Industry Analysis

The business environment of the firm consists of all the external influences that affect its decisions and
performance. Given the vast number and range of external influences, how can managers hope to monitor, let
alone analyze, environmental conditions? The starting point is some kind of system or framework for
organizing information. For example, environmental influences can be classified by source (e.g. into political,
economic, social, and technological factors (“PEST analysis”)) or by proximity (the “micro-environment” or
“task environment” can be distinguished from the wider influences that form the “macro-environment”).1
Though systematic, continuous scanning of the whole range of external influences might seem desirable, such
extensive environmental analysis is unlikely to be cost effective and creates information overload.
The prerequisite for effective environmental analysis is to distinguish the vital from the merely important. To
do this, let’s return to first principles. For the firm to make profit it must create value for customers. Hence, it
must understand its customers. Second, in creating value, the firm acquires goods and services from
suppliers. Hence, it must understand its suppliers and how to form business relationships with them. Third,
the ability to generate profitability from value-creating activity depends on the intensity of competition
among firms that vie for the same value-creating opportunities. Hence, the firm must understand
competition. Thus, the core of the firm’s business environment is formed by its relationships with three sets
of players: customers, suppliers, and competitors. This is its industry environment.
This is not to say that macro-level factors such as general economic trends, changes in demographic structure,
or social and political trends are unimportant to strategy analysis. These factors may be critical determinants
of the threats and opportunities a company will face in the future. The key issue is how these more general
environmental factors affect the firm’s industry environment (Figure 3.1). Consider the threat of global
warming. For most companies this is not an important strategic issue (at least, not for the next few hundred
years). For the producers of automobiles, however, the implications of global warming for taxes on gasoline
and restrictions on
FIGURE 3.1 From environmental analysis to industry analysis
The national/ international economy

Technology
Government and politics
The natural environment
Demographic structure
Social structure
THE INDUSTRY ENVIRONMENT
n Suppliers
n Competitors n Customers
THE DETERMINANTS OF INDUSTRY PROFIT: DEMAND AND COMPETITION 69
burning fossil fuels mean that global warming is a vital issue. However, to analyze the strategic implications
of global warming, the automobile manufacturers need to trace its implications for their industry
environment:
n What will be the impact on demand? Will consumers favor more fuel-efficient cars, or will there be a shift
from gasoline-powered to electrically powered vehicles?
n Will
there be substitution of public transportation for private transportation? n Will there be new entry by
manufacturers of electric vehicles into the car
industry?
n Will
the heavy R&D costs associated with adapting cars to the new environmental challenge cause the
industry to consolidate?
THE DETERMINANTS OF INDUSTRY PROFIT:
DEMAND AND COMPETITION

If the purpose of strategy is to help a company to survive and make money, the starting point for industry
analysis is a simple question: What determines the level of profit in an industry?
As already noted, business is about the creation of value for the customer either by production (transforming
inputs into outputs) or commerce (arbitrage). Value is created when the price the customer is willing to pay
for a product exceeds the costs incurred by the firm. But value creation does not translate directly into profit.
The surplus of value over cost is distributed between customers and producers by the forces of competition.
The stronger is competition among producers, the more of the surplus is received by customers in consumer
surplus (the difference between the price they actually pay and the maximum price they would have been
willing to pay) and the less is the surplus received by producers (as producer surplus or economic rent). A
single supplier of bottled water at an all-night rave can charge a price that fully exploits the dancers’ thirst. If
there are many suppliers of bottled water, then, in the absence of collusion, competition causes the price of
bottled water to fall toward the cost of supplying it.
The surplus earned by producers over and above the minimum costs of production is not entirely captured
in profits. Where an industry has powerful suppliers – monopolistic suppliers of components or employees
united by a strong labor union – a substantial part of the surplus may be appropriated by these suppliers (the
profits of suppliers or premium wages of union members).
The profits earned by the firms in an industry are thus determined by three factors:
n The value of the product to customers.

n The intensity of competition.
n The bargaining power of the producers relative to their suppliers.
Industry analysis brings all three factors into a single analytic framework.
70
INDUSTRY ANALYSIS: THE FUNDAMENTALS
ANALYZING INDUSTRY ATTRACTIVENESS

