Thursday, March 1, 2007

Understanding Business Strategy

"Strategy" is the most overused word in the vocabulary of business which is just another way of saying "this is important".The reality is there are a very few effective strategies. According to Professsor Michael Porter there are five forces which affect the industry outcome.They are the porters five forces which shape the basic strategy framework.
1)Bargaining power of suppliers
2)Bargaining power of customers
3)Threat of new entrants
4)Threat of substitutes
5)Competition among firms
But one of them is clearly much more important than others and one needs to focus only on it.that force is "barriers to entry" which prevents threat of new entrants.If there are barriers to entry then it is difficult for new firms to enter the market. Essentially there are two possibilities either the existing firm within the market is protected by barriers to entry or it is not. No other feature of the competitive landscape has as much influence on a company's success as where it stands in regard to these barriers.
With a universe of companies seeking profitable opportunities for investment, the returns in an unprotected industry will be driven down to levels where there is no economic profit that is no returns above the cost of invested capital. If demand conditions enable any single firm to earn unusually high returns, other firms will notice the same opportunity and flood in. Both theory and history support this proposition. As more firms enter,demand is fragmented among them. Costs per unit rise as fixed costs over fewer units sold, prices fall, and the high profits that attracted the new entrants disappear.
The erosion of profitability due to increased competition from new entrants isn't confined to commodity markets as one might expect . It occurs as well in markets for differentiated products, so long as all actual and potential competitors have equal access to customers,technology and resources. Consider the luxury car market in the United States. When Cadillac and Lincoln were the only significant competitors, their brands commanded higher prices, relative to costs leading to higher returns on invested resources. These returns attracted other competitors to the market: First the Europeans (Jaguar, Mercedes & BMW) and then the Japanese (Acura,Lexus & Infiniti) started to sell cars in America as there were no barriers to entry for the europeans and japanese car manufacturers.
The arrival of these competing products did not lower prices as it might have for a commodity like copper. Differentiation protected against that possibility. But profitability still suffered. Cadillac and Lincoln lost sales to the newcomers. As sales volume fell, fixed cost per car sold - such as advertising, product development, special service support,market intelligence and planning-inevitably increased, since these costs had to be covered by the revenue from the smaller number of units sold. Margins fell- same old prices, higher unit costs- so profits took the double hit of lower margins and reduced sales. If there were very low barriers to entry, entrants attracted by the reduced but still above average return on investment would have continued to arrive until all the excess profits were eliminated.
Barriers to entry are easier to maintain in sharply circumscribed markets. The conduct of strategy requires the competitive arena to be "local" either in the geographic sense or in the sense of being limited to one or handful no of products. The two most powerful competitive advantages, customer capitivity and economies of scale- which pack an even bigger punch when combined and are more achievable and sustainable in markets restricted in these ways.Indeed its perilous to chase growth across borders. Because a global market's dimensions are wider and less defined than a nation's or a region's firms face a higher risk of frittering away the advantages they have secured on small playing fields. If a company wants to grow and still mantain superior returns, the appropriate strategy is to assemble and dominate a series of discrete but preferably smaller markets and then expand at edges.

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