The first step in creating an effective strategy for your business is to identify and thoroughly understand the fundamental economic forces that establish the "ground rules" of competition for the industry in which your company operates. This simple, but profound, concept was developed by Michael E. Porter in 1980 in his landmark book, Competitive Strategy. A broad range of business owners and managers, academicians, and other management practitioners quickly acclaimed Porter’s approach to strategy development. Competitive Strategy has been required reading for nearly a generation of MBA students; it is nearing its 60th printing in English and has been translated into at least 19 languages.

This is the second in a series of articles that is examining the role that effective business strategy plays in improving the financial performance of printing companies. The first article explained why a well-conceived business strategy is necessary for superior financial performance. This article will use Porter’s approach to industry analysis to describe the economic forces that create the competitive environment in which all printing companies operate. The final article will provide printing company owners and managers with a framework for developing effective strategies for today’s challenging marketplace.

The economic characteristics of competition in the printing industry are governed by five basic competitive forces – the rivalry among existing industry competitors, the bargaining power of the industry’s customers, the threat of substitute products and services, the bargaining power of suppliers to the industry, and the threat of new entrants into the industry. The collective strength of these five competitive forces determines the average long-term profitability of the industry – that is, the average rate of long-term profitability produced by all printing companies. If the combined strength of these competitive forces is relatively high, we can expect the average profitability of the industry to be relatively low. Recent history tells us this is the case in the printing industry.

All five competitive forces derive their strength from the underlying economic structure of the printing industry. In order to develop sound business strategies, printing company owners and managers must identify the key structural features of their industry that generate the power of each of the five basic competitive forces. One goal of a printing company’s competitive strategy is to establish a position in the industry where the company can minimize the negative effects of these forces or influence them in its favor. That goal cannot be achieved without understanding what makes each of the five forces strong or weak in a given situation. In the paragraphs that follow, we will describe the five competitive forces and outline some of the underlying structural features of industries that determine the strength of these forces.

Rivalry Among Existing Competitors

When most of us refer to "competition" in business, this is what we mean – the competition among firms in an industry that occurs on a daily basis. The tactics used in this competition are very familiar – lower prices, improved service, higher quality products, and so on. When analyzing this force, it is critical to distinguish between the outward appearance of the competitive rivalry and its underlying strength. The rivalry among competitors can be very strong and intense, even when that rivalry is conducted in a very polite and friendly manner. Strong rivalry results from a number of structural industry features:

1. Numerous, Small Competitors – Competitive rivalry tends to be strong in highly fragmented industries because such industries do not contain a dominant company or leadership group that possesses sufficient power to dictate the "rules" of competition for that industry. Competitive rivalry will also tend to be strong in industries that are composed primarily of small, privately held firms because the owners of these companies often bring a wide range of personal goals and objectives into their business decision-making. For example, many of these owners may be willing to accept a very low rate of return on the capital they have invested in their companies in order to continue receiving the non-economic benefits of business ownership.

2. Slow Industry Growth – In a rapidly growing industry, many firms may be able to achieve an acceptable rate of growth simply by keeping pace with the industry. But for companies operating in a mature industry, achieving acceptable growth usually requires taking market share from competitors, and competition for market share tends to cause intense rivalries.

3. Lack of Differentiation – When buyers do not perceive any significant differences among competing suppliers for a particular product or service, those buyers will base their purchase decisions primarily on price and generic service features. Competition based on price and generic service attributes tends to create strong competitive rivalry because competitive moves by one company are fairly easy for other firms to match. When a company is able to differentiate itself from its competitors, however, it creates a layer of insulation against competitive pressures by building and nourishing strong customer preferences and "brand" loyalty.

4. High Exit Barriers – Exit barriers are circumstances that cause companies to remain in an industry even when they consistently produce subpar financial results. When exit barriers are high, underperforming companies do not leave the industry and will often resort to extreme (and economically irrational) tactics merely to survive. These actions can cause the average profitability of the entire industry to be persistently low. Exit barriers can be economic or emotional in character. In industries that are composed primarily of small, privately held companies, exit barriers can be particularly high, because of the personal goals and fears of business owners.

