S.

1 - THE CONCEPT OF STRATEGY

What makes a strategy successful?

● Clear, consistent, long-term goals

● Profound understanding of the competitive environment
● Objective, appraisal of resources
● Effective implementation

The basic strategy framework

The four elements of a successful strategy are recast into two groups (the firm and the
industry) which are linked by the strategy.

- The firm embodies → goals, objective appraisal of resources and effective implementation
- The industry embodies → Profound understanding of the competitive environment

● Business strategy task → determine how the firm will deploy its resources within its
environment and so satisfy its long term goals and how it will organise itself to implement
that strategy.

Strategic fit

Def → refers to the consistency of a firm's strategy, first with the internal and then with the external
environment.

- Decisions and actions are aligned to create consistent strategic direction → michael porter’s
conceptualization of the firm as an activity system (‘Strategy is the creation of a unique
and differentiated position involving a different set of activities’)

- One component of the contingency theory → postulates that there is no single best way
of organising or managing. The best way depends upon the circumstances.

What is strategy?

The conception of firm strategy has changed over time. As the business strategy becomes
more unstable and unpredictable, strategy is less concerned with detailed plans and more
with guidelines for success.

- There has been a transition from strategy-as-plan to strategy-as-direction

Distinguishing strategy from tactics

● Strategy is the overall plan for deploying resources to establish a favourable position
● Tactic is a scheme for a specific manoeuvre

Characteristics of strategic decisions

● important
● Involve a significant commitment of resources
● Not easily reversible

Why do firms need strategy?

Strategy assist the effective management of organisations by:

- Enhancing the quality of decision making

- Facilitating coordination
- Focusing organisations on the pursuit of long-term goals

Strategy as decision support → Strategy is a pattern or theme that gives coherence to the
decisions of an individual or organisation.

Strategy as a coordinating device → The central challenge of management is coordinating the

actions of multiple organisational members. Strategy acts as a communication device to promote
coordination. The strategic planning process provides a forum in which views are exchanged and
consensus developed

Strategy as target → Strategy is forward looking. It establishes direction for the firm’s
development and sets aspirations that can motivate and inspire members of the organisation.

Where do we find strategy?

Types of statement through which companies communicate their strategies.

1. mission statement → describes organisational purposes ‘Why we exist’

2. A statement of principles or values outlines → ‘what we believe in and how we will behave’
3. Vision statement → ‘what we want to be’
4. The strategy statement → articulates the company’s competitive game plan

To identify a firm’s strategy, it is necessary to draw upon multiple sources of information in

order to build a picture of whether a company’s actions match its rhetoric.

Corporate & business strategy

Corporate strategy → defines the scope of the firm in terms of the industries and markets in which it
competes. Corporate strategy decisions include choices over diversification, vertical integration,
acquisitions, and new ventures, and the allocation of resources between the different businesses of the
firm

- Is the responsibility of corporate top management

- Industry attractiveness
- Example: P&G have one strategy but compete in different markets
- ‘Where is the firm competing’

Business strategy → is concerned with how the firm competes within a particular industry or market.
It also refers to the competitive strategy.

- Responsibility of the senior managers of divisions and subsidiaries.

- ‘How the firm is competing’

Sources of superior profitability

Rate of profit above the cost of capital (how do we make money?)

● Industry attractiveness --> which business should we be in?

● Corporate strategy -> integrate different activities (industry attractiveness) -

business i am going to compete

● Competitive advantage --> how should we compete?

● Business strategy -> situation where I am concerned with the way i want to
compete (competitive advantage) - how should we compete?

Describing strategy

How is strategy made?

Henry Mintzberg distinguishes between different types of strategies:

- Intended strategy → is strategy as conceived by the leader or top management of the team.
An outcome of inspiration, negotiation, bargaining, and compromise among those involved in
the strategy making process.

- Realised strategy → ‘the actual strategy that is implemented’, is only partly related to that
which was intended.

- Emergent strategy → the decisions that emerge from complex process in which individual
managers interpret the intended strategy and adapt it to changing circumstances

In practice, strategy making involves both thought and action. Top-down rational design
combines with decentralised adaptation.

