Profits – Harbor Capital Group Inc.

Diagnosis: Understanding your industry structure and the competitive forces driving profits

A good place to start your diagnosis is with an overall understanding of your industry and the forces driving prices and therefore profitability. The concepts are taken primarily from Michael Porters’ book, “The Five Competitive Forces That Shape Strategy.” Mr. Porter is a professor at Harvard. The book is years old but the material is still relevant. This information will get you off on a good footing for diagnosing the problem.

Every industry is different but the underlying drivers of profitability are the same in every industry. These five forces will help you:

Asses industry attractiveness

See how trends will affect industry competition

Determine which industries a company should compete in

Visualize how companies can position themselves for success

Anticipate shifts in competition

See how industry structure evolves

Find better strategic positions within the industry

Following is a summary of the five forces that shape strategy.

One. The Bargaining Power of Buyers

How buyers can use their clout to force prices down or demand more services at existing prices. Therefore, capturing more value for themselves. Power is highest when buyers are large compared to competitors, products are undifferentiated and represent a significant cost to buyers, and there are few switching costs.

Two. The Bargaining Power of Suppliers

Powerful suppliers can use their negotiating leverage to charge higher prices or demand more favorable terms which lower industry profitability and switching suppliers can be difficult, expensive or time-consuming.

Three. The Threat Of New Entrants

This threat can keep prices down and cause the company to spend more to retain customers. Entry brings more supply and lower prices. The threat of entry puts a cap on the profit potential of an industry. The threat depends on the barriers to entry, economies of scale, cost of building awareness, government restrictions, etc.

Four. The Threat of Substitute Products or Services

When a new product or service meets the same basic customer need in a different way, industry profitability suffers. However, it depends on the price-performance trade-offs.

Five. Rivalry Among Existing Competitors

If rivalry is intense, it drives down prices or dissipates profits by raising the cost of competing companies. A rivalry tends to be fierce if:

Competitors are numerous or roughly equal in size and market position

Industry growth is slow

There are high fixed costs which are incentives for price-cutting

Exit barriers are high (e.g., high debt load)

Rivals are highly committed to the industry.

This analysis will give you a good foundation to move on to other analyses like the next one on Creating Blue Ocean strategies.

In the last article, we ended with a definition of a strategy as a simple description of how your company will exploit the opportunity you have identified and do so in a way that captures a significant share of your selected market and at the same time, puts your competitors at a disadvantage in this market.

Our research shows that of all the problems businesses have, one of the most critical is a clearly articulated strategy. About 80% of CEOs say that strategy is very important. But, only about 50 % have a strategy. Many CEOs said they had a strategy but when asked what it was, they would give a mission statement or define goals.

In an executives study by PwC, the consulting firm found that 79% were concerned their strategy was not clear, and 73% though their strategy was not meaningfully different from the competition.

That study also found that companies that got their strategies right are 3X as likely to report above-average growth and 2X as likely to report above-average profits.

Before we go deeper into creating a strategy, I want to say a little more about the kernel we talked about last time. A strategy is more than the kernel, but if the kernel is absent or missing, you will have a problem. Once you determine the kernel, it is much easier to create, describe, and evaluate a strategy. It allows you to approach the task like a doctor who makes a diagnosis, then describes a therapeutic approach, and then prescribes a solution or prescription.

In business, we are often talking about change and competition, but sometimes the problem could be internal to the organization itself.

Starbucks is an example. In 2008, they were experiencing flat or declining same-store traffic growth and lower margins. So they began to question: how serious was this situation? Are we reaching saturation? Were their opportunities for expansion overseas? Was their differentiation vanishing? Management people came up with different definitions of the problem and consequently, different diagnoses.

Here is the problem. None of these problem definitions, by themselves, was actionable. In other words, each suggested a range of things that might be done. Also, none of these diagnoses could be proved to be correct, and each was a judgment about which issue was predominant.

Therefore, the diagnosis was a judgment about the meaning of facts. What is a fact? Understanding what a fact means is a critical discussion, and we will talk about it in another article. However, for our purposes here, we will say a physical thing, a bridge, a ballpark, etc. is an indisputable fact. If the fact is not physical, it is a fact because of an aggregated consensus of a group of people who believe it is a fact. For example, 49% of people think George is smart, and 51% of people think George is dumb.

Consequently, Starbuck’s problem was “ill-structured” (per Richard Rumelt), meaning no one could be sure how to define the problem or the actions that would be required to solve the problem.

Therefore, because the problem was not well defined, the diagnosis or the conclusions or solutions could not be put into a real strategy based on observed facts. More analysis was required, or they had to use a diagnosis based on an educated guess.

With an explicit agreement as to the problem, your diagnosis should replace the overwhelming complexity of the problem with a simple story that calls attention to the critical aspects of the problem.

A simplified and agreed-upon definition of the problem that makes sense of the situation allows you to engage in further problem-solving.

Tag: Profits

Diagnosis: Understanding your industry structure and it’s competitive forces

Getting To An Agreed Definition Of The Problem