A few days ago I reviewed a classic business strategy book "Competitive Strategy" by Michael Porter and I promised to explain industry analysis or market analysis so this is the first of what will be a series of postings on industry analysis.
Today I am going to look at what is industry analysis and why it is important.
In subsequent articles we'll take a detailed look at Michael Porter's Five Forces model which is the most famous method for analysing industries and markets before wrapping it all up with a guide on how to prepare an industry analysis.
What Is Industry Analysis?
Industry analysis is a structured process for reviewing the profitability of your industry at the moment and in the future to help you position your business in the most advantageous way.
Industry analysis explains why one industry is very profitable and all the competitors make good money while another industry has much lower profit and many businesses operate on a marginal basis.
I will use industry analysis and market analysis as the same basic concept so that there is some variety in the words I use. Strictly speaking, industry analysis looks from the supply side while market analysis looks from the demand side.
So you have the airline industry and the market for air travel.
Why is Industry Analysis Important?
There are only three alternatives:
- You are thinking about starting a business in a particular industry, so industry analysis asks "Is this a sensible market for us to enter? Is this market a source of superior profits?"
- You already have a business in an industry and you are committed to it so industry analysis asks "How can we make sure that we perform better than our competitors?"
- You have a business but you are considering selling it, either because it is struggling or because it is very successful and you will be paid a great price. In the disposal situation, industry analysis asks "How are the future prospects of the industry likely to be affected and how does that affect my decision to sell.?"
So industry analysis helps you to move from having a "gut feel" about the prospects for the market to having scenarios that you can explain to others and seek their feedback.
It is for the big strategic questions and not for the smaller tactical decisions that many businesses spend their time focusing on.
There Are Only Two Reasons For Superior Profits
Unfortunately there are only two sources of superior profit
Either :
a) you have a business which is in an attractive industry or
b) you have a competitive advantage which means that you can capture the majority of profits made in your immediate market. Some industries are very fragmented and localised so one shop for example may be in a city where there is no competition while an identical shop in a city 100 miles away, may have two hot competitors which severely ration profits available.
The Strange World Of Perfect Competition
Economists have a concept called perfect competition but as a business person it won't sound very perfect to you.
Perfect competition is a world where there is an equilibrium and all the firms operating in the market produce profits which exactly match their cost of capital (the return you have to pay on your bank loans and the return you should demand on the money you have invested in your business.)
Perfect competition is a world where there are many competitors who are free to move into the industry if companies start to make more than the cost of capital and to move out of if returns fall below the cost of capital.
Perfect competition is a world where there is no product differentiation. Everyone knows how to make the product or service to the same standard and in the same time periods.
In perfect competition there are many buyers and they are all of similar sizes and they all have perfect information of their buying options. Information is free and there aren't any transactions costs which make it easier or cheaper to deal with one supplier than another.
But this is the important point - it is when these assumptions are broken that create the opportunity for sustained profit or loss within an industry:
- When there are few buyers
- When there are few suppliers
- When products and services are different
- When new competitors find it difficult to enter an industry
- When existing competitors find it difficult to leave
- When information isn't freely available to customers about the best prices and deals
- When information isn't available to competitors about the best methods to market, sell and supply their products
- When there are transactions costs which create a connection between particular buyers and sellers and a disincentive to trade with others.
All these create an opportunity for profit but they can all change over time.
These are the factors that you will look at during your Industry analysis and the most famous approach is the Five Forces model of Michael Porter.
Paul Simister is a business coach who helps small business owners to profit from differentiation, be distinctive in the eyes of their customers and stand out in a crowded marketplace.
You too can move past your profit tipping point by answering the 7 big questions of business success.
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