- The design aspect of strategy comprises organisational processes through which

strategy is deliberated, discussed and decided. (board meetings, planning process…)

- The enactment of strategy through decisions and actions being taken throughout the
organisation is a decentralised process where middle managers play a central role.

I refer to this process of strategy-making that combines design and emergence as ‘planned
emergence’ . The balance between the two depends greatly upon the stability and
predictability of the organisation's business environment.

Applying strategy analysis

The purpose of strategy analysis is not to provide answers but to help probe the relevant
issue.

Developing a strategy for a business typically involves four main stages:

1. Setting the strategic agenda → identify the important issues that the strategy must
address

- Identify the current strategy → what the strategy is

- Appraisal performance → how well is performing the strategy

2. Analysing the situation

- Diagnose performance → sources of unsatisfactory performance or if its good

performance, what are the factors driving this.

- Analyse the industry → how the strategy will perform in the future

- Analyse resources and capabilities of the firm

 3. Formulating strategy → the steps above help provide a basis for generating strategic
options

4. Implementing strategy → requires allocating resources and motivating people.

Strategic management of not-profit organisations

Strategy is as important in non-for-profit organisations as it is in business firms.

The benefits attributed to strategic management in terms of improved decision-making,

achieving coordination, and setting performance targets may be even more important in the
nonprofit sector.

The basic distinction here is between those not-for-profit organisations that operate in
competitive environments and those that do not.

Among the tools of strategy analysis that are applicable to all types of not-for-profit
organisations, those that relate to the role of strategy in specifying organisational goals and
linking goals to resource allocation.

- For business, profit is a key goal

- For not-for-profit, goals are typically more complex

The role of analysis in strategy making:

● Strategy analysis improves decision processes, but doesn’t give answers

● Strategy analysis assists us to identify and understand the main issues
● Strategy analysis helps us to manage complexity
● Strategy analysis can enhance flexibility and innovation by supporting learning

S.2 - VALUE CREATION, GOALS & PERFORMANCE

Value creation

Organisational purposes → create value

Value → is the monetary worth of a product or asset. It can be created in two ways:

- By production → creates value by physically transforming products that are less valuable
into products that are more valuable.

- By commerce → creates value by repositioning them in space and time.

The difference between profit and value creation

How do we measure the value created by a firm?

- Value creation = total customer value - real costs of production.

Value is different from profit → value created usually exceeds profit

- The value received by customers is typically greater than the amount they pay. It is
measured by their willingness to pay, not what they actually pay

- The difference is called consumer surplus (willingness to pay above price)

● similarly , the real cost of production is usually less than the firm’s accounting costs

Stakeholders v. shareholders

- Customers receive consumer surplus

- Owners receive profits
- Employees receive ‘rents’ (remuneration in excess)

Whose interests should the firm consider when considering which component of value to pursue? →
there are two answers:

- Stakeholder value maximisation → the firm should operate in the interests of all its
constituents groups which implies that the goal of the firm should be to maximise total value
creation
Encounters two difficulties:

- Measuring performance
- Corporate governance

- Shareholder value maximisation → is based upon two principles:

- The firm should operate in the interests of their owners

 - The effectiveness of the market economy is dependent upon firms responding
to profit incentives

Profit, cash flow and enterprise value

Profit → is the surplus of revenues over costs available for distribution to the owners of the firm.

Types of profit:

- Accounting profit → is measured at different levels

- gross profit → is sales revenue less the cost of bought-in materials and components
- Operating profit (operating income) → is the gross profit less operating expenses,
before deduction of interest and taxes
- Net profit (net income) → is profit the deduction of all expenses and charges

- Economic profit → is pure profit. Is the surplus available after all inputs have been paid
for.

- economic profit = operating profit - (WACC x Capital employed)

- WACC = weighted average cost of capital

Advantages over accounting profit:

- More realistic performance indicator

- Improves the allocation of capital between the different businesses of the firm
by taking account of the real costs of more capital-intensive businesses.