Tables 3.1 and 3.2 show the profitability of different US industries. Some industries (such as tobacco,
pharmaceuticals, and medical equipment) consistently earn high rates of profit; others (such as iron and
steel, nonferrous metals, airlines, and basic building materials) have failed to cover their cost of capital. The
basic premise that underlies industry analysis is that the level of industry profitability is neither random nor
the result of entirely industry-specific influences – it is determined by the systematic influences of the
industry’s structure. The US pharmaceutical industry and the US steel industry not only supply very different
products, they also have very different structures, which make one highly profitable and the other a
nightmare of
TABLE 3.1
INDUSTRY
Pharmaceuticals
T obacco
Household and Personal Products
Food Consumer Products Diversified Financials Medical Products and Equipment
Beverages
Securities
Scientific, Photographic,
and Control Equipment Saving Institutions Commercial Banks
Food Services
Engineering, Construction Publishing, Printing Petroleum Refining
Apparel
Computer Software
Mining, Crude-Oil Production Computer and Data Services Furniture
Electronics, Electrical Equipment
Chemicals
Specialty Retailers Automotive Retailing
and Services
Computers, Office Equipment
Healthcare
Source: Fortune 1000 by Industry.
The Profitability of US Industries, 1999–2002

MEDIAN ROE 1999–2002 (%)
INDUSTRY
Trucking, Truck Leasing Energy

General Merchandisers Utilities: Gas and Electric Food and Drug Stores Industrial and Farm Equipment
Wholesalers: Food and Grocery

Motor Vehicles and Parts Home Equipment, Furnishings Railroads
Mail, Package, and Freight Delivery

Pipelines
Hotels, Casinos, Resorts Insurance: Life and Health Real Estate
Building Materials, Glass

T emporary Help
Metals
Semiconductors and Other Electronic Components Insurance: Property and Casualty
Food Production
T elecommunications
Forest and Paper Products
Network and Other
Communications
Equipment (4.0) Airlines (34.8)
26.8 22.0
20.5 22.8 18.5
18.8 17.3 16.5
16.3 16.0 15.8 15.5 14.3 14.3 14.3 13.5 13.5 13.5 13.3 13.3
12.8 12.8 12.3
11.8
11.5 11.0
MEDIAN ROE 1999–2002 (%)
10.8 10.8 10.5 10.5 10.3
10.0
10.0 9.8 9.5 9.0
8.8 8.5 8.0 7.6 7.3 7.0 6.5 6.0
5.8
5.3 5.3 3.5 3.5

TABLE 3.2
1986–97
INDUSTRY
T obacco
Computer Software
and Services Entertainment Personnel-Supply Services
Personal Care
Medical Products
Food Processing
Food Retailing
IT Consulting Services Apparel
Games and Toys Packaging
Drugs and Research Chemicals
Beverages
Eating Places
Car Parts and Equipment T extiles
Fashion Retailing
Food Distribution
Building Materials
Drug Distribution
Metals
Telephone Companies Discount Retailing Semiconductors and Components
Paper and Products

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The business environment of the firm consists of all the external influences that affect its decisions and

FIGURE 3.1 From environmental analysis to industry analysis

The national/ international economy

Government and politics

The natural environment

THE INDUSTRY ENVIRONMENT

THE DETERMINANTS OF INDUSTRY PROFIT: DEMAND AND COMPETITION 69

THE DETERMINANTS OF INDUSTRY PROFIT:

DEMAND AND COMPETITION

n The value of the product to customers.

INDUSTRY ANALYSIS: THE FUNDAMENTALS

ANALYZING INDUSTRY ATTRACTIVENESS

Food Consumer Products Diversified Financials Medical Products and Equipment

Source: Fortune 1000 by Industry.

The Profitability of US Industries, 1999–2002

Trucking, Truck Leasing Energy

Wholesalers: Food and Grocery

Mail, Package, and Freight Delivery

Building Materials, Glass

20.5 22.8 18.5

18.8 17.3 16.5

12.8 12.8 12.3

MEDIAN ROE 1999–2002 (%)

10.8 10.8 10.5 10.5 10.3

10.0 9.8 9.5 9.0

8.8 8.5 8.0 7.6 7.3 7.0 6.5 6.0

5.3 5.3 3.5 3.5

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