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Industry Competition

3

Chapter Outline
3-1 Industry Life Cycle Stages
3-2 Industry Structure
3-3 Intensity of Rivalry among Incumbent Firms
3-3a Concentration of Competitors
3-3b High Fixed or Storage Costs
3-3c Slow Industry Growth
3-3d Lack of Differentiation or Low Switching Costs
3-3e Capacity Augmented in Large Increments
3-3f Diversity of Competitors
3-3g High Strategic Stakes
3-3h High Exit Barriers
3-4 Threat of Entry
3-4a Economies of Scale
3-4b Brand Identity and Product Differentiation
3-4c Capital Requirements
3-4d Switching Costs
3-4e Access to Distribution Channels
3-4f Cost Advantages Independent of Size
3-4g Government Policy
3-5 Pressure from Substitute Products
3-6 Bargaining Power of Buyers
3-7 Bargaining Power of Suppliers
3-8 Limitations of Porter’s Five Forces Model
3-9 Summary
Key Terms
Review Questions and Exercises
Practice Quiz
Notes
Reading 3-1

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T

Industry
A group of competitors that produce similar products or services.

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his chapter marks the beginning of the strategic management process and is one of two that considers the external environment. At this point it is appropriate to focus on factors external to the organization and to view firm performance from an industrial organization perspective. Internal factors are considered later in the process and in future chapters. Each business operates among a group of companies that produces competing products or services known as an industry. The concept of an industry is a simple one, but it is often confused in everyday conversations. The term industry does not refer to a single company or specific firms in general. For example, in the statement, “A new industry is moving to the community,” the word industry should be replaced by company or firm.
Although usually differences exist among competitors, each industry has its own set of combat rules governing such issues as product quality, pricing, and distribution. This is especially true for industries that contain a large number of firms offering standardized products and services. Most competitors—but not all—follow the rules. For example, most service stations in the United States generally offer regular unleaded, midgrade, and premium unleaded gasoline at prices that do not differ substantially from those at nearby stations. Breaking the so-called rules and charting a different strategic course might be possible, but may not be desirable. As such, it is important for strategic managers to understand the structure of the industry(s) in which their firms operate before deciding how to compete successfully.
Defining a firm’s industry is not always an easy task. In a perfect world, each firm would operate in one clearly defined industry; however, many firms compete in multiple industries, and strategic managers in similar firms often differ in their conceptualizations of the industry environment. In addition, some companies have utilized the Internet to redefine industries or even invent new ones, such as eBay’s online auction or Priceline’s travel businesses. As a result, the process of industry definition and analysis can be especially challenging when Internet competition is considered.1
Numerous outside sources can assist a strategic manager in determining
“where to draw the industry lines” (i.e., determining which competitors are in the industry, which are not, and why). Government classification systems, such as the Standardized Industrial Classification (SIC), as well as distinctions made by trade journals and business analysts may be helpful. In 1997, the U.S. Census
Bureau replaced the SIC system with the North American Industry Classification
System (NAICS), an alternative system designed to facilitate comparisons of business activities across North America. Astute managers assess all of these sources, however, and add their own rigorous and systematic analysis of the competition when defining the industry.
Numerous descriptive factors can be used when drawing the industry lines. In the case of McDonald’s, for example, attributes such as speed of service, types of products, prices of products, and level of service may be useful. Hence, one might define McDonald’s industry as consisting of restaurants offering easy to consume, moderately priced food products rapidly and in a limited service environment.
Broad terms such as “fast food” are often used to describe such industries, but doing so does not eliminate the need for a clear, tight definition.
Some factors are usually not helpful when defining an industry, however, such as those directly associated with strategy and firm size. For example, it is not a good idea to exclude a “fast-food” restaurant in McDonald’s industry because it is not part of a large chain or because it emphasizes low-priced food. Rather, these

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factors explain how such a restaurant might be positioned vis-à-vis to McDonald’s, a concept discussed in greater detail in Chapter 7.
The concept of primary and secondary industries may also be a useful tool in defining an industry. A primary industry may be conceptualized as a group of close competitors, whereas a secondary industry includes less direct competition. When one analyzes a firm’s competition, the primary industry is loosely considered to be
“the industry,” whereas the secondary industry is presented as a means of adding clarity to the analysis. For example, McDonald’s primary industry includes such competitors as Burger King and Wendy’s, whereas its secondary industry might also include restaurants that do not emphasize hamburgers and offer more traditional restaurant seating such as Pizza Hut and Denny’s. The distinction between primary and secondary industry may be based on objective criteria such as price, similarity of products, or location, but is ultimately a subjective call.
Once the industry is defined, it is important to identify the market share, which is a competitor’s share of the total industry sales, for the firm and its key rivals. Unless stated otherwise, market share calculations are usually based on total sales revenues of the firms in an industry rather than units produced or sold by the individual firms. This information is often available from public sources, especially when there is a high level of agreement as to how an industry should be defined.
When market share is not available or substantial differences exist in industry definitions, however, relative market share, or a firm’s share of industry sales when only the firm and its key competitors are considered, can serve as a useful substitute. Consider low-end discount retailer Dollar Tree as an example and assume that the only available market share data considers Dollar Tree to be part of the broadly defined discount department store industry. If a more narrow industry definition is proposed—perhaps one limited to deep discount retailers— new market share calculations will be necessary. In addition, it becomes quite complicated when one attempts to include the multitude of mom-and-pop discounters in the calculations. In this situation, computing relative market shares that consider Dollar Tree and its major competitors can be useful. Assume for the sake of this example that four major competitors are identified in this industry—
Dollar General, Family Dollar, Dollar Tree, and Fred’s—with annual sales of $6 billion, $5 billion, $2 billion, and $1 billion, respectively. Relative market share would be calculated on the basis of a total market size of $14 billion
(i.e., 6 + 5 + 2 + 1). In this example, relative market shares for the competitors are
43 percent, 36 percent, 14 percent, and 7 percent, respectively. From a practical standpoint, calculating relative market share can be appropriate when external data sources are limited.
A firm’s market share can also become quite complex as various industry or market restrictions are added. Unfortunately, the precise market share information most useful to a firm may be based on a set of industry factors so complex that computing it becomes an arduous task. In a recent analysis, the Mintel
International Group set out to identify the size of the “healthy snack” market in the United States, a task complicated by the fact that many products such as cheese, yogurt, and cereal are eaten as snacks in some but not all instances.2 To overcome this barrier, analysts computed a total for the healthy snack market by adding only the proportion of each food category consumed as a healthy snack.
In other words, 100 percent of the total sales of products such as popcorn and trail mix—foods consumed as “healthy snacks” 100 percent of the time—were included in the total. In contrast, only 40 percent of cheese consumption, 61 percent of yogurt consumption, and 21 percent of cereal consumption were included

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Market Share
The percentage of total market sales attributed to one competitor (i.e., firm sales divided by total market sales).

Relative Market
Share
A firm’s share of industry sales when only the firm and its key competitors are considered (i.e., firm sales divided by total sales of a select group firms in the industry).

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Case Analysis 3-1
Step 2: Identification of the Industry and the Competitors
After the organization has been introduced, its industry must be specifically identified.
This process can be either relatively simple or difficult. For example, most would agree that Kroger is in the “grocery store industry,” and its competition comes primarily from other grocery stores. However, not all decisions are simple. For example, should WalMart be classified in the department store industry (competing with upscale malloriented stores) or in the discount retail industry (competing with low-end retailers such as Family Dollar)? Is Taco Bell in the fast-food industry or in the broader restaurant industry? To further complicate matters, many corporations are diversified and compete in a number of different industries. For example, Anheuser Busch operates breweries and theme parks. In cases in which multiple business units are competing in different industries, one needs to identify multiple industries. Market shares or relative market shares for the firm and its key competitors—based on the best available data—should also be identified. It is important to clarify industry definition at the outset so that the macroenvironmental forces that affect it can be realistically assessed. In addition, a firm’s relative strengths and weaknesses can be classified as such only when compared to other companies in the industry.

in the total. Although this approach is reasonable and can be quite useful, it can only be calculated when one has access to data that may not be readily available.
Hence, analysts must use the best data available to describe the relative market positions of the competitors in a given industry (see Case Analysis 3-1).