- Cash flow → measures a firm’s cash transactions

- Operating cash flow → cash generated by the firm's operations
- Free cash flow → operating cash flow - capital investment

Linking profit to enterprise value

Profit maximisation translates into maximising the value of the firm. The value of the firm is
calculated in the same way as any other asset → Net present value (NPV) of the returns that the asset
generates

- Firms are valued using the same discounted cash flow (DFC) methodology that we
apply to the valuation of investment projects
- The value of an enterprise (V) is the sum of its free cash flows (c) in each year t,
discounted at the enterprise's cost of capital

In practice, valuing companies by discounting economic profit gives the same result as by
discounting net cash flows. The difference is in the treatment of the capital consumed by the
business.
 - Cash flow approach → deducts capital at the time the capital expenditure is maded
- Economic profit approach → follows the accounting convention of charging capital as it is
consumed (depreciation)

Enterprise value and shareholder value

Enterprise values = market capitalization of equity + market value of debt

Why has shareholder maximisation attracted so much criticism?

- Because stock market cannot see the future with much clarity; hence its valuations of
companies are strongly influenced by short-term and psychological factors

- The danger is that top management focuses upon boosting their firm’s stock
market value rather than increasing profits over the lifetime of the firm.

Putting performance analysis into practice

There are four key areas where our analysis of profit performance can guide strategy:

1. Appraising current and past performance → asses the current situation. Identify how
well the strategy is doing in terms of performance

- forward-looking performance measures: Stock market value → if our goal

is to maximise profit over the lifetime of the firm, then to evaluate the performance of
a firm we need to look at its stream of profit over the rest of its life. → problem is that
we can only estimate a few years ahead

- Backward-looking performance measures: Accounting ratios (return on

equity, return on assets, return on capital employed…)

2. Performance diagnosis → if profit performance is unsatisfactory, we need to identify the

sources of poor performance so that management can take corrective action. The main tool of
diagnosis is a disaggregation of return on assets in order to identify fundamental value drivers

3. Selecting among alternative strategies → when we have the basis for corrective
action, these corrective actions are likely to be both strategic (with a medium, long-term
focus) and operational (focused on the short-term)

- Companies with bad performance → better to focus on the short-term, survival is the
dominant concern
- Companies with good performance → financial analysis allows us to understand the
sources of superior performance so that strategy can protect and enhance these.

● However the world of business is one constant change and the ripple of
strategy is to help the firm to adapt to change
 4. Setting performance targets → an important role for strategic planning systems is to
translate strategic goals into performance targets and then monitor the performance achieved
against these targets

- Performance targets need to be consistent with long-term goals, linked to

strategy, and relevant to the tasks and responsibilities of individual
organisational members

- 3 main approaches to setting performance targets:

- Financial disaggregation
- Balanced scorecards → this methodology provides an integrated
framework for balancing financial and strategic goals and cascading
performance measures down the organisation to individual business units and
departments

The performance measures derive from the answers to four questions:

- How do we look to shareholders?

- How do customers see us?
- What must we excel at?
- Can we continue to improve and develop?

By balancing strategic and financial goals, the scorecard methodology

provides actionable targets that link the strategy of the business to the
creation of both value for shareholders and other stakeholders.

- Strategic profit drivers → financial value drivers and balanced

scorecards are systematic techniques of performance management
based upon the notion that, if overall goals can be disaggregated into
precise, quantitative, time-specific targets, each member of the
organisation knows what is expected of them can be incentivized
toward achieving the targets set.

- In relation to profit maximisation, setting profit targets may

induce behaviour that undermines that goal’s attainment. Thus,
many of the firms that are most successful at creating
shareholder value are those that emphasise purpose over
profit.

Beyond profit: Values and corporate social responsibility

There is the role of the government to intervene in the company where the pursuit of profit
conflicts with the interest of society, using taxes and regulations to align profit incentives with
social goals and legislation to criminalise unethical behaviour.
Values and principles → a sense of purpose is often complemented by beliefs typically
comprising a set of values and a set of principles to guide decisions and actions of organisational
members.

