What are the determinants of firm profitability inan industry?
Competition, buyer and supplier power, substitutes, potential entry, cooperation and complementary products/services are the determinants of firm profitability in an industry. They are primary industry forces. The first five may drive profits down by forcing prices down or costs up and prevent less profitable firms from becoming more profitable. The last two may increase profits by allowing price increase or cost decrease. The evolving stage of an industry determines the strength of these individual industry forces, competitive or cooperative landscape and the degree of impact on firm profitability.
As a new industry starts with new product/service solutions to meet high market demands, this industry or market is growing rapidly. At this stage, the evolutionary path of the market is highly uncertain. Many players focus on a subset of the new market and have heterogeneous value and cost drivers. During the growth stage of the industry, the industry forces – competition, buyer power, substitutes, and potential entry – are relatively weak and supplier power is relatively strong, as customers need a solution. Two other determinants – cooperation and complementary products/services are very strong.
They are essential in the initial stage of industry development, when there is less similarity among several competing products or services and there is no clear standard for the market. Cooperation helps implement an integrated product or solution without having to build it all internally due to the lack of sufficient resources for a start up. Documentum emerged when an Enterprise document management solution was desperately needed. Given the importance of infrastructure interoperability and the ability to support various content formats for enterprise document management vendors, Documentum Inc. eveloped a number of key technology cooperation (Frame, Inc. , Oracle, Sun).
However, as an industry moves towards its maturity, the industry stabilizes. A few large players dominate this mature market. At this stage, market growth is slowing. The industry forces – competition, buyer power and substitutes are strong. Lincoln Electric was competing in a cyclical and commodity type industry. Buyers of arc welding machines could choose various products based on the price, the quality, and the service level.
Lincoln Electric had to defend against these forces and enhance the supplier’s power and increase barrier to entry in order to win on this mature market. Individual industry forces determine firm profitability through exerting their impact on the value and cost of firm’s products or services. A firm profitability in an industry depends on firms’ abilities to formulate and execute its strategy in these two areas: (1) increasing the value of its products or services, and (2) lowering cost of its products or services compared to other firms in an industry.
Strategy execution is about building the resources and capabilities that lead to competitive advantage through critical value and cost drivers. ” ((Modern Competitive Strategy, Gordon Walker). Lincoln Electric had concentrated its efforts on building various administrative and operational systems in manufacturing to achieve a lower cost structure than the competitions without degrading quality and passing the savings through to the customer by continuously lowering prices. Southwest innovated its operations in many ways to retain the cost-effective leadership position.
Doing own ticketing saved substantial commission fees paying to travel agent. Implementing the point-to-point route system instead of the hub-and-spoke system that adopted by all the major airlines truly increased the operation efficiency and aircraft utilization. Flying to less congested airports shortened average flight time, therefore resulted in a big saving for the company also. Flying only Boeing 737 jets achieved the most fuel efficiency and cut down the training and maintenance cost. Not joining any alliances program saved the cost on connecting flights, transferring baggage and sharing frequent flyer program with other airlines.
All these simplicity in its strategy execution make its lean operation possible and successful. Southwest Airlines also differentiated the service by providing customers with fun and enjoying journey, which created a whole new experience for the traveler and therefore contributed to the high customer retention rate. One key element of strategy execution is how to vertically integrate the organization. Decisions regarding this are critical piece of a firm’s strategy and crucial to firm’s profitability. Does the firm integrate all key primary activities in Porter’s value chain as it executes its strategy?
To address this, the firm has to examine (1) what is the economic return to the supply relationship? (2) What are the supplier investments in assets and human resources? And (3) how does a supplier handle strategic information about its own operations and about the firm? Successful utilizing vertical integration will help a firm to achieve higher return. Unlike many of its competitors, who sold value through distributors, Lincoln Electric had a vertical integrated sales force consists of engineers experienced in welding.
Lincoln’s sales staff could provide customer support on the factory floor and bring to the table technical expertise. This knowledgeable sales force was an essential component of Lincoln’s strategy execution and market share success – more than 40% market share in the U. S. As a start up, lack of high-level vertical integration may not be a bad thing. Relying on partners to access in-depth knowledge and expertise that a company has no previous experience, a firm could broaden its sales presence in many opportunities.
Furthermore, flexibility without committing large human resources or capitals enables companies in an early stage of industry to adjust or improve their services and products more quickly as the market takes its shape. In the end, if a firm can successfully cooperate with many players and leverage on existing complementary products or services, then it will be able to set a foot in the developed industry and begin to grow the business upon the foundation built through cooperation and extract high economic value from its products. Documentum did not have all strategic assets or resources and capabilities, i. e. system integration or customer training capabilities. It had to rely on other partners to perform system integration (CSC) or customer training (CSC).
It is important for a company to retain competitive advantage and build isolating mechanism to set up the entry barrier for the rivals. Southwest Airlines is a classic story of how a successful company defends a strong market position in a highly competitive market by focusing on driving high value and low cost. By developing many isolating mechanisms, Southwest Airlines really distinguished itself from its competitor and its superior strategy execution could not be imitated.
Lincoln’s compensation system and knowledgeable sales force was a brilliant isolation system. It would be difficult for a competitor to extract the same or higher economic value without adopting many Lincoln’s supporting practices and committing large investment in its sales force. Carrying out the right practices throughout the organization could contribute largely to a firm’s economic performance. There are four key capabilities the company needs to focus on. First, consistent strategy execution needs to align with the demands of the firm’s market position.
Southwest’s continuous innovations are always consistent with their low-cost mission and remain the low price leader in the airline industry. Second, control and coordination system needs to be set up for the strategy execution. Lincoln Electric’s piece rate compensation system was a remarkable control system to measure the performance and profit at that time. Third, incentive system needs to be set up parallel with the strategy and the execution. Lincoln’s year-end bonus could be equal or exceed an individual’s full annul regular pay, and the company also had guaranteed employment policy.
All these truly enhanced worker productivity and gained loyalty, which made Lincoln’s competitive advantage possible. Fourth, the selection and development of the firm’s people through its formal procedures and the strength of the firm’s culture are key components of capability building and effective decision-making. (Modern Competitive Strategy, Gordon Walker) Southwest’s family fun culture is the fundamental of its success. It is the people and the culture that can never be imitated overnight, yet it is the people and the culture that sustain their success for years and years.
Southwest’s average flight turn around time is only one third of the industry’s average, and it is just impossible for its competitors to achieve the same result, because there is no way they could reach the same level of cooperation among the employees. As we can see from many cases, at which industry stage the firm is in, the strength of individual industry forces determine firm profitability. But in the end, how the firm defends or leverages these industry forces and how the firm leverages its value and cost advantage consistently can grow continuously and profitably.