3-1 Industry Life Cycle Stages
Industry Life Cycle
The stages (introduction, growth, shakeout, maturity, and decline) through which industries often pass.

Like firms, industries develop and evolve over time. Not only might the group of competitors within a firm’s industry change constantly, but also the nature and structure of the industry can change as it matures and its markets become better defined. An industry’s developmental stage influences the nature of competition and potential profitability among competitors.3 In theory, each industry passes through five distinct phases of an industry life cycle (see Figure 3-1).
A young industry that is beginning to form is considered to be in the introduction stage. Demand for the industry’s outputs is low at this time because product and/or service awareness is still developing. Virtually all purchasers are first-time buyers and tend to be affluent, risk tolerant, and innovative. Technology is a key concern in this stage because businesses often seek ways to improve production and distribution efficiencies as they learn more about their markets.
Normally, after key technological issues are addressed and customer demand begins to rise, the industry enters the growth stage. Growth continues but tends to slow as the market demand approaches saturation. Fewer first-time buyers remain, and most purchases tend to be upgrades or replacements. Many competitors are
FIGURE

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3-1

T he I n dustr y Life Cy cle

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profitable, but available funds may be heavily invested into new facilities or technologies. Some of the industry’s weaker competitors may go out of business in this stage. Shakeout occurs when industry growth is no longer rapid enough to support the increasing number of competitors in the industry. As a result, a firm’s growth is contingent on its resources and competitive positioning instead of a high growth rate within the industry. Marginal competitors are forced out, and a small number of industry leaders may emerge.
Maturity is reached when the market demand for the industry’s outputs is completely saturated. Virtually all purchases are upgrades or replacements, and industry growth may be low, nonexistent, or even negative. Industry standards for quality and service have been established, and customer expectations tend to be more consistent than in previous stages. The U.S. automobile industry is a classic example of a mature industry. Firms in mature industries often seek new uses for their products or services or pursue new markets, often through global expansion.
The decline stage occurs when demand for an industry’s products and services decreases and often begins when consumers turn to more convenient, safer, or higher quality offerings from firms in substitute industries. Some firms may divest their business units in this stage, whereas others may seek to “reinvent themselves” and pursue a new wave of growth associated with a similar product or service.
A number of external factors can facilitate movement along the industry life cycle. When oil prices spiked in 2005, for example, firms in oil-intensive industries such as airlines and carmakers began to feel the squeeze.4 When an industry is mature, however, firms are often better able to withstand such pressures and survive. Although the life cycle model is useful for analysis, identifying an industry’s precise position is often difficult, and not all industries follow these exact stages or at predictable intervals.5 For example, the U.S. railroad industry did not reach maturity for many decades and extended over a hundred years before entering decline, whereas the personal computer industry began to show signs of maturity after only seven years. In addition, following an industry’s decline, changes in the macroenvironment may revitalize new growth. For example, the bicycle industry fell into decline some years ago when the automobile gained popularity but has now been rejuvenated by society’s interest in health and physical fitness.

3-2 Industry Structure
Factors associated with industry structure have been found to play a dominant role in the performance of many companies, with the exception of those that are its notable leaders or failures.6 As such, one needs to understand these factors at the outset before delving into the characteristics of a specific firm. Michael
Porter, a leading authority on industry analysis, proposed a systematic means of analyzing the potential profitability of firms in an industry known as Porter’s “five forces” model. According to Porter, an industry’s overall profitability, which is the combined profits of all competitors, depends on five basic competitive forces, the relative weights of which vary by industry (see Figure 3-2).
1.
2.
3.
4.
5.

Intensity of rivalry among incumbent firms
Threat of new competitors entering the industry
Threat of substitute products or services
Bargaining power of buyers
Bargaining power of suppliers

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FIGURE

3-2

P or te r ’s F iv e Force s M ode l

These five factors combine to form the industry structure and suggest (but do not guarantee) profitability prospects for firms that operate in the industry. Each of the factors is discussed in greater detail in sections 3-3 through 3-7.

3-3 Intensity of Rivalry among
Incumbent Firms
Competition intensifies when a firm identifies the opportunity to improve its position or senses competitive pressure from other businesses in its industry, which can result in price wars, advertising battles, new product introductions or modifications, and even increased customer service or warranties.7 Rivalry can be intense in some industries. For example, a battle wages in the U.S. real-estate industry, where traditional brokers who earn a commission of 5 to 6 percent are being challenged by discount brokers who charge sellers substantially lower fees.
Agents for the buyer and seller typically split commissions, which usually fall in the $7,000 range for both agents when a home sells for $250,000. Discount brokers argue that the primary service provided by the seller’s agent is listing the home in a multiple listing service (MLS) database, the primary tool used by most buyers and their agents to peruse available properties. Discount brokers provide sellers with a MLS listing for a flat fee in a number of markets, sometimes less than $1,000. Traditional brokers are angry, however, and argue that discount brokers simply do not provide the full array of services available at a so-called full-service broker. Traditional brokers dominate the industry, accounting for
98 percent of all sales in 2005. They often control the local MLS databases, and many discount brokers charge that they are not provided equal access to list their properties.8 Hence, rivalry in this industry—especially between full-service and discount brokers—remains quite intense.
Competitive intensity often evolves over time and depends on a number of interacting factors, as discussed in sections 3-3a through 3-3h. Factors should be assessed independently and then integrated into an overall perspective.

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3-3a Concentration of Competitors
The number of companies in the industry and their relative sizes or power levels influence an industry’s intensity of rivalry. Industries with few firms tend to be less competitive, but those with many firms that are roughly equivalent in size and power tend to be more competitive, as each firm fights for dominance.
Competition is also likely to be intense in industries with large numbers of firms because some of those companies may believe that they can make competitive moves without being noticed.9

3-3b High Fixed or Storage Costs
When firms have unused productive capacity, they often cut prices in an effort to increase production and move toward full capacity. The degree to which prices
(and profits) can fall under such conditions is a function of the firms’ cost structures. Those with high fixed costs are most likely to cut prices when excess capacity exists, because they must operate near capacity to be able to spread their overhead over more units of production.

The U.S. airline industry experiences this problem periodically, as losses generally result from planes that are flying substantially less than full or those that are not flying at all. This dynamic often results in last-minute fare specials in an effort to fill seats that would otherwise fly vacant. During the difficult times for
U.S. airlines immediately following the 9/11 terrorist attacks, frequent price wars were often initiated by low-cost airlines such as JetBlue, Southwest, and AirTran.10
Interestingly, airlines filled 73.4 percent of their seats in 2003 compared to only
63.5 percent a decade earlier.11

3-3c Slow Industry Growth
Firms in industries that grow slowly are more likely to be highly competitive than companies in fast growing industries. In slow-growth industries, one firm’s increase in market share must come primarily at the expense of other firms’

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shares. Competitors often attend more to the actions of their rivals than to consumer tastes and trends when formulating strategies.
Slow industry growth can be caused by a sluggish economy, as was the case for vehicles during the early 2000s. As a result, manufacturers began to emphasize value by enhancing features and cutting costs. Ford, DaimlerChrysler, Nissan,
Toyota, and others began to produce slightly larger trucks with additional features, while trimming prices. Producers also began to develop lower priced luxury cars in a fierce battle for sales.12
Slow industry growth—and even declines—are frequently caused by shifts in consumer demand patterns. For example, per capita consumption of carbonated soft drinks in the United States fell from its peak of fifty-four gallons in 1997 to approximately fifty-two gallons by 2004. During this same period, annual world growth declined from 9 percent to 4 percent as consumption of fruit juices, energy drinks, bottled water, and other noncarbonated beverages continued to rise. Coca-Cola and PepsiCo acquired or developed a number of noncarbonated brands during this time in efforts to counter the sluggish growth prospects in soft drinks. Interestingly, these rivals now appear to have modified their industry definitions from a narrow “soft drink” focus to a broader perspective including noncarbonated beverages.13

3-3d Lack of Differentiation or Low Switching Costs
Switching Costs
One-time costs that buyers of an industry’s outputs incur as they switch from one company’s products or services to another’s.