- Statements of values and principles may be regarded as instruments of companies’

external image management. Yet, to the extent that companies are consistent and
sincere in their adherence to values and principles, they can form a critical
component of organisational identity and an important influence on employees’
commitment and behaviour.

Corporate social responsibility → the efficacy argument for CSR emphasises the evolutionary
fitness of the firm. The firm is embedded within natural and social ecosystems to which it must adapt
and sustain.

3 reasons why CSR might also be interest of a company:

1. Sustainability argument
2. Reputation argument
3. Licence-to-operate argument

At the intersection between corporate and social interests is what Porter and Kramer refer to
as shared value → creating economic value in a way that also creates value for society

Creating shared value involves reconceptualizing the firm’s boundaries and its relationships
from a transactional to a co-dependency viewpoint.
3 types of opportunity for shared value creation:

- Reconceiving products and markets

- Redefining productivity within the value chain
- Building local clusters of suppliers, distributors, and related bus at the place where
the firm does business.

Beyond profit: Strategy and real options

The resulting field of real option analysis has emerged as vitally important both for
investment decisions and for strategy formulation.
In a world of uncertainty, where investments, once made, are irreversible, flexibility is
valuable. Instead of committing to an entire project, there is virtue in breaking the project into
a number of phases, where the decision of whatever and how to embark on the next phase
can be made in the light of prevailing circumstances and the learning gained from the
previous stage of the project.

Strategy as Options management

For strategy formulation, our primary interest is how we can use the principles of option
valuation to create enterprise value. There are two types of real option:
 - Growth options → allow a firm to make small initial investments in a number of future
business opportunities but without committing to them.

- Flexibility options → relate to the design of project and plant that permit adaptation to
different circumstances.

When building strategy our primary concern is with growth options, these might include:

- Platform investments → investments in core products or technologies that crate a stream

of additional business opportunities.

- Strategic alliances and joint ventures → are limited investments that provide a
development stage for creating a new business or a new strategy

- Organisational capabilities → can also be viewed as options that offer the potential to
create competitive advantage across multiple products and businesses.

BESANKO

Competitive advantage and value creation: Conceptual foundations

A firm’s profitability depends jointly on the economics of its market and its success in
creating more value than its competitors. The amount of the value the firm creates compared
to its competitors depends on its cost and benefits position relative to competitors.

Competitive advantage → when a firm earns a higher rate of economic profit than the average rate of
economic profit of other firms competing within the same market.

- Firms achieve a competitive advantage by creating and delivering more economic

value than their rivals and capture a portion of this value in the form of profits.

Maximum willingness to pay and consumer surplus

A consumer’s willingness to pay for a good is intangible, as it depends on that consumer’s

taste.

● Consumer surplus needs to be positive for the purchase to occur. (B-P >0)
● If there is a choice between two or more products consumers will choose the one
with the largest consumer surplus.
● Thus, the first step for firms to compete successfully is to deliver consumer surplus.

Consumer surplus parity → when firms are offering a consumer the same amount of consumer
surplus
Value created

Economic value is created when a producer combines inputs such as raw materials, labor,
and purchased components to make a product whose perceived benefit exceeds the cost
incurred in making the product.

Value created must be divided between consumers and producers

- Value created = Consumer surplus + Producer surplus

- The difference between maximum willingness to pay and cost is the value created

Value creating and win-win business opportunities

No product can be viable without creating positive economic value. If B (benefit perceived) -
C (cost) was negative, there would be no price that consumers would be willing to pay for
the product.

Win-win trade (gains from trade) → deals that leave all parties better off than they would be if they
did not deal with each other.

Value creation and competitive advantage

Although a positive B-C is necessary for a product to be economically viable, just because a
firm sells a product whose B-C is positive is no guarantee that it will make a positive profit.

- In order for a firm to earn positive profit in a competitive industry, it must create more
economic value than its rivals
The most aggressive consumer surplus ‘bid’ that either seller would be prepared to offer is the one at
which its profit equals 0 → Price = costs
The

Value added analysis as WTP of producer

A firm’s WTP is related to the impact of an input on a firm's profitability.

