The trade-off between value creation and value capture - industry profitability
Context - Question from the LSE
Using information from the case study and the Unit 1 enrichment activity, compare the carbonated soft drink industry and the PC industry by populating the following table, which provides a space for your analysis of each of the five forces. First name the industry with the weaker force before you explain your evaluation.
Read the following case study about the PC industry, which will inform your five forces analysis.
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In 2001, there were many players in the PC industry, without industry leaders that could initiate price increases. Personalised computers were basic products with open standards by then, a form of computing equipment that would lose value at a fast pace due to technological obsolescence. Given the absence of brand loyalty to PCs, manufacturers were left to compete on prices, which in turn placed downward pressure on profit margins (Yoffie & Kim, 2010).
Companies bought PCs in large volumes, with IT departments often replacing computers every 3–4 years. These business buyers with their respective IT departments tended to be very knowledgeable, familiar with new technology, and price sensitive with little willingness to pay high sums. The year 2001 was particularly challenging for PC manufacturing, because a struggling economy incentivised cost-cutting measures, and larger companies decided to postpone upgrading their suite of computers (Hamblen, 2002).
Other customers, such as governments and schools were also price-sensitive, not to mention home consumers who viewed PCs as generic commodities and were willing to shop around for the best price (Yoffie & Kim, 2010). Building a PC was simple and straightforward; components were easily accessible on the market and were standardised. Additionally, assembly required no technical skills; anyone could assemble a PC in their garage. It was not uncommon for consumers to assemble “white box” computers that amalgamate different components from different manufacturers, and computer stores would often offer to do the assembly for customers (Dem, 2004).
Access to distribution channels was costless: Large corporations bought PCs directly from manufacturers and customers bought PCs online. White boxes became ever more popular, especially in emerging markets. Alternatives to PCs were abundant, including PDAs (personal digital assistants), TV set-top boxes, and video game consoles. Even PC-only software could be replaced with internet-based videos and games (Yoffie & Kim, 2010).
Due to a price war, prices of these alternative goods were very favourable. Suppliers of basic components, such as disk drives, memory chips, and keyboards, were plentiful and cheap (The Economist, 2001). That said, suppliers of microprocessors and operating systems were only produced and available from two large organisations, Intel and Microsoft – strong brand names that locked in customers (Markoff, 2008).
My thoughts - Answer for the LSE
Rivalry
Industry with a weaker force: Carbonated soft drink (CSD) industry
Rationale: Weaker force - In the drinks industry rivalry is low. Pepsi & Coke hold 70% market share and compete on brand/product differentiation. Decades of investment in brand building meant that they didn’t need to compete directly.
Stronger force - In the PC industry rivalry is high (5 players with 42% share of the global market). The PC industry in 2001 entered a global downturn (5% drop in units), as consumer and corporate customers started choosing not to replace their technology, manufacturers has less customer to fight over. Low product differentiation occurred as it was difficult for customer to decipher between brands/white box as well as what type/manufacturer of component was inside. As Dell initiated a price war, rivals were left with a choice to burn through cash to survive or sell the business.
Threat of entrants
Industry with a weaker force: Carbonated soft drink industry
Rationale: Weaker force - Numerous barriers exist. Coke & Pepsi benefited from established scale. They have well-established and far-reaching distribution channels in retail and fast-food outlets. Regardless of the type of drink an entrant could introduce, they would have significant advertising costs to get cut through to win customers away from Coke & Pepsi who spend $4bn on advertising per year.
Stronger force – if we define the market as ‘the market that sells PCs,’ given these were basic products with little brand loyalty we can define the threat of entry as high. This was proven by different types of white box vendors successfully entering the market at the national (mail/web/phone) and local (franchises and small storefronts) level. Dell introduced unbranded versions of their systems (i.e. ‘re-entering’ the market). Incumbents did not benefit from experience (consumers able to build PCs themselves) and access to distribution was costless.
Threat of close substitutes
Industry with a weaker force: Carbonated soft drink industry
Rationale: Weaker force - Despite the rise of coffee shops and movement toward healthier alternatives, with growth of 3% in CSD in 2000 Coke and Pepsi (70% share) demonstrated resilience to substitutes in the non-alcoholic drink category.
Stronger force - In the PC industry the emergence of white box PCs was a clear substitute to established brands. It gave the customer more choice and flexibility (building PC from ground up). The increased transparency of what components and brands make up the PC meant the customer got the best of both worlds (a PC more performant to their need, possibly at lower price). ICT advances also meant that internet-enabled hardware alternatives were increasingly seen as PC substitutes.
Buyer power
Industry with a weaker force: Carbonated soft drink industry
Rationale: Weaker force - Bargaining power of consumers buyers is weak. Switching costs are not high and customers are not price sensitive (i.e. it is likely a Pepsi loyal consumers would rather pay £1.20 for a Pepsi than £1 for a coke). Corporate customers have bargaining power as they buy in larger quantities. Bottlers locked into exclusive deals have less. Overall moderate bargaining power.
Stronger force - In the PC industry corporate customers replace technology every 3-4 years, are knowledgeable and price sensitive. Governments and schools were price sensitive but would most likely have higher switching costs. In the consumer PC industry poor economic conditions meant less buyers in a market which already had little brand/product differentiation. White box vendors gave consumers enhanced product knowledge which would have helped them to build themselves, negotiate on price and component quality. Therefore, significant power for both groups.
Supplier power
Industry with a weaker force: Carbonated soft drink industry
Rationale: Weaker force - In CSD ingredients such as sugar, caffeine and water are ubiquitous, low cost and there are a large number of suppliers. Coke/Pepsi will be one of the largest customers.
Stronger force – There were a large number of component suppliers however they would change their strategy looking to negotiate bulk deals with consumer electronics manufacturers not suffering from price wars (i.e. PDAs, set-top boxes). This would give them leverage over PC manufacturers. Intel and Microsoft (microprocessors and operating systems) had significant power (no alternative suppliers).
Context - Question from the LSE
Using the findings from the five forces analysis conducted in the table above, state which of the industries you believe is more profitable, and explain your choice.
Answer - Question for the LSE
Average profitability is higher in the CSD market (weaker forces) than in the PC industry (stronger forces). The CSD is more attractive as the value is divided between 2 large rivals rather than 5 main rivals in PC. Consequently, pre-tax profit margins in CSD were 35% as incumbents had brand loyalty so didn’t compete on price. Lack of brand loyalty in PCs meant manufacturers competed on price; a price war initiated by Dell squeezed margins further.
Threat of entry was low in CSD due to the significant capital required for advertising and distribution challenges. In the PC industry market entry was pervasive. With white box-vendors and brand names themselves launching PCs that were unbranded but had branded components. CSD was an impulse lifestyle choice (hard to substitute) whereas the prevalence of cheap processors meant many PC alternatives were available. Buyer power was strong in the PC industry in 2001 as economic conditions combined with perceived lack of performance gains allowed buyers to demand lower prices. In CSD many available suppliers (cheap product) meant power for Coke/Pepsi. There were many PC component suppliers, however they had alternative electronics manufacturers as potential customers and the microprocessor suppliers had power due to scarcity