Business

Friday October 16, 2009

Role of boards in understanding competitive risk

Whose Business Is It Anyway - By John Zinkin


MICHAEL Porter’s “Five Forces” framework serves to remind boards that there is more to understanding the threat posed by competition than looking at market share taken by so-called “head-to-head” competitors, or at their value chain, as I did in my last article.

His key insight is that what really matters is who competes with the company for market margin – the surplus value created from the beginning of the value chain, where raw materials are created, to the end of the value chain where final customers pay for the product they consume.

In a supply chain, there are additional players who determine what the level of market margin in the market as a whole will be, as well as the head-to-head competitors fighting for market share. They are suppliers to the company on the one hand and its customers on the other.

The amount of market margin available to each of them is determined by the relative power each has over the other in negotiations. This is perhaps reasonably obvious to anyone who understands the notion of a supply chain. The margin between the start of the chain and the final customer has to be divided up between its players somehow.

What is less obvious to people who are not industrial economists were his insights into the importance of new entrants and the existence of substitutes and alternatives in capping how much margin a market could realistically keep for itself.

The mere fact that potential entrants exist puts a ceiling on the prices a market can charge for its products and services, providing there are few barriers to entry. The reason is simple.

When a market becomes too profitable, it attracts the envious interest of other players. If there are no barriers to entry, they will enter the market and reduce the margin available to incumbents in two ways:

·by increasing supply for the same amount of demand, thus depressing prices; and

·perhaps more serious, they may have more modern, lower cost processes, allowing them to make a reasonable return while the incumbents with older processes and legacy costs find themselves unable to compete on cost.

What matters, therefore, are the barriers to entry, and even more important, barriers to exit. If there are high barriers to exit, companies cannot get out of unattractive markets and so, they have to fight for every dollar in the bloodbaths described in Mauborgne and Chan’s Blue Ocean Strategy.

As Warren Buffett put it, a well-run company in a lousy industry still makes lousy returns, whereas a badly-run company in a good industry will make good returns.

Alternatives and substitutes also cap the amount of money a market can make. Both have the same short-term effect when prices rise too high. Customers switch from one type of product to another type of product – for example, biodiesel only becomes economic when the price of oil reaches a certain level.

Substitutes are like subs in a football game – they are an inferior product to the original that customers have switched to because they can no longer afford the real thing. Thus if the prices come down again, customers will switch back. So the damage is temporary. That is not the case with alternatives.

The switch to alternatives requires some kind of investment in fixed costs that makes it very difficult for people to switch back again even when the price of the original goods or services drops.

A good example is the demise of the copy typist, replaced by photocopiers. Once companies made the investment in photocopiers, it did not matter how little copy typists were paid, they were obsolete.

The same will no doubt become true of cars that do not use petrol. Once there are enough electric cars or hydrogen-powered cars to justify a ubiquitous hydrogen distribution network or easy access to battery chargers, people may stick with the new technology, come what may, rather than switch back to petrol.

As Ali Naimi once said, when worrying about the future of oil, “The Stone Age did not come to an end because the world ran out of stones”.

So we can see that the concept of market margin and the forces that determine how much market margin a market can command are important insights for any board in thinking about managing competitive risk.

However, there is an unfortunate drawback – this approach is based on zero-sum thinking and leads to adversarial relationships between members of a given supply chain.

Instead of focusing as the Japanese do on maximising the value the entire supply chain can capture, Porter’s approach can lead to debilitating fights over margin between members of a supply chain – working against each other rather than together as valued partners in value creation, losing out to the Japanese as a result.

·The writer is CEO of Securities Industry Development Corp, the training and development arm of the Securities Commission.

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