● One way to measure it is through Value-added analysis

● Value added --> The difference between the value of the firm’s output and the cost
of its material inputs (this is later defined also as producer surplus)

Value creation as organizational purpose

Organisations exist for a purpose

● Organisational purposes vary considerably and are beyond making money

● Common denominator: The desire and need to create value

Value creation and distribution

Two ways of value creation:

1. Production → physical transformation of products

2. Commerce → reposition products in space and time

How is the value added distributed? → Stakeholders:

● Employees (salary and wages)

● Lenders (interest)
● Landlords (rent)
● Government (taxes)
● Owners (profit)
● Customers (consumer surplus)
From value creation to competitive advantage

● B- C > 0 product is economic viable However, B-C > 0 does not imply Profit >0

● In order that Profit > 0 of Firm 1 in a competitive industry

○ (B-C) of Firm 1 > (B-C) of Firm 2

● B-C large enough that competitors cannot generate it and duplicate it

● The firm with the highest competitive advantage in the competition is the one with
highest B-C

How can we measure a firm's ability to create / capture value?

Which are the metrics to check how a firm can create/capture value?

● The main sources of data are corporate balance sheets and data coming from stock
exchanges (market value)
● A good way to organise the analysis is dividing measures into

1. Backward-looking performance measures --> based on balance sheets

2. Forward-looking performance measures --> based on the stock market values

Backward-looking ratios:

The main source of data in this respect are corporate balance sheets. Classical measures
are:

● ROI = EBIT/ (FA + (CA – CL))

● ROA = EBIT / TA
● ROE = NET INCOME / EQUITY

In each measure, the numerator is a measure of the firm’s ability to generate profits from its
operations
● ROE accounts for the capital invested by the shareholders,
● ROA includes all the assets
● ROI denotes Fixed Asset and Positive/Neg Working Capital

● All measures lead to consistent results, they can vary for the weight of equity or debt
and much more across sectors

ROS, Value capture and value creation

ROS=(EBIT/SALES). It measures how many profits the company is able to generate given
its sales.
 ● It is a good proxy of efficiency of operations, because you can note that you have a
sales component both in the numerator and in the denominator, but in the numerator
you also have the cost of a good sold component.
● This is why it could be read as a good measure of value capture.

CT=(SALES/(FA + WC)). It is the Capital Turnover, which represents how many sales a
company it is able to generate given the capital invested.

● This measure tends to vary greatly with industry characteristics because industries
that require more capital tend to have a higher denominator.
● Usually industries with CT lower than 3, meaning that sales are less than three times
the capital invested, tend to be dominated by large firms. Values higher than 3, we
could start talking about a fragmented scenario.
● This is why it is a good proxy of value creation, meaning how many sales and volume
you are able to generate given your capital. But no cost proxy is inside this measure.

Forward-looking (long-term) measures

 S.3 & 4 - INDUSTRY ANALYSIS

From environmental analysis to industry analysis

The business environment of the firm consists of all the external influences that impact its
decisions and its performance

The prerequisite for effective environmental analysis is to distinguish the vital from the
merely important. Hence, we need to establish what features of a firm’s external
environment are critical to its decisions.

- The core of the firm’s business environment is formed by its relationships with three
sets of players; customers, suppliers and competitors.
- Macro Level factors also affect the firm.

The profits earned by the firms in an industry are determined by three factors:

- The value of the product to customers

- The intensity of competition
- The bargaining power of industry members relative to their suppliers and buyers

Analysing industry attractiveness

The underlying theory of how industry structure drives competitive behaviour and determines
industry profitability is provided by industrial organisation economics. The two reference
points are the theory of monopoly and the theory of perfect competition.

- Monopoly → protected by high barriers to entry

- Perfect competition → many firms supply a homogeneous product and there are no entry
barriers.

While a monopolist can appropriate as profit the full amount of the value it creates, under
perfect competition, the rate of profit falls to a level that just covers firms’ cost of capital.

Porter’s five forces of competition framework:

The strength of each of these competitive forces is determined by a number of key structural
variables.

Competition from substitutes → the prices that customers are willing to pay for a product
depends, in part, on the availability of substitutes products

Threat of entry → If entry is unrestricted, profitability will fall toward its competitive level. An
industry where no barriers to entry exist is a contestable.
The principle sources of barriers to entry are as follows:

- Capital requirements
- Economies of scale
 - Absolute cost advantage → often result from the ownership of low-cost sources of raw
materials
- Product differentiation
- Access to channels of distribution
- Governmental and legal barriers → some of the most effective barriers
- Retaliation → such retaliation may take the form of aggressive price-cutting, increased
advertising, sales promotion or litigation.
- The effectiveness of barriers to entry → depends on the resources and capabilities that
potential entrants possess.

Rivalry between established competitors

In most industries, the major determinant of competition and profitability is rivalry among the
firms within the industry.

The intensity of price competition of price competition between established firms is the result
of five main factors:

- Concentration → seller concentration → refers to the number and size distribution of

firms competing within a market. It is measured by the concentration ratio → the combined
market share of the leading producers.

- Diversity of competitors → the ability of rival firms to avoid price competition by

coordinating their prices depends on how similar they are in their origins, objectives,
costs, and strategies.

- Product differentiation → the more similar the offerings among rival firms, the more
willing are customers to switch between them and the greater is the inducement for firms to
cut prices to boost sales.

- Excess capacity and exit barriers → the key is the balance between demand and
capacity.

- Unused capacity → encourages firms to offer price cuts to attract new business.
- Excess capacity → may be cyclical

Barriers to exit are impediments to capacity leaving an industry. Where assets are
durable and specialised, and where employees are entitled to job protection, barriers
to exit may be substantial.

- Cost conditions: Scale economies and the ratio of fixed to variable costs → the
key factor is cost structure. Where fixed costs are high relative to variable costs, firms will
take on marginal business at any price that covers variable costs

Bargaining power of buyers

The profit margin earned by the firms in an industry depends on the prices they can charge
their customers.

- Buyer’s price sensitivity → the extent to which buyers are sensitive to the prices they are
charged depends primarily upon the proportion of buyers' total cost that the product accounts
for

- Relative bargaining power → bargaining power rests, ultimately, on the refusal to deal
with the other party. The balance of power between the two parties to a transaction depends
on the credibility and effectiveness with which each makes this threat.

bargaining power of suppliers

The relevant factors are the ease with which the firms in the industry can switch between
different input suppliers and the relative bargaining power of each party.

- The suppliers of commodities tend to lack bargaining power relative to their

customers; hence, they may use cartels to boost their influence over prices

- The suppliers of complex, technically sophisticated components may be able to exert

considerable bargaining power.

Applying industry analysis to forecasting industry profitability

Identifying industry structure → it requires identifying who are the main players - the producers,
the buyers, the suppliers of inputs, and the producers of substitute goods - then distinguishing the key
structural characteristics of each that will impact competition and bargaining power.

Forecasting industry profitability → investment decisions made today will commit resources
to an industry for years, hence, it is critical that we are able to predict what level of returns
the industry is likely to offer in the future.

- Current profitability is a poor indicator of future profitability. However, if an industry’s

profitability is determined by the structure of that industry, then we can use
observations of the structural trends in an industry to forecast likely changes in
competition and profitability.

To predict the future profitability of an industry, our analysis proceeds in three stages:

1. Examine how the industry’s current and recent levels of competition and profitability
are a consequence of its present structure

2. Identify the trends that are changing the industry’s structure.

3. identify how these structural changes will affect the five forces of competition and
resulting profitability of the industry.
Using industry analysis to develop strategy

Once we understand how industry structure influences competition, which in turn determines
industry profitability, we can use this knowledge to develop firm strategies.

Strategies to alter industry structure → Understanding how the structure of an industry

determines competition and the level of profitability, we can identify how to change the industry
structure in order to alleviate competitive pressures.

- The fact that industries are in a state of continual evolutions means that all firms, not
just the market leaders, have the potential to influence changes in industry structure
to suit their own interests.

Positioning the company → Recognizing and understanding the competitive forces that a firm
faces within its industry allows managers to position the firm where competitive forces are weakest

- Effective positioning requires the firm to anticipate changes in the competitive forces
likely to affect the industry

Defining industries: Where to draw the boundaries

A key challenge in industry analysis is defining the relevant industry

Industries and markets:

Economists define industry as a group of firms that supplies a market → so is there any difference
between analysing industry structure and analysing market structure? → one major difference is that
industry analysis views industry profitability as determined by competition in two markets:

- Product markets
- Input markets

In everyday usage the term industry tends to refer to firms within a broad sector, whereas a
market refers to the buyers and sellers of a specific product.

Substitution in demand and supply:

The basic issue in defining a firm’s industry is to establish who is competing with whom. To
do this, we need to draw upon the principle of substitutability, both on the demand side and
on the supply side.

In practice, drawing the boundaries of markets and industries is a matter of judgement that
depends on the purposes and context of the analysis
- Decisions regarding pricing and market positioning → require microlevel’ approach
- Decisions over investments → require a wider view of the relevant market

From industry attractiveness to competitive advantage: Identifying key success factors

Key success factors → those factors within an industry that influence the firm’s ability to outperform
rivals

To survive and prosper in an industry, a firm must meet two criteria.

- It must attract customers → who are they and what do they want
- It must survive competition → requires that we examine the nature of competition in the
industry

Key success factors can also be identified through the direct modelling of profitability,
thereby identifying the drivers of a firm’s profitability relative to rivals

Does industry matter?

A firm’s industry environment is a relatively minor determinant of its profitability. → this does not
imply that we do not have to care about it → Industry analysis is important because, without a deep
understanding of their competitive environment, firms cannot make sound strategic decisions

- Industry analysis is not just about choosing which industries to locate within, it is also
important for identifying competitive threats, attractive segments, and the sources of
competitive advantage

Hypercompetition:

The porter’s five forces framework is based upon the assumption that industry structure determines
competitive behaviour, which in turn determines industry profitability but → Competition unleashes
the forces of innovation and entrepreneurship that transform industry structures

The stability of industry structure is being eroded by the disruptive impact of digital
technologies

- Hypercompetition → intense and rapid competitive moves, in which competitors must move
quickly to build new advantages and erode the advantages of their rivals

Winner-take-all industries:

In some industries, the disparities in profitability between firms are so great as to render
irrelevant the whole notion of industry attractiveness.

- Market share confers massive competitive advantage → typically this advantage is the result
of positive feedback, the most important of which are network externalities
- In online auctions and social media, users gravitate to the firm that has the
greatest market presence
- More generally, a firm with market share leadership attracts resources away
from competitors
 THE US AIRLINE INDUSTRY IN 2015

Airline profitability was benefiting from the fall in oil prices and the revival of the US
economy.

- The major carriers focused on reducing the cost gap between themselves and the
low cost carriers by better use of IT, winning substantial concession on pay, gained
benefits from outsourcing…

The consolidation in the industry as a result of mergers and acquisitions had created the
conditions for a more restrained price competition.

The US airline industry had been plagued by intense competition and dismal profitability
since it was deregulated in 1978

The financial woes of the airline industry were not restricted to the US: the global airline industry had
consistently failed to earn returns that covered its cost of capital.

- Of the hundreds of airlines surveyed by IATA over the period 2000–2009, only 15 earned a
return on capital that exceeded their cost of capital. Among these were Ryanair, Emirates,
Singapore Airlines, and Southwest Airlines.1

The US air- lines’ response the revival in their profits and share prices had been to add capacity at a
rate that far outstripped demand growth.

From regulation to competition

The history of the US airline industry comprises 2 eras:

1. The period of regulation up until 1978

2. The period of deregulation thereafter

During the 1970s, the impetus for deregulation was supported by new developments in economics
which undermined the conventional view that scale economies and network effects caused the
industry to be a natural monopoly.

The theory of contestable markets proposed that an industry did not need to be competitively
structured in order to result in competitive outcomes

- So long as barriers to entry and exit were low then the potential for hit-and-run entry would
cause established firms to charge competitive prices and earn competitive rates of return.
- The outcome was the Airline deregulation act, which in October 1978, abolished the CAB
(Civil aeronautics board) and inaugurated a new era of competition in the airline industry.