Bargaining Power of Customers

The bargaining power of an industry’s customers can have a dramatic impact on the average profitability of that industry. If a substantial portion of an industry’s customers possess significant bargaining power (like the bargaining power of the major automobile manufacturers in the auto parts industry), most companies operating in that industry will have little pricing power and will face constant downward pressure on profit margins. Most industries, however, sell to a variety of customers, and not all buyers possess the same bargaining power. This fact makes customer selection a critical strategic decision. A customer will have strong bargaining power in the following circumstances:

1. Large Volume Purchases – When a given customer purchases a substantial portion of a company’s total sales, that customer will possess significant bargaining power. The bargaining power of a high volume buyer will be particularly strong if the selling company has high fixed costs and, therefore, has a potent incentive to keep capacity fully utilized.

2. Lack of Differentiation or Switching Costs – When a customer can purchase substantially equivalent products and services from several suppliers, that customer will be in a strong position to pit suppliers against each other to lower prices. Likewise, if a buyer faces little or no switching costs in moving from one supplier to another, the bargaining power of that buyer will be enhanced.

3. Threat of Backward Integration – If a customer is capable of threatening backward integration in a credible way, that customer will have substantial bargaining power. Backward integration essentially means that the customer will begin producing internally whatever product or service that customer had previously purchased from an outside supplier. When attempting to assess this threat, it is critical to remember that technological advances can enable a customer to take on functions that previously would not have been feasible either from an economic or a practical standpoint.

Threat of Substitutes

All companies in a given industry compete, at least indirectly, with industries that produce substitute products or services. Substitutes set an upper limit on the prices that firms in an industry can profitably charge and, therefore, limit the profit potential of that industry. The strength of this competitive force depends on the attractiveness of the substitute from a price-performance perspective. When the relative attractiveness of the substitute is low, that substitute will have little impact on the industry’s sales or profits. But, as the substitute becomes more attractive, it will tend to depress both the industry’s profits and its total sales.

Bargaining Power of Suppliers

Like customers, suppliers to an industry can have a significant impact on the average profitability of that industry. Powerful suppliers can threaten industry profits by increasing the prices that industry firms must pay for equipment, raw materials and supplies. A supplier or a supplier group will have strong bargaining power if the following conditions exist:

1. Supplier Size and Concentration – In general, if a supplier is substantially larger than its customers, it will have significant bargaining power. The bargaining power of a large supplier will be further enhanced if it operates in an industry that is more concentrated that the industry or industries it serves. This general rule is subject to one important caveat. If an industry is an important customer of a supplier group, then that supplier group will tend to view its success and the success of the customer industry and interdependent. In this case, the suppliers will tend to be more restrained in the exercise of their bargaining power.

2. Product Importance – If the product or service provided by a supplier is important to the success of the customer’s business, that supplier will be in a strong bargaining position, and its bargaining power will be further strengthened if it has differentiated itself and its product or service in a meaningful and sustainable way.

Threat of New Entrants

The average profitability of an industry will often be reduced when new firms enter the industry because new competitors add capacity and usually bring a willingness to use aggressive pricing to gain market share quickly. The strength of this threat depends on the barriers to entry that exist. If the barriers to entry are high, the threat of new entrants is low. The following circumstances create significant barriers to entry:

1. Economies of Scale – If an industry benefits from significant economies of scale, potential new competitors will be forced to enter the industry at a large scale and risk substantial assets, or to enter at a small scale and compete with an operating cost disadvantage.

2. Differentiation – If the established firms in an industry have successfully differentiated themselves and created brand and customer loyalties, new competitors will be required to make substantial investments of time and money in order to overcome those loyalties.

3. High Capital Requirements – If entry into an industry will require substantial capital expenditures, the number of potential entrants will likely be limited. Even when a potential new competitor has sufficient capital, entering a new industry is inherently risky, and the more money that must be placed at risk, the more closely the decision will be scrutinized.

Porter’s approach to industry analysis may seem somewhat complicated at first, but it can provide printing company owners and managers with a solid foundation for creating effective business strategies. When using this approach, however, printers must keep two important considerations in mind. First, the analysis must be performed from the perspective of a specific, individual printing company. In an industry as diverse as the printing industry, the five competitive forces will not affect all printing companies or all industry segments in the same way. A competitive force that is extremely strong in one area of the industry may be very weak in another industry segment. Second, while the collective strength of the five competitive forces determines the average profitability of the printing industry, these forces do not control or dictate the financial results that are attainable by any specific printing company. Good business strategies must be developed in the context of these elemental economic forces. But, good business strategies (along with good execution of those strategies) will enable a printing company to attain a position in the industry from which it can defend itself against these forces or tilt them in its favor. In our next article, we will examine the elements of effective business strategies and the art of strategic thinking.