The more similar the offerings among competitors, the more likely customers are to shift from one to another. As a result, such firms tend to engage in price competition. Switching costs are one-time costs that buyers incur when they switch from one company’s products or services to another. When switching costs are low, firms are under considerable pressure to satisfy customers who can easily switch competitors at any time. When products or services are less differentiated, purchase decisions are based on price and service considerations, resulting in greater competition.
Interestingly, firms often seek to create switching costs in efforts to encourage customer loyalty. Internet Service Provider (ISP) America Online, for example, encourages users to obtain and use AOL e-mail accounts. Historically, these accounts were eliminated if the AOL customer switched to another ISP. Free e-mail accounts with Yahoo and other providers proliferated in the mid-2000s, however. As a result, AOL loosened this restriction in 2006, suggesting that most consumers no longer see the loss of an e-mail account as a major factor when considering a switch to another ISP (see Strategy at Work 3-1). Frequent flier programs also reward fliers who fly with one or a limited number of airlines. The
Southwest Airlines generous program rewards only customers who complete a given number of flights within a twelve-month period, thereby effectively raising the costs of switching to another airline.
The cellular telephone industry in the United States benefited from key switching costs for a number of years. Until regulations changed in late 2003, consumers who switched providers were not able to keep their telephone numbers. Hence, many consumers were reluctant to change due to the hassle associated with alerting friends and business associates of the new number. Today, however, “number portability” greatly reduces switching costs, allowing consumers to retain their original telephone number when they switch providers.14

3-3e Capacity Augmented in Large Increments
When production can be easily added one increment at a time, overcapacity is not a major concern. If economies of scale or other factors dictate that

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3-1

Rivalry and Cooperation in Internet Services
Amidst a flurry of copromotion agreements between retailers and Internet brands, Microsoft and Best Buy embarked on a strategic alliance that includes Internet, broadcasting, and in-store promotional projects.
Microsoft utilizes the new agreement to expand its distribution and increase subscribers to its Internet services. The agreement also displays and promotes the
Best Buy logo and BestBuy.com links at Microsoft’s
Web sites and broadcasting properties, including the
Expedia.com travel service, Microsoft’s e-mail services, Hotmail, WebTV Network, the new MSN eShop online, and MSNBC. In return, Best Buy became a major advertiser with Microsoft’s Internet and broadcast properties.

Wal-Mart and America Online (AOL) have also teamed up to drive traffic to Wal-Mart’s Web site and introduce millions of customers to the AOL brand. AOL is most interested in the in-store promotion of its online service in more than four thousand Wal-Mart stores in the United States, in return for promoting Wal-Mart’s online store to its 18 million subscribers. Under the agreement, AOL also provides Web design assistance to the nation’s largest retailer.
Sources: R . Spiegel, “Microsoft and Best Buy Join Alliance Frenzy,”
E -Commerce Times, 1 6 December, 1999; C. Dembeck, “WalMart Looking to AOL for E-Commerce Boost,” E -Commerce
Times, 1 3 December, 1999; C. Dembeck, “Yahoo! and Kmart
Forge Alliance to Counter AOL,” E -Commerce Times, 1 4
December 1999.

production be augmented in large blocks, however, then capacity additions may lead to temporary overcapacity in the industry, and firms may cut prices to clear inventories. Airlines and hotels, for example, usually must acquire additional capacity in large increments because it is not feasible to add a few airline seats or hotel rooms as demand warrants. When additional blocks of seats or rooms become available, firms are under intense pressure to cover the additional costs by filling them.

3-3f Diversity of Competitors
Companies that are diverse in their origins, cultures, and strategies often have different goals and means of competition. Such firms may have a difficult time agreeing on a set of combat rules. As such, industries with global competitors or with entrepreneurial owner-operators tend to be diverse and particularly competitive. Internet businesses often change the rules for competition by emphasizing alternative sources of revenue, different channels of distribution, or a new business model. This diversity can sharply increase rivalry.

3-3g High Strategic Stakes
Competitive rivalry is likely to be high if firms also have high stakes in achieving success in a particular industry. For instance, many strong, traditional companies cannot afford to fail in their Web-based ventures if their strategic managers believe a Web presence is necessary even if it is not profitable. These desires can often lead a firm to sacrifice profitability.

3-3h High Exit Barriers
Exit barriers are economic, strategic, or emotional factors that keep companies from leaving an industry even though they are not profitable or may even be losing money. Examples of exit barriers include fixed assets that have no alternative uses, labor agreements that cannot be renegotiated, strategic partnerships among business units within the same firm, management’s unwillingness to leave an industry because of pride, and governmental pressure to continue operations

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to avoid adverse economic effects in a geographic region.15 When substantial exit barriers exist, firms choose to compete as a “lesser of two evils,” a practice that can drive down the profitability of competitors as well.

3-4 Threat of Entry

Barriers to Entry
Obstacles to entering an industry, including economies of scale, brand identity and product differentiation, capital requirements, switching costs, access to distribution channels, cost disadvantages independent of size, and government policy.

An industry’s productive capacity expands when new competitors enter. Unless the market is growing rapidly, new entrants intensify the fight for market share, thus lowering prices and, ultimately, industry profitability. When large, established firms control an industry, new entrants are often pelted with retaliation when they establish their operations or begin to promote their products aggressively.
For example, when Dr. Pepper launched Like Cola directly against Coke and
Pepsi, an effort to make inroads into the cola segment of the soft drink market, the two major competitors responded with strong promotional campaigns to thwart the effort. If prospective entrants anticipate this kind of response, they are less likely to enter the industry in the first place. As such, entry into an industry may well be deterred if the potential entering firm expects existing competitors to respond forcefully. Retaliation may occur if incumbent firms are committed to remaining in the industry or have sufficient cash and productive capacity to meet anticipated customer demand in the future.16
The likelihood that new firms will enter an industry is also contingent on the extent to which barriers to entry have been erected—often by existing competitors—to keep out prospective newcomers.17 From a global perspective, many barriers have declined, as firms in countries such as India and China make use of technology—and specifically a developing global fiber-optic network—to gain access to industries in the West. For example, as many as half a million IRS tax returns are prepared annually in India. Hence, barriers are always changing as technology, political influences, and business practices also change.18
The seven major barriers (obstacles) to entry are described in sections 3-4a through 3-4g (see also Strategy at Work 3-2). As with intensity of rivalry, they should be assessed independently and then integrated into an overall perspective on entry barriers.

3-4a Economies of Scale
Economies of scale refer to the decline in unit costs of a product or service that occurs as the absolute volume of production increases. Scale economies occur when increased production drives down costs and can result from a variety of factors, most namely high firm specialization and expertise, volume purchase discounts, and a firm’s expansion into activities once performed at higher costs by suppliers or buyers. Substantial economies of scale deter new entrants by forcing them either to enter an industry at a large scale—a costly course of action that risks a strong reaction from existing firms—or to suffer substantial cost disadvantages associated with a small-scale operation. For example, a new automobile manufacturer must accept higher per-unit costs as a result of the massive investment required to establish a production facility unless a large volume of vehicles can be produced at the outset.

3-4b Brand Identity and Product Differentiation
Established firms may enjoy strong brand identification and customer loyalties that are based on actual or perceived product or service differences. Typically, new entrants must incur substantial marketing and other costs over an extended time to overcome this barrier. Differentiation is particularly important among products

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3-2

Creating Barriers to Entry in the Airline Industry
U.S. airline deregulation in 1978 was intended to encourage new start-up ventures and to foster competition. For a while, it seemed to be working; new companies such as Southwest Airlines and AirTran helped to lower ticket prices significantly. Over time, however, the major airlines have succeeded in erecting enormous barriers to entry, such as the following: 1. The global alliances that exist among major world carriers result in substantial control over hubs and passenger-loading gates at large airports, where such carriers already typically hold twenty- to fortyyear leases. In addition, most airlines have a large number of U.S. hub airports, a feeder system to those hubs, and international routes that tie into the hubs. Such systems take decades and hundreds of millions of dollars to acquire.
2. Major airlines own the computer reservation systems, negotiate commission arrangements with travel agents for bringing business to them, and charge small carriers hefty fees for tickets sold through these systems. By operating their own Web sites, U.S. airlines have been able to eliminate the commission fees paid for domestic bookings. 3. All major carriers operate frequent flier programs that encourage passengers to avoid switching airlines. Many of the programs expire when a passenger does not fly on the airline after a specific period of time, often three years.
4. Airline computer-pricing systems enable them to selectively offer low fares on certain seats and

to certain destinations (often purchased well in advance or at the last minute), thereby countering a start-up airline’s pricing edge.
5. The dominant major carriers are willing to match or beat the ticket prices of smaller, niche airlines, and often respond to price changes within hours.
Most are capable of absorbing some degree of losses until weaker competitors are driven out of business. These barriers are designed to keep control of the airline industry’s best routes and markets in the hands of a few carriers, even after two decades of deregulation. As such, newly formed carriers are often limited to less desirable routes. Although many upstarts fail in their first year or two of operation, others such as
Southwest, AirTran, and JetBlue have been successful and are filling viable niches in the industry. Interestingly, the airline industry fallout from the events of 9/11 were felt the most by established competitors such as
USAir and United Airlines.
Sources: T. A. Hemphill, “Airline Marketing Alliances and U.S.
Competition Policy: Does the Consumer Benefit?” Business Horizons,
March 2000; P. A. Greenberg, “Southwest Airlines Projects $1B in Online Sales,” E-Commerce Times, 8 December 2000; P. A.
Greenberg and M. Hillebrand, “Airlines Band Together to Launch Travel
Site,” E-Commerce Times, 8 December 2000; P. A. Greenberg,
“Six Major Airlines to Form B2B Exchange,” E-Commerce Times,
8 December 2000; P. Wright, M. Kroll, and J. A. Parnell, Strategic
Management: Concepts (Upper Saddle River, NJ: Prentice Hall,
1998); S. McCartney, “Conditions Are Ideal for Starting an Airline, and Many Are Doing It,” Wall Street Journal, 1 April 1996, A1, A7;
“Boeing 1st-Quarter Profit Off 34%,” L.A. Times Wire Services,
30 April 1996; A. L. Velocci, Jr., “USAir Defends Aggressive Pricing,”
Aviation Week & Space Technology, 21 August 1995, 28;
T. K. Smith, “Why Air Travel Doesn’t Work,” Fortune, 3 April
1995, 42–49.

and services where the risks associated with switching to a competitive product or service are perceived to be high, such as over-the-counter drugs, insurance, and baby-care products.

3-4c Capital Requirements
Generally speaking, higher entry costs tend to restrict new competitors and ultimately increase industry profitability.19 Large initial financial expenditures may be necessary for production, facility construction, research and development, advertising, customer credit, and inventories. Some years ago, Xerox cleverly created a capital barrier by offering to lease, not just sell, its copiers. As a result, new entrants were faced with the task of generating large sums of cash to finance the leased copiers.20

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3-4d Switching Costs
Switching costs are the upfront costs that buyers of one firm’s products may incur if they switch to those of a competitor. If these costs are high, buyers may need to test the new product first, make modifications in existing operations to accommodate the change, or even negotiate new purchase contracts. When switching costs are low—typically the case when consumers try a new grocery store—change may not be difficult. When switching costs are high, however, customers may be reluctant to change. For example, for a number of years, Apple has had the unenviable task of convincing IBM-compatible customers not only that Apple produces a superior product, but also that switching from IBM to Apple justifies the cost and inconvenience associated with software and file incompatibility. In contrast, fast-food restaurants generally have little difficulty persuading consumers to switch from one restaurant to another at the introduction of a new product.

3-4e Access to Distribution Channels
In some industries, entering existing distribution channels requires a new firm to entice distributors through price breaks, cooperative advertising allowances, or sales promotions. Existing competitors may have distribution channel ties based on long-standing or even exclusive relationships, requiring the new entrant to create its own channels of distribution. For example, certain manufacturers and retailers have formed partnerships with FedEx or UPS to transport merchandise directly to their customers. As a distribution channel, the Internet may offer an alternative to companies unable to penetrate the existing channels.

3-4f Cost Advantages Independent of Size
Many firms enjoy cost advantages emanating from economies of scale. Existing competitors may have also developed cost advantages not related to firm size, however, that cannot be easily duplicated by newcomers. Such factors include patents or proprietary technology, favorable locations, superior human resources, and experience in the industry. For example, eBay’s experience, reputation, and technological capability in online auctions have made it difficult for prospective firms to enter the industry. When such advantages exist for one or more existing competitors, prospective new entrants are usually hesitant to join the industry.

3-4g Government Policy
Governments often control entry to certain industries with licensing requirements or other regulations. For example, establishing a hospital, a nuclear power facility, or an airline cannot be done in most nations without meeting substantial regulatory requirements. Although firms generally oppose government attempts to regulate their activity, this is not always the case. Existing competitors often lobby legislators to enact policies that make entry into their industry a complicated or costly endeavor.

3-5 Pressure from Substitute Products
Substitute Products
Alternative offerings produced by firms in another industry that satisfy similar consumer needs. 26061_03_ch03_p037-060.indd 48

Firms in one industry may be competing with firms in other industries that produce substitute products, offerings produced by firms in another industry that satisfy similar consumer needs but differ in specific characteristics. Note that products and services affected by a firm’s competitors (i.e., companies in the same industry) do not represent substitutes for that firm. By definition, substitutes emanate from outside of a firm’s industry.

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Although they emanate from outside the industry, substitutes can limit the prices that firms can charge. For instance, low fares offered by airlines can place a ceiling on the long-distance bus fares that Greyhound can charge for similar routes. Hence, firms that operate in industries with few or no substitutes are more likely to be profitable.

3-6 Bargaining Power of Buyers
The buyers of an industry’s outputs can lower that industry’s profitability by bargaining for higher quality or more services and playing one firm against another.
Levi Strauss discovered this when negotiating a sizeable contract with megaretailer Wal-Mart. The famous American jean-maker was forced to create a lower cost brand by overhauling production and distribution efforts.21
The following circumstances can raise the bargaining power of an industry’s buyers. 1. Buyers are concentrated, or each one purchases a significant percentage of total industry sales. If a few buyers purchase a substantial proportion of an industry’s sales, then they will wield considerable power over prices. This is especially prevalent in markets for components and raw materials.
2. The products that the buyers purchase represent a significant percentage of the buyers’ costs. When this occurs, price will become more critical for buyers, who will shop for a favorable price and will purchase more selectively.
3. The products that the buyers purchase are standard or undifferentiated. In such cases, buyers are able to play one seller against another and initiate price wars.
4. Buyers face few switching costs and can freely change suppliers.
5. Buyers earn low profits, creating pressure for them to reduce their purchasing costs.
6. Buyers have the ability to engage in backward integration by becoming their own suppliers. Large automobile manufacturers, for example, use the threat of self-manufacture as a powerful bargaining lever.
7. The industry’s product is relatively unimportant to the quality of the buyers’ products or services. In contrast, when the quality of the buyers’ products is greatly affected by what they purchase from the industry, the buyers are less likely to have significant power over the suppliers because quality and special features will be the most important characteristics.
8. Buyers have complete information. The more information buyers have regarding demand, actual market prices, and supplier costs, the greater their bargaining power.
The advent of the Internet has increased the quantity and quality of information available to buyers in a number of industries.