The height of barriers to entry in the airline industry is unclear → While capital costs of setting up an airline can
be modest, establishing a scheduled airline service requires setting up a complex system.

Since deregulation, the industry has been subject to turbulence caused by external shocks and
internal competition
 - Profitability is acutely sensitive to the balance between demand and capacity: losses result
from industry load factors falling below the breakeven level

Firm strategy and industry evolution

Changes in the structure of the airline industry during the past three decades were primarily a result of
the strategies of the airlines as they sought to adjust to the con- ditions of competition in the industry
and to gain competitive advantage.

Route strategies: The hub-and-spoke system

During the l980s, the major airlines reorganised their route networks. Systems of point-to-point routes
were replaced by hub-and-spoke systems where each airline concentrated its routes on a few major
airports

- It allowed greater efficiency

- It allowed major carriers to establish dominance in regional markets and on particular routes.

Mergers

The effect of continued new entry in reducing seller concentration in the industry has been offset by
mergers and acquisitions between existing players

- As a result of a more permissive attitude from the department of justice, the pace of
consolidation in the industry accelerated with several mergers among leading airlines

Yet, despite consolidation, there is limited evidence that competition has been significantly affected.

- As a result of capacity reduction by the biggest airlines and market share gains by smaller carriers →
concentration has continued to decline since 2000.
- In recent years, the average number of competitors has not substantially changed, despite
the several major airline mergers

Pricing

The intensification of competition that followed deregulation was typically led either by established
airlines becoming financially distressed or by LCCs
Price cutting by the major carriers tends to be highly selective, with airlines seeking to separate price-
sensitive leisure customers from price-inelastic business travellers.

the ability of the major airlines to compete against the budget airlines was limited by the majors’ cost
structures

- To meet the competition of low-cost newcomers, several of the majors set up new
subsidiaries to replicate the strategies and cost structures of the budget airlines.
- In many instances, radical cost cutting was preceded by major airlines entering into
bankruptcy.

The quest for differentiation

Under price regulation, competition among airlines focused upon branding, customer service, and in-flight food
and entertainment. Deregulation brutally exposed the myth of customer loyalty → customers' choice of airline
became primarily dependent upon price.

- Efforts at differentiation became primarily focused upon business and first-class travellers

The most widespread and successful initiative to build customer loyalty was the introduction of
frequent-flyer schemes

- Offering free tickets and upgrades on the basis of miles flown.

The industry in 2015

Market for air travel → airlines were the dominant mode of long-distance travel in the US.

Most forecasts pointed to continued growth in the demand for air travel, but a much lower rate than in
earlier decades.

- Changes were occurring within the structure of demand

- Changes in the distribution of airline tickets contributed to increased price competition.

Cost conditions → a key feature of the industry’s cost structure was the high proportion of fixed costs. In the
short term, most costs varied little with fluctuations in demand.

- Labour costs were boosted by high levels of employee remuneration.

- Fuel expenditure depended on the age of an airline’s fleet, average flight length and oil prices.
- Equipment -> aircraft were the biggest capital expenditure item for the airlines. The airlines’
weak finances and high borrowing costs meant a preference for leasing rather than
purchasing planes
- Airport facilities play a critical role → they are hugely complex, expensive facilities and few in number
- Cost differences between airlines → in practice they reflect managerial, institutional and historical
factors rather than the influence of economies of scale, scope or density

Looking to the future

At the end of April 2015, the US airline industry presented a mixed picture. Despite the sustained
upturn in profitability, the balance sheets of most airlines remained weak

the critical issue was whether the recent improvement in industry profitability was
 - a cyclical phenomenon driven by weak oil prices, an improv- ing domestic economy, and the
impact of higher load factors in moderating price competition
- or whether it was supported by a more fundamental shift in industry structure and competitive
behaviour

Previous revivals in airline industry profitability ended either as a result of exter- nal events or by the
industry’s own propensity to overinvest.