Chapter 2 Chapter 2
Strategy Analysis
Discussion Questions
1. Judith, an accounting major, states, “Strategy analysis seems to be an unnecessary detour in doing
financial statement analysis. Why can’t we just get straight to the accounting issues?” Explain to Judith
why she might be wrong.
Strategy analysis enables the analyst to understand the underlying economics of the firm and the
industry in which the firm competes. There are a number of benefits to developing this knowledge
before performing any financial statement analysis.
1. Strategy understanding provides a context for evaluating a firm’s choice of accounting policies
and hence the information reflected in its financial statements. For example, accounting policies
2. What are the critical drivers of industry profitability?
Rivalry Among Existing Firms. The greater the degree of competition among firms in an industry,
the lower average profitability is likely to be. The factors that influence existing firm rivalry are
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Threat of New Entrants. The threat of new entry can force firms to set prices to keep industry
Threat of Substitute Products. The threat of substitute products can force firms to set lower
Bargaining Power of Buyers. The greater the bargaining power of buyers, the lower the industry’s
Bargaining Power of Suppliers. The greater the bargaining power of suppliers, the lower the
3. One of the fastest growing industries in the last twenty years is the memory chip industry, which
supplies memory chips for personal computers and other electronic devices. Yet the average profitability
for this industry has been very low. Using the industry analysis framework, list all the potential factors
that might explain this apparent contradiction.
Concentration and Balance of Competitors. The concentration of the memory chip market is
Degree of Differentiation and Switching Costs. In general, memory chips are a commodity
product characterized by little product differentiation. While some product differentiation occurs as
Scale/Learning Economies and the Ratio of Fixed to Variable Costs. Scale and learning
economies are both important to the memory chip market. Memory chip production requires
significant investment in “clean” production environments. Consequently, it is less expensive to
low, providing an incentive for manufacturers to reduce prices to fully utilize their plant’s capacity.
Chapter 2 Strategy Analysis 3
Excess Capacity. Historically, memory chip plants tend to be built in waves, so that several plants
Threat of Substitute Products. There are several alternatives to memory chips including other
Price Sensitivity. There are two main groups of buyers: computer manufacturers and computer
4. Rate the pharmaceutical and lumber industries as high, medium, or low on the following dimensions of
industry structure.
Pharmaceutical firms historically have had some of the highest rates of return in the economy,
whereas timber firms have had relatively low returns. The following analysis reveals why.
Pharmaceutical Industry
Lumber Industry
Rivalry
Medium
High
Threat of
Low
Low
Firms compete fiercely to develop and
patent drugs. However, once a drug is
Industry growth rates are low.
Products typically have very little
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New Entrants
have established relationships with
doctors, which act as a further
drug companies on behalf of the
doctors in their network.
Economies of scale and first mover
advantages are very high for the In
addition, drug firms’ sales forces
Entry into the lumber industry
requires access to timber supplies
Threat of
Substitute
Products
Low
High
New drugs are protected by patents
giving manufacturers a monopoly to
There are many substitutes for
lumber, including steel, plastic,
Bargaining
Power of
Buyers
Low
Medium
Historically, doctors have had little
buying power. However, managed-
Many buyers are very large, such
as
low, giving buyers additional
leverage.
sell to any lumber mill.
Bargaining
Power of
Low
High
Chapter 2 Strategy Analysis 5
5. Joe Smith argues, “Your analysis of the five forces that affect industry profitability is incomplete. For
example, in the banking industry, I can think of at least three other factors that are also important—
namely, government regulation, demographic trends, and cultural factors.” His classmate Jane Brown
disagrees and says, “These three factors are important only to the extent that they influence one of the five
forces.” Explain how, if at all, the three factors discussed by Joe affect the five forces in the banking
industry.
Government regulation, demographic trends, and cultural factors will each impact the analysis of
the banking industry. While these may be important, they can each be recast using the five forces
Rivalry Among Existing Firms. Government regulation has played a central role in promoting,
maintaining, and limiting competition among banks. Banks are regulated at the federal and state
Threat of New Entrants. Government regulations at both the federal and state levels have limited
the entry of new players into the banking industry. New banks must meet the requirements set by
Threat of Substitute Products. The primary functions of banks are lending money and providing a
place to invest money. Thrifts, credit unions, brokerage houses, mortgage companies, and the
Bargaining Power of Buyers. Business and consumer buyers of credit have little direct bargaining
power over banks and financial institutions. The decline in relationship banking towards a
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Bargaining Power of Suppliers. Depositors have historically had little bargaining power.
In summary, bank regulations have historically had a very important role in determining bank
6. Coca-Cola and Pepsi are both very profitable soft drinks. Inputs for these products include corn syrup,
bottles/cans, and soft drink syrup. Coca-Cola and Pepsi produce the syrup themselves and purchase the
other inