit. It’s therefore important that the loss-making firms can exit the market easily. If there are high exit barriers, then competition increases in a desperate fight for survival.

Using The Generic Strategies To Defend Against The Damage Done By Competitive Rivalry

Michael Porter’s generic strategies offer a way out of the worst damage from competitive rivalry.

If the business is differentiated, then it effectively creates its own private market, insulated to some extent from what’s happening in the wider market. The business can’t be complacent because big changes will cause the customer value line to shift, making established positions uncompetitive without a response to improve customer value or reduce price.

If the business genuinely has a substantial cost advantage, it can afford to sell at prices that will make its competitors weep. A strong short term argument can be made for pricing based on marginal costs with its contribution to overheads but it makes no sense for any competitor to go below marginal cost unless it is desperate for cash to stave off imminent bankruptcy.

It is the businesses that are stuck in the middle that have the most strategic threat if rivalry increases.

Other Articles On The Five Forces

Michael Porter has developed the standard way to look at industry analysis with the Five Forces model.

If you are new to it and you want to understand how the forces interact, you should read the other articles:

Five Forces Analysis

Barriers To Entry & The Threat Of New Entrants

Bargaining Power Of Buyers

Bargaining Power Of Suppliers

Threat of Substitutes

Have You Experienced The Damage Done By Intense Competitive Rivalry?

Has your business been caught in a price war or other competitive battle which seriously eroded profits. I’d like to hear the story so please leave a comment.

I’ve seen several.

The first was a company I worked for when the recession of 1990/91 was the trigger to shift us from co-existence to conflict. WE were caught in the classic profit squeeze of falling sales volumes, price cuts and lower productivity as the hourly paid workers tried to stretch their work out to fill the week. Profits fell from £100k or more a month to a £30k loss in three months and whilst the business was restored to profit, margins never returned to the old levels.

The second was a client I started working with after the damage was done. They couldn’t understand why their accounts showed losses every month but investigation into their price changes showed that competitive rivalry from the main competitor changing its value chain by outsourcing inefficient operations had forced them to slash prices beyond a level that was sensibly economically.

The threat of substitutes is an important element in the Five Forces Analysis model introduced by Michael Porter in his book Competitive Strategy.

The issue of the threat of substitutes is always a factor which limits the profit potential of a market.

In times of economic difficulties, the threat accelerates sharply but it also represents an opportunity to help lure new customers into your market as customers priorities, needs and wants change.

Other Articles On Industry Analysis and the Five Forces Model

This article on the threat of substitutes can be read in isolation but if you are not familiar with Michael Porter’s Five Forces model, it will help to read Porter’s Five Forces first and then later read about the other forces that influence industry profitability.

Threat of New Entrants

Bargaining Power Of Buyers

Bargaining Power Of Suppliers

Threat of Competitive Rivalry

What Is The Threat of Substitutes?

The threat of substitutes force recognises that every customer has a choice when they buy which is not limited to the same industry or market.

There are different ways to satisfy a particular need. See What Are You Doing On Saturday Night.

Substitutes Offer Customers the Choice Of How To Solve A Problem

If I want to travel from my home in Birmingham to Paris, I can:

• Drive (including the Channel Tunnel);
• Travel by train;
• Fly.

The airlines that fly from Birmingham are not just competing between British Airways, Air France and BMI Baby. They must recognise that I have substitute solutions to meet my desire to travel to Paris.

This threat of substitutes (driving or train) places restrictions on what the airlines have to offer to convince me that flying is the best solution. The customer value attribute map or what Blue Ocean Strategy calls the strategy canvas is a useful way to look across the dimensions of customer value to show the advantages and disadvantages of substitutes from the customer’s perspective.

The Threat of Substitutes Increases In A Recession

Takeaway restaurants have seen a migration of customers in the recession and open up opportunities for businesses like Housebites.

The threat of substitutes can impact your business both ways and, if you owned a takeaway business, you need to have marketing strategies to tempt people away from restaurants and defend against the threat of the ready meals.

For example to tempt regular restaurant trade to the substitute takeaway service, a takeaway business could emphasise the quality of the food and give tips on how you can turn your Chinese takeaway into a romantic event at home or into a party night with a small group of friends.

To protect against the threat of substitution from ready meals, the takeaway business would again emphasise quality, introduce a delivery service (it is what stops me buying fish and chips compared to Indian, Chinese, pizza etc) and have a regular buyer reward scheme e.g. buy on four occasions and get the fifth free (with some kind of value limit).

Threat of Substitutes: The Theory

Let’s take a look at how Michael Porter explained the threat of substitutes in his Five Forces Model.

The main issue is that the existence of substitute products and services place a ceiling on the price a market and companies with the market can sustain.

Going back to the takeaway food example, the closer the price the cost of the takeaway gets to the price of a restaurant meal, the less threat it is as a substitute solution.

The key issues on the threat of substitutes are:

• The willingness of customers to switch across different products (which is often a factor of how easy it is to compare and contrast the different offerings); and
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• The relative price/value offered by the different substitutes.

If we return to my example of getting to Paris for a weekend break, what I want is to travel easily, quickly and cheaply so that I have most opportunity to enjoy my time in Paris.

A cheap flight going out early Friday morning and returning late afternoon on Sunday is ideal but what if I can’t fly out until 4:00pm on the Friday?

That writes off Friday as a holiday and if combined with a forced early flight back on Sunday, it means I’m paying for the flight and two nights in Paris for the pleasure of having effectively one full day to relax and have a good time.

That could make other methods of transport attractive, especially if I lived near the south coast of England and if I have the belief that Airlines Suck (an interesting perspective on the difference between customer satisfaction and  customer value.)

Alternatively the flight times could tempt me to look at flying to Paris from a substitute airport or could get me thinking about substituting Paris for Rome, Florence, Prague or any of the other great cities in Europe. What I really want is a lovely weekend break.

The comparisons are difficult. I’m not comparing like with like and that’s why the desire to switch is so important. If I really want to go to Paris for a special reason, my potential substitutes narrow to how I can get there in ways that maximise my time in Paris and minimise the pain of the journey.

Differentiation And The Threat of Substitution

Effective differentiation will create buyer preference within a product category because it helps one product stand out as a bullseye match between what it offers and what the customer wants.

A product that has very strong differentiation will turn competitors’ products into possible substitutes rather than direct alternatives. The threat doesn’t go away entirely but it is reduced.

Substitutes and Customer Value

Customers want value for money and because this is a ratio, it can get better if:

• The value or benefits you receive as a customer increase.

• The price you pay reduces.

Value for money gets worse when the value reduces or the price increases.

The relative customer value between different substitutes can change because of changes in one alternative rather than the other which is why it’s important to watch what’s happening in the substitute markets.

Even with the Euro crisis, the UK has seen the value of sterling fall against the Euro, making the Christmas shopping trip to Paris a lot less attractive than in the last couple of years. The thrill of the experience of visiting Paris hasn’t changed but the price has in sterling terms.

Other times, it is the value that changes between substitutes. Some products can make fast incremental or breakthrough changes in performance which shift the relative appeal of the products and increase the threat of substitution.

Analysing The Threat Of Substitutes

Step 1  of assessing the threat from substitutes is very much seeing your business as competing within a market and also within a wider generic solution market.

Too often business managers are focused on their direct competitors and miss what’s happening in substitute markets until sales volumes are disappearing quickly.

What problems do your products or services solve? Make a list.

Then identify how else a customer can potentially solve these problems. What substitutes will the customer consider as viable alternatives?

Then start looking at each substitute so you understand the appeal.

• What benefits does the substitute provide compared to you?
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• What price point is it at?
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• What is the weakness of the substitute? What constraints or limitations does it impose on a customer?
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• Why would a customer switch between substitutes?
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• What barriers are there to stop customers switching?
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• What trends are there is the substitute markets? Where is customer value being gained or lost? What can cause sudden changes in price?

When you have the basic information, you can then start to look at building strategies to either defend against the threat of substitutes or to attract customers from another substitute market.

How can you tilt the value for money comparison in your favour by increasing the perceived value or reducing the perceived price?

How can you:

1. Identify potential switchers from a substitute market?
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2. Communicate and educate about your offerings?
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3. Tempting them into wanting to make a trial purchase?
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4. Provide reassurance against any fears of switching?
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5. Retain their customer loyalty?

A lot of this is good marketing but it is aimed at encouraging customers of substitutes to switch to a different product and when they do, to choose you.

Conclusion on the Threat of Substitutes

I have tried to show that substitution between products and services is both an opportunity and a threat and therefore can appear on both sides of your SWOT analysis.

If you don’t recognise the existence of substitutes, you won’t put in place the right defensive strategies to keep some of your current customers and you won’t follow offensive strategies to attract new customers to you.

If you want to know more about Michael Porter and his Five Forces model, his Competitive Strategy book is rightly considered a classic.

The bargaining power of buyers or customers is one of the five forces that determine industry profitability in Michael Porter‘s Five Forces Analysis model explained in his book Competitive Strategy.

The basic idea is that by using their  bargaining power as a powerful buyer, some customers can capture a high proportion of the value you create for them by forcing down your selling prices and increasing your costs to serve them.

This applies to both business to business transactions and business t o consumer although it’s usually a more powerful force in B2B because of the size of the deals.

Introduction To The Bargaining Power Of Buyers And Customers

This is the third article focused on Michael Porter’s Five Forces model for Industry Analysis:

Introduction To Five Forces Analysis

The Threat of New Entrants

The other forces are:

Bargaining Power Of Suppliers

Threat Of Substitutes

Threat Of Competitive Rivalry

This focuses on how buyers can use bargaining power to reduce the profits of a business and what the business can do to resist.

Negotiations With Buyers – Win-Win or Win-Lose?

There are two elements to any negotiation between a buyer and a seller:

1. How can you add value to my business?
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2. What price will you charge?

The first is collaborative. The customer wants the supplier to add as much value as possible and the supplier wants to establish the existence of benefits which create a competitive advantage over the competition.

When it comes to price, any reduction the buyer negotiate with a supplier transfers profit from the supplier to the buyer.

In a commodity business where there is little or no differentiation, little time is spent of the first question because buyer preference is won on price. A stronger buyer will negotiate hard on the customer value elements and then claim that the produce /  service combination is close to what’s available from competitors so a deal is possible if “the price is right.”

How well each party performs in he negotiations will depend on individual negotiation skills of the buyer and sales-person and the industry structure which usually biases the negotiating power one way or another.

Two Major Factors Determine Relative Bargaining Power Of Buyers

1. The price sensitivity of the customer to paying a high or low price.
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2. The relative bargaining power that comes from a readiness to walk away from any deal and go elsewhere.

Price Sensitivity And Its Impact On the Bargaining Power Of The Buyer

Buyers will be more willing to switch from one supplier to another to get a lower price if:

1. The product is important to the buyer because it represents a high proportion of costs but there is little difference in the products from one supplier or another. The buyer knows that the product can be bought from somewhere but doesn’t particularly care where, provided the price is the lowest.
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2. The buyer will be much more sensitive to price if the buyer and its industry is under competitive pressure in its own market and has to fight for every drop of profit. Good times economically can protect suppliers from the excessive use of the bargaining power of buyers but as markets get tougher (see PEST Analysis) pressure to reduce prices will increase as buyers try to compensate for profit lost in its market. This can be a major threat which should be on your SWOT analysis.

The Ability To Walk Away And Its Impact On The Bargaining Power Of Buyers?

The second factor that determines whether buyers or sellers capture the majority of the profit from a transaction is the bargaining power that comes from the knowledge you can walk away from any deal you don’t like.

It’s a wonderful position to be in

If you are a seller and the business is performing well, it is important to keep reminding yourself that you always have a choice. You don’t have to accept any deal the supplier proposes, only the deals that are profitable.

Michael Porter’s Five Forces model says that the buyer has the advantage in bargaining power if:

1. The buyer is large and the supplier is small. This suggests that the deal is more important to the supplier.
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2. There are few buyers and many suppliers. The buyer has the choice of many suppliers to play off against each other but the supplier knows that to achieve good sales volumes, at least one of the small number of large accounts needs to be captured.
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3. The buyer knows the undifferentiated product very well and has no problem comparing goods and prices from different suppliers. Buying apples v apples and dominating the price negotiation is easy. It gets much more difficult to compare apples with oranges and feel confident that the deal is right for you.
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4. The buyer does not incur any penalties or other switching costs from moving its purchases from one supplier to another.
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5. The buyer can make a credible threat to enter the suppliers industry and provide its own supplies of the product unless the price is very low while the supplier cannot move into their customers market safely. This issue of vertical integration forward and back is a big topic which I will be covering in future business strategy articles.
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6. There are substitutes available from another a related industry and supplies are readily available.

Can you see how some of these factors apply to your relationships with your customers and hinder your negotiations?

The Bargaining Power Of Buyers May Not Just Be Price Pressure

It is easy to fall into the trap of thinking that the bargaining power of a buyer is focused on getting the best price and often it is.

Sometimes a strong buyer will insist on extra service requirements (next day delivery at no cost) or a favourable financial arrangement (extended credit terms or consignment stock) which increases the costs to service and makes that customer less profitable to the supplier.

How To Protect Your Business From The Bargaining Power Of Buyers

Chapter 6 of Michael Porter’s book Competitive Strategy is titled Strategy Towards Buyers and Suppliers and looks in detail at the bargaining power of buyers.

You can reduce the bargaining power of buyers through strategy although you may not like some implications.

1. You can differentiate your products or services. If a buyer wants what you sell but cannot get it from someone else, then the power relationship shifts in your favour. Although a professional buyer will try to knock down your prices and get the best deal, you may have a stronger position that you think. It is a common problem in negotiating to think that the other party has the stronger bargaining power because you want the business.
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2. You can also use the other generic strategy, cost leadership to protect your profits. Competitors who behave rationally can only go to a certain price before they lose money. Irrational competitors who lose money on each transactions won’t be survive for long.
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3. You can target the less price sensitive buyers and buyers where the costs to serve are less. If you don’t have a differentiation or cost advantage, then the high volume customers may not be right for you. The sales volumes may look good but margins will be small and you will be better filling your capacity with business from smaller customers.
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4. Understand your product or service costs and be ready to walk away from any deal that is wrong. If you don’t have a walk away price, the buyer will know that he or she can keep pushing to extract more price reductions. Understand the cost implications of the extras that a powerful buyer will ask for and where you or they have a cost advantage. I worked with a client who came under pressure to concede on extended terms and foreign exchange risks when it would have cost the buyer much less to put those aspects into place.
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5. Make sure you’re not trying to sell an over-engineered or r-specified solution. Different buyers want different things and if you’re selling something with features or benefits that the buyer doesn’t appreciate then you’re incurring costs to provide something that the buying won’t pay for. Have a low-priced base offering and add extras to it that the buyer does want.
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6. To fight back against the bargaining power of buyers who are highly concentrated, a firm can consolidate its part of the industry value chain.

How To Choose Buyers Who Won’t Use Their Bargaining Power

Factors to look out for when looking for buyers who are not sensitive to price and therefore less likely to use their bargaining power include:

• Buyers for whom the cost of the purchase is small relative to the rest of the business – who cares about the cost of paper clips when time is limited and there are more important things to do.
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• Where the penalty for product failure is high – sometimes quality and reliability is much more important than price.
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• The product will be an important part of the supplier’s product because it is a de facto standard – PC assemblers risk being excluded from consideration by their customers if they don’t use Windows and Intel microprocessors.
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• The buyer wants a custom designed product and there are few suppliers with the capabilities to deliver to the right standard.
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• The buyer is very profitable and is in a powerful position with its customers and can pass on cost increases easily.
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• The buyer is poorly informed about the market.

Conclusion on The Bargaining Power Of Buyers

Powerful buyers represent a serious threat to the profitability of individual firms and all the firms in the industry.

Careful strategy can help you to reduce the damaging effects of the bargaining power of buyers.