3-7 Bargaining Power of Suppliers
The tug of war between an industry’s rivals and their suppliers is similar to that between the rivals and their buyers. When suppliers to an industry wield collective power over the firms in the industry, they can siphon away a portion of excess profits that may be gleaned. Alternatively, when an industry’s suppliers are weak, they may be expected frequently to cut prices, increase quality, and add services. This was the case among U.S. automakers during the 1990s and early 2000s.
Marred by mounting financial losses, Detroit’s “Big Three” producers constantly squeezed their suppliers for price concessions. By the mid to late 2000s, however, many of these suppliers found themselves in Chapter 11 bankruptcy while others had developed a profitable nonauto business. Hence, power shifted from the automakers in favor of the suppliers during this time, an unwelcome reality to struggling GM, Ford, and Chrysler.22

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The struggle between U.S. service stations and their suppliers—big oil companies—is another interesting example. When the popularity of E85 ethanol—a mixture containing 85 percent ethanol and 15 percent gasoline— began to rise in the mid to late 2000s, many U.S. service stations were prohibited from carrying the alternative fuel. Oil companies that do not supply E85 lose sales every time a driver fills the tank with the ethanol mix. As a result, many prohibit their franchisees from carrying fuel from other producers.
Service stations that are allowed to carry E85 are often required to dispense it from a pump on a separate island not under the main canopy—a costly endeavor. Because there are only a few major oil companies and thousands of service stations in the United States, the oil companies are able to wield most of the power.23
The conditions that make suppliers powerful are similar to those that affect buyers. Specifically, suppliers are powerful under the following circumstances.
1. The supplying industry is dominated by one or a few companies. Concentrated suppliers typically exert considerable control over prices, quality, and selling terms when selling to fragmented buyers.
2. There are no substitute products, weakening buyers in relation to their suppliers.
3. The buying industry is not a major customer of the suppliers. If a particular industry does not represent a significant percentage of the suppliers’ sales, then the suppliers control the balance of power. If competitors in the industry comprise an important customer, however, suppliers tend to understand the interrelationships and are likely to consider the long-term viability of their counterparts—not just price—when making strategic decisions.
4. The suppliers pose a credible threat of forward integration by “becoming their own customers.” If suppliers have the ability and resources to operate their own manufacturing facilities, distribution channels, or retail outlets, then they will possess considerable control over buyers.
5. The suppliers’ products are differentiated or have built-in switching costs, thereby reducing the buyers’ ability to play one supplier against another.

3-8 Limitations of Porter’s Five
Forces Model
Generally speaking, the five forces model is based on the assumptions of the industrial organization (IO) perspective on strategy, as opposed to the resourcebased perspective. Although the model serves as a useful analytical tool, it has several key limitations. First, it assumes the existence of a clear, recognizable industry. As complexity associated with industry definition increases, the ability to draw coherent conclusions from the model diminishes. Likewise, the model addresses only the behavior of firms in an industry and does not account for the role of partnerships, a growing phenomenon in many industries. When firms work together, either overtly or covertly, they create complex relationships that are not easily incorporated into industry models.
Second, the model does not consider that some firms, most notably large ones, can often take steps to modify the industry structure, thereby increasing their prospects for profits. For example, large airlines have been known to lobby for hefty safety restrictions to create an entry barrier to potential upstarts. Mega-retailer Wal-Mart even employs its own team of lobbyists on
Capitol Hill.
Third, the model assumes that industry factors, not firm resources, comprise the primary determinants of firm profit. This issue continues to be

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widely debated among both scholars and executives.24 This limitation reflects the ongoing debate between IO theorists who emphasize Porter’s model and resource-based theorists who emphasize firm-specific characteristics. The resource-based perspective is addressed later in the strategic management process. Finally, a firm that competes in many countries typically must analyze and be concerned with multiple industry structures. The nature of industry competition in the international arena differs among nations, and may present challenges that are not present in a firm’s host country.25 One’s definition of McDonald’s industry may be limited to fast-food outlets in the United States, but may also include a host of sit-down restaurants when other countries are considered.
Different industry definitions for a firm across borders can make the task of assessing industry structure quite complex.
These challenges notwithstanding, a thorough analysis of the industry via the five forces model is a critical first step in developing an understanding of competitive behavior within an industry.26 In a general sense, Porter’s five forces model provides insight into profit-seeking opportunities, as well as potential challenges, within an industry (see Case Analysis 3-2).

Case Analysis 3-2
Step 3: Potential Profitability of the Industry
Porter’s five forces model should be applied to the industry environment, as identified in step 2, by examining threat of entry, rivalry among existing competitors, pressure from substitute products, and the bargaining power of buyers and suppliers. Each of the specific factors identified in the rivalry and new entrants sections (3-3 and 3-4) should be assessed individually. In addition, each of the five forces should be evaluated with regard to its positive, negative, or neutral effect on potential profitability in the industry. It is also useful to provide an overall assessment (considering the composite effect of all five forces) of potential profitability that identifies the industry as either profitable, unprofitable, or somewhere in between.

Step 4: Who Has Succeeded and Failed in the Industry, and Why? What Are the Critical Success Factors?
Every industry has recent winners and losers. To understand the critical success factors (CSFs)—factors that tend to be essential for success for most or all competitors within a given industry—one must identify the companies that are doing well and those that are doing poorly, and determine whether their performance levels appear to be associated with similar factors. For example, McDonald’s, Burger King, and Taco
Bell are successful players in the fast-food industry. In contrast, Rax and Hardee’s have been noted for their subpar performance. Are any common factors partially responsible for the differences in performance? Consider that many analysts have noted that consistency and speed of service are critical success factors in the fast-food industry.
Indeed, McDonald’s, Burger King, and Taco Bell are all noted for their fast, consistent service, whereas Rax and Hardee’s have struggled in this area.
A business may succeed even if it does not possess a key industry CSF; however, the likelihood of success is diminished greatly. Hence, strategies that do not shore up weaknesses in CSF areas should be considered carefully before being implemented. 26061_03_ch03_p037-060.indd 51

Critical Success
Factors (CSFs)
Factors that are generally prerequisites for success among most or all competitors in a given industry.

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3-9 Summary
An industry is a group of companies that produce similar products or services.
Michael Porter has identified five basic competitive industry forces that can ultimately influence profitability at the firm level: intensity of rivalry among incumbent firms in the industry, the threat of new entrants in the industry, the threat of substitute products or services, bargaining power of buyers of the industry’s outputs, and bargaining power of suppliers to the industry. Firms tend to operate quite profitably in industries with high entry barriers, low intensity of competition among member firms, no substitute products, weak buyers, and weak suppliers. These relationships are tendencies, however, and do not mean that all firms will perform in a similar manner because of industry factors. Although Porter’s model has its shortcomings, it represents an excellent starting point for positioning a business among its competitors.

Key Terms barriers to entry critical success factors exit barriers

industry industry life cycle market share

relative market share substitute products switching costs

Review Questions and Exercises
1. Visit the Web sites of several major restaurant chains.
Identify the industry(s) in which each one operates.
Would you categorize them in the same industry or in different industries (fast food, family restaurants, etc.)? Why or why not?
2. Identify an industry that has low barriers to entry and one that has high barriers. Explain how the difference in entry barriers influences competitive behavior in the two industries.

3. Identify some businesses whose sales have been adversely affected by substitute products. Why has this occurred?
4. Identify an industry in which the suppliers have strong bargaining power and another industry in which the buyers have most of the bargaining power.
How does this affect potential profitability in both industries? Practice Quiz
True or False

1. Each firm operates in a single, distinct industry.
2. All industries follow the stages of the industry life cycle model.
3. The likelihood that new firms will enter an industry is contingent on the extent to which barriers to entry have been erected.
4. Higher capital requirements for entering an industry ultimately raise average profitability within that industry. 5. Substitute products are produced by competitors in the same industry.

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6. A key limitation of Porter’s five forces model is its reliance on resource-based theory.
Multiple Choice

7. Industry growth is no longer rapid enough to support a large number of competitors in which stage of industry growth?
A. growth
B. shakeout
C. maturity
D. decline

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8. The intensity of rivalry among firms in an industry is dependent on which of the following?
A. concentration of competitors
B. high fixed or storage costs
C. high exit barriers
D. all of the above
9. The decline in unit costs of a product or service that occurs as the absolute volume of production increases is known as
A. production effectiveness.
B. effective operations management.
C. economies of scale.
D. technological analysis.
10. When switching costs are high,
A. customers are less likely to try a new competitor.
B. companies spend more on technology.
C. companies seek new suppliers to reduce costs.
D. none of the above

53

11. Which of the following is not a cost advantage independent of scale?
A. proprietary technology
B. favorable locations
C. experience in the industry
D. high volume of production
12. What is occurring when those who purchase an industry’s goods and services exercise great control over pricing and other terms?
A. high bargaining power of suppliers
B. low bargaining power of suppliers
C. balance of power among suppliers
D. none of the above

Notes
1. M. E. Porter, “Strategy and the Internet,” Harvard Business
Review 29(3) (2001): 62–79; M. E. Porter, “Clusters and the
New Economics of Competition,” Harvard Business Review
76(6) (1998): 77–90.
2. P. Daniels, “The New Snack Pack,” Prepared Foods (February
2006): 11–17.
3. C. W. Hofer, “Toward a Contingency Theory of Business
Strategy,” Academy of Management Journal 18 (1975):
784–810; G. Miles, C. C. Snow, and M. P. Sharfman, “Industry
Variety and Performance,” Strategic Management Journal 14
(1993): 163–177.
4. D. Michaels and M. Trottman, “Fuel May Propel Airline
Shakeout,” Wall Street Journal (7 September 2005): C1, C5.
5. T. Levitt, “Exploit the Product Life Cycle,” Harvard Business
Review 43(6) (1965): 81–94.
6. G. Hawawini, V. Subramanian, and P. Verdin, “Is Performance
Driven by Industry- or Firm-Specific Factors? A New Look at the Evidence,” Strategic Management Journal 24 (2003):
1–16.
7. J. R. Graham, “Bulletproof Your Business against Competitor
Attacks,” Marketing News (14 March 1994): 4–5; J. Hayes,
“Casual Dining Contenders Storm ‘Junior’ Markets,” Nations’
Restaurant News (14 March 1994): 47–52.
8. J. R. Hagerty, “Discount Real-Estate Brokers Spark a War over Commissions,” Wall Street Journal (12 October 2005):
A1, A6.
9. See A. Taylor III, “Will Success Spoil Chrysler?” Fortune
(10 January 1994): 88–92.
10. S. Carey and E. Perez, “Traveler’s Dilemma: When To Fly the Cheap Seats,” Wall Street Journal ( 22 July 2003):
D1, D3.
11. S. McCartney, “A Middle-seat Manifesto,” Wall Street Journal
(3 December 2004): W1, W14.

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12. L. Hawkins, Jr., “Trucks Get Bigger, Fancier and
Cheaper, Wall Street Journal ( 2 October 2003): D1,
D2; N. E. Boudette, “Volkswagen Stalls on Several Fronts after Luxury Drive,” Wall Street Journal ( 8 May 2003): A1,
A17.
13. C. Terhune and B. McKay, “Behind Coke’s CEO Travails: A
Long Struggle over Strategy,” Wall Street Journal (4 May
2004): A1, A10.
14. J. Drucker, “How to Dump Your Cellphone Company,” Wall
Street Journal (18 November 2003): D1, D4.
15. P. Wright, M. Kroll, and J. A. Parnell, S trategic
Management:Concepts ( Upper Saddle River, NJ:
Prentice Hall, 1998).
16. K. C. Robinson and P. P. McDougall, “Entry Barriers and
New Venture Performance: A Comparision of Universal and
Contingency Approaches,” Strategic Management Journal 22
(2001): 659–685.
17. J. K. Han, N. Kim, and H. Kim, “Entry Barriers: A Dull-,
One-, or Two-Edged Sword for Incumbents? Unraveling the Paradox from a Contingency Perspective,” Journal of
Marketing 65 (2001): 1–14.
18. T. L. Friedman, The World Is Flat (New York: Farrar, Straus and Giroux, 2005).
19. M. Pietz, “The Pro-Competitive Effect of Higher Entry Costs,”
International Journal of Industrial Organization 20 (2002):
353–364.
20. Wright et al., Strategic Management.
21. Corporate author, “In Bow to Retailers’s New Clout, Levi
Strauss Makes Alterations,” Wall Street Journal (17 June
2004): A1, A15.
22. J. McCracken and P. Glader, “New Detroit Woe: Makers of
Parts Won’t Cut Prices,” Wall Street Journal (20 March 2007):
A1, A16.

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23. L. Meckler, “Fill up with Ethanol? One Obstable Is Big Oil,”
Wall Street Journal (2 April 2007): A1, A14.
24. S. F. Slater and E. M. Olson, “A Fresh Look at Industry and
Market Analysis,” Business Horizons (January–February
2002): 15–22; Hawawini et al., “Is Performance Driven by
Industry- or Firm-Specific Factors?”

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25. Y. Li and S. Deng, “A Methodology for Competitive Advantage
Analysis and Strategy Formulation: An Example in a
Transitional Economy,” European Journal of Operational
Research 118 (1999): 259–270.
26. Porter, “Clusters and the New Economics of Competition”;
Slater et al., “A Fresh Look at Industry Analysis.”

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READING

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3-1

Insight from strategy+business
The airline industry has undergone remarkable changes during the past two decades, particularly after the 9/11 terrorist attacks. In this chapter’s strategy+business reading, Hansson and associates challenge the wisdom of the business models employed by traditional airlines. They argue that the structure of the industry has changed and that astute airlines will tailor their approaches to the new reality. Flight for Survival

A New Business Model for the Airline Industry
To pare down their colossal operating costs, giant U.S. and European carriers must restructure the hub-and-spoke system and eliminate complexity.
By Tom Hansson, Jürgen Ringbeck, and Markus Franke

S

ince the 1970s, traditional market leaders in industry after industry, saddled with complex, high-cost business models, have been under attack by companies with new, simpler ways to manage their operations and contain costs.
This scenario occurred in the steel industry when minimills took on traditional smelters; in automobile manufacturing when more standardized Japanese cars won out over customized U.S. vehicles; and in retailing when superstores overtook conventional grocery stores.
In each instance, the established companies struggled, often in vain, to rationalize operations and still deliver products and services to satisfy customer desires, defend their market positions, and reestablish profitability.
The lesson is fundamental: As markets mature, incumbent companies that have developed sophisticated, but complex, business models face tremendous pressure to find less costly approaches that meet broad customer needs with minimal complexity in products and processes. The trouble is, many companies – manufacturers and service providers alike – have increased the scope and variety of their products and services over the years by layering on new offerings to serve ever larger and more diverse customer bases. Although each individual business decision to enhance a product line or service can usually be justified on its own, the result often is a cost structure that is sustainable only if the principal competitors take a similar approach. More often than not,

though, as incumbents expand the breadth and depth of their offerings, leveraging their sophisticated business infrastructure, they are undermined by smaller, nimbler competitors that supply a more focused product, usually to a specific set of customers, at a substantially lower cost. In these situations, the incumbent may know that the cost of complexity is dragging it down, but finds changing its business model easier said than done.
No companies illustrate this dilemma more vividly than the large U.S. and European hub-and-spoke airlines. Their business model – essentially designed to seamlessly take anyone from anywhere to everywhere – was a great innovation. But this model is no longer competitively sustainable in its current form. Tied to massive physical infrastructure, complex fleets of aircraft, legacy information systems, and large labor pools, the major carriers in both regions now face a double whammy: some of the worst economic conditions in the industry’s history, and low-cost carriers that dictate prices in large and growing parts of the market.
U.S. carriers lost more than $10 billion in 2002, according to the Air Transport Association, up from $8 billion in the disastrous year of 2001. Worldwide, losses topped
$50 billion. Bankruptcies litter the industry. Sabena,
Swissair, US Airways, United Air Lines, and Hawaiian
Airlines have all sought protection from their creditors.
Others are likely to follow. The need for a new, less complex business model among hub-and-spoke carriers is growing stronger with each boom and bust cycle.

Source: Reprinted with permission from strategy + business, the award-winning management quarterly published by Booz Allen Hamilton. http://www.strategy-business.com. 26061_03_ch03_p037-060.indd 55

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EXHIBIT

1

A v e r ag e C o s t p e r S ea t M ile ( in 2 0 0 0 )

Source: Booz Allen Hamilton

In this article, we examine the significant downside of business complexity and provide a formula that would allow the airlines to simplify their operations, cut expenses, and compete with their low-cost competitors.
It’s not incremental change, but a fundamental overhaul.

Complexity Costs
While the major carriers face a future of red ink, low-cost carriers such as Southwest Airlines, JetBlue Airways, and Ryanair are prospering by exploiting a huge cost-ofoperations advantage. Low-cost carriers spend seven to eight cents per seat mile to complete a 500- to 600-mile flight, according to our analysis. That’s less than half of what it costs the typical hub-and-spoke carrier to fly a flight of the same duration and distance. (See Exhibit 1.)
It is easy to see how costs mount quickly in the huband-spoke airlines’ intricate system of operations. Their business model is predicated on offering consumers a larger number of destinations, significant flexibility (ranging from last-minute seat reassignments and upgrades to complete itinerary and routing changes), and “frills” (e.g., specialty meals, private lounges, and in-flight entertainment). It is a model burdened by the built-in cost penalties of synchronized hub operations, with long aircraft turnaround times and slack built into schedules to increase connectivity by ensuring there is time for passengers and baggage to make connections.
It’s a system that implicitly accepts a slower business pace to accommodate continual change. In addition, the hub-and-spoke business model relies on highly sophisticated information systems and infrastructure to optimize its complex operations. By contrast, lowcost carriers have designed a focused, simple, highly productive business model around nonstop air travel to

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and from medium- to high-density markets at a significantly lower price point.
We have analyzed the cost gap between large full-service airlines and low-cost carriers (LCCs) on both sides of the Atlantic, and the similarities are striking. On both continents, cost differences exist across the board; pilots, onboard services, sales and reservations, maintenance, aircraft ownership, ground handling. The low-cost carriers are not simply paying lower salaries or using cheaper airports, they are leveraging all resources much more effectively. In fact, the cost differential between the full-service and low-cost carriers is 2 to 1 for the same stage length and aircraft, even after adjustments for differences in pay scales, fuel prices, and seat density are made.
Surprisingly, only about 5 percent of this cost differential can be attributed to the extra amenities the huband-spoke carriers offer. Some 65 percent of the LCCs’ cost advantage is the result of other production-model choices; another 15 percent comes from work rules and labor agreements; and 12 percent can be attributed to differences in balance-sheet structure and financial arrangements. (See Exhibit 2.)
Of the costs attributable to production-model differences, the largest contributing factors are business pace, process complexity, and ticket distribution. In fact, “no frills” and “full service” are misleading labels to describe the distinction between the two types of carriers. It is the relative simplicity or complexity of their operations that truly distinguishes them.
Most debilitating for the major carriers is the inability to overcome their cost burden with boom period pricing, as they did in the second half of the 1990s. As corporations tightened their belts and reduced the frequency of travel, business travelers, who have traditionally accounted for

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EXHIBIT

2

57

B re a k out of the Cost pe r S e a t M ile Ga p Be twe e n FullS e r v ice a n d Low- Cost Ca r r ie r s ( in 2 0 0 0 )

Source: Booz Allen Hamilton

as much as 60 percent of mainline airline revenues – and well over 100 percent of their profits – were no longer willing to pay the high fares they tolerated in the dot-com boom. Weakened by this fundamental change in customer choice as well as “industry leading” labor agreements and rising fuel prices, the U.S. hub-and-spoke airlines’ cost per seat mile (CASM) rose above revenue per seat mile
(RASM) by the third quarter 2000, a full year before the
September 11 terrorist attack slashed air travel further.
This eventually increased to an unprecedented costto-revenue gap of close to 2 cents per seat mile at the beginning of 2002 in the U.S.
That revenue outlook is likely to get worse. By our conservative estimates, low-cost carriers could potentially— and successfully – participate in more than 70 percent of the U.S. domestic market. Southwest Airlines typically prices 50 percent lower than large carriers in one- to two-hour nonstop markets. Even though traditional airlines have attracted a richer business mix than the lowcost carriers, they still stand to lose 25 to 35 percent price realization in those markets.

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Recently, huh-and-spoke airlines have been trying to lower operating costs through new, less onerous labor agreements – American Airlines, United Air Lines, and US
Airways have led the way in eking out pay concessions from their employees; negotiating better deals with intermediaries and financiers; eliminating discretionary costs; and, in some cases, smoothing out hub operations. Major carriers in the U.S. and Europe have also announced that they will add low-cost airline subsidiaries to their business portfolios to compete with the likes of Ryanair and
Southwest Airlines.

A New Path
Many of these restructuring initiatives are clearly valuable and necessary, but they will likely not prove to be enough. Core airline operations need to become competitive with those of low-cost carriers, especially as LCC market penetration grows in the U.S. and makes inroads in Europe. The steps large carriers have taken so far do not address the fundamental productivity differences between themselves and the low-cost airlines. Traditional

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airlines will not achieve a competitive cost structure if they do not tackle the fundamental cost penalties associated with their business models. But they must do so without compromising the services, service quality, and coverage that distinguish them from their new rivals.
Although making such fundamental changes in a longstanding business model is difficult and risky, it is not without precedent. Successful change in other industries— such as manufacturing and financial services—provides important insights into the ways the burden and cost of complexity can be reduced. Not long ago, a major U.S.based manufacturer of a highly engineered product realized that its policy of allowing extensive customization was increasing operating cost without delivering commensurate revenue benefits. Certain elements of this company’s products required customization, but by a natural progression of complexity, customization had become an unintentional—and unnecessary—centerpiece of the manufacturing process. Inventory, scheduling, delivery logistics, and the like were built around the ability to alter specifications quickly. The company’s operational resources directed toward the most complicated features of manufacturing, rather than the simplest. And that was introducing significantly higher costs into its business model.
The manufacturer did an exhaustive study and found, to its surprise, that about 70 percent of the features in its products were never customized. The company introduced engineering controls to these less complicated aspects of the manufacturing process. By taking that step, the manufacturer was able to strategically apply complex systems–such as manufacturing resource planning, inventory, and expediting programs–to only the 30 percent of the design and plant processes that required customization. These segmented operations are called tailored business streams (TBS). Because of this action, which did not hamper service for those customers needing customization, the company is on course to slash 15 percent from its operational expense.
Large carriers must seriously consider three critical elements when restructuring the hub-and-spoke model and eliminating complexity from their business model.


Remove Scheduling Constraints. At present, huband-spoke airlines generally schedule flights in a so-called wave system, which means that departures and arrivals are concentrated in peak periods to maximize effective passenger connections. However, the approach causes long aircraft turnarounds (to allow passengers and baggage to connect to their next flight), traffic congestion, and aircraft

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downtime at the origin cities, resulting in low labor and aircraft utilization. This system, which is structured around the needs of the least profitable connecting passengers, also necessitates more complicated logistics and provides significantly lower yields–up to 45 percent less revenue per mile than for passengers traveling nonstop. Nevertheless, because of current pricing strategies and fleet structures, airlines rely on connecting passengers to fill seats that otherwise would be empty.

By redesigning the airline’s network around the needs of nonstop passengers, and making connections a byproduct of the system as Southwest Airlines does, large carriers should be able to cut turnaround times by as much as half, increase aircraft utilization, reduce congestion, and significantly improve labor productivity.
A large portion of manpower costs is driven by how long an aircraft is at the gate. Shorter turns would mean that pilots, flight attendants, baggage handlers, maintenance staff, and other personnel could be much more productive, and still in compliance with safety regulations.
Moreover, with aircraft ready to take off more quickly, airlines could schedule more flights and provide more attractive timetables for nonstop passengers.
The trade-off between efficient operations and connectivity has to be evaluated carefully, however. Most likely the solution will involve “continuous” or “rolling” hubs, which would allow for more operationally efficient, continuous flight schedules throughout the day. The approach would be particularly suited for “mega-hubs,” where the local “point-to-point” market is sufficiently large to support more frequent flights without relying as much on connecting traffic. Some airlines are already experimenting with rolling hubs. To fully realize the cost reduction opportunities created by this approach, and to justify the scheduling change, airlines will need to fundamentally alter airport operations, through such innovations as compressed turns and simplified baggage handling. •

Implement Tailored Business Streams. In other industries, such as manufacturing, complexity reduction has been achieved by applying a TBS approach.
The basic principle is to segment operations into distinct business streams: Separate processes are created to handle routine and complex activities; capabilities and approaches are tailored to the inherent complexity of the chosen task and based on what customers are willing to pay. That often entails standardizing or
“industrializing” the routine and stable processes, while segmenting and isolating the parts of the operation that are more complicated and variable.

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By and large, the hub-and-spoke airlines have done exactly the opposite. Airlines have sophisticated, universally applicable processes for handling most, if not all, possible situations. It doesn’t matter whether the passenger is on a simple one-hour flight or is traveling from one continent to another. This has added unnecessary costs to processes, and made them hard to automate and change, requiring massive retraining of personnel when a process is altered.
If the airlines embraced TBS, simplified their policies, and streamlined their core processes to address the basic needs of the majority of customers, they could drastically reduce the number of activities performed at airports. Furthermore, they could automate many more of them, saving huge amounts of time and money. In this environment, the reservation and passenger-handling process would be designed so that passengers wouldn’t need last-minute changes or long, multiple interactions with airline staff at the airport.
Instead, travelers would be able to get to the gates faster.
At airports, dedicated processing staff would still deal with the small percentage of travelers who need to change itineraries, connect to a different airline, or request other special services. And customers who require extras (except for perhaps the most frequent flyers) would potentially pay for them in the ticket price or through a transaction fee.
Efficiency improvements would be systemwide, cascading from reservations to front-line staff Overall, the product and experience would be better, and the organization would be much more efficient at delivering it.

approach would enable greater product distinction than there is today. The objective is twofold: Change the business model to serve all customers better by providing a more efficient and less time-consuming experience; and provide dedicated services (and flexibility) to the customer segments prepared to pay for them.
These proposed restructuring elements are highly interdependent. If they’re effectively coordinated, they will increase the pace of airline operations, reduce and isolate complexity, and increase service specialization– all results that are necessary for carriers to fly beyond the industry turbulence they’re experiencing today. We estimate that by adopting these approaches, the major airlines would bring costs more in line with those of lowcost carriers, reducing their unit cost disadvantage for leisure travel by 70 to 80 percent.
It won’t be easy to achieve. Any industry that undertakes such change faces the fear that not only will revenue premiums be lost, but costs will not fall commensurately. It is difficult to reduce fixed-cost structures.
Existing infrastructure may be underutilized with the new business model, and the current aircraft base may not fit the new requirements. Another key challenge for airlines would be the potential drop in revenue in connecting markets. But they could make up this loss by using their lower cost base to stimulate market growth, and by offering viable new services that are not economically feasible at current cost levels.



The Horizon

Create Separate Business Systems for Distinct
Customer Segments. In simplifying their business model, large carriers have to be careful to retain the loyalty of their most profitable and frequent customers by providing more differentiated amenities, lounges, and services on the ground and in the air than they do today.
This could mean separating both airport and onboard services into two (or more) classes, focused on either leisure or business passengers. Other industries’ experiences suggest that mingling complex and simple operations, each of which has distinct objectives and missions, often increases costs and lowers service standards. This must be avoided: The goal is to offer a higher service level where it is needed, at a low operating cost. Besides providing more amenities, this approach would help create purer business streams that reflect the distinct needs of different customer segments.

It will be important for large carriers to retain the key service advantages they have over low-cost carriers, including destination breadth, superior loyalty programs, and select onboard amenities. At a minimum, this

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26061_03_ch03_p037-060.indd 59

To survive, major airlines have no choice but to change course. With a fundamentally lower cost structure, the large airlines would be far better positioned to become profitable, grow, and launch a marketplace offensive against low-cost carriers.
At this point, the outlook for the industry is highly uncertain. If the hub-and-spoke carriers stick to the current business model, and attempt to reduce costs within today’s operational framework, they risk facing continued market share loss to LCCs, a round robin of bankruptcies, and a struggle for survival. The large U.S. airlines’ early 1990s crisis was a cyclical, economy-based downturn.
LCCs were not a major issue then. When the economy and their performance improved, the airlines largely ignored the threat posed by the lower-cost format. That inaction only hid the real emerging problem.
This time the crisis is again cyclical, but it is exacerbated by the presence of low-cost carriers. If the economic picture brightens significantly, it’s possible that the large

1/10/08 11:05:37 AM

60

Chapter 3

airlines will rebound, and that the fundamental business model problems will not be addressed. If that happens, the next cyclical crisis will be so much worse. In the U.S., the low-cost carriers could then dictate pricing in more than 70 percent of the domestic market, as opposed to the current 40 to 45 percent. At that point, a turnaround would be significantly more challenging than it is today.
Alternatively, if a few large carriers adopt the new business model that we suggest, the industry could be led by a couple of thriving carriers in the U.S. and Europe, with one to two random hubs each serving intercontinental and small community markets, a more differentiated service offering, and a number of centers of mass similar to those operated by Southwest Airlines.
The risk of inaction is much greater than the risk of change. The first traditional airline to apply a fundamentally new business model will reshape the industry’s competitive landscape. The first prize that awaits the boldest flyers is significant, not just in terms of cost reduction, but also in considerable growth and future market leadership opportunities.

Resources
Tom Hansson, Jürgen Ringbeck, and Markus Franke. “Flight for Survival: A New Operating Model for Airlines,” s + b enews.
December 6, 2002;

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w w w. s t r a t e g y - b u s i n e s s . c o m / p r e s s / e n e w a r t i c l e / ? a r t =
19050189&pg=0
David Newkirk, Brad Corrodi, and Alison James. “Catching Travels on the Fly,” s + b, Fourth Quarter 2001; www.strategy.-business. com/press/article/?art=24979&pg=0 Susan Carey and Scott McCartney; “United’s Bid to Cut Labor Costs
Could Force Rivals to Follow,” Wall Street Journal, February 25, 2003; http://online.wsj.com/home/us Darin Lee, “An Assessment of Some Recent Criticisms of the U.S.
Airline Industry,” The Review of Network Economics, March 2003; www.rnejournal.com/archives.html Shawn Tully, “Straighten Up and Fly Right,” Fortune, February 17,
2003; www.fortune.com

Tom Hansson (hansson_tom@bah.com) is a vice president in Booz Allen Hamilton’s Los Angeles office. He focuses on strategy and operational restructuring in the airlines and travel arena. Jürgen Ringbeck (ringbeck_jurgen@bah.com) is a vice president in Booz Allen Hamilton’s Düsseldorf office. He focuses on strategy and transformation for companies in global transportation industries, such as airlines, tourism operators, postal and logistics companies, and railways.
Markus Franke (franke_markus@bah.com is a principal in Booz
Allen Hamilton’s Düsseldorf office. He focuses on strategy, network management, sales, and distribution in the airline, transportation, logistics, and rail industries.

1/10/08 11:05:37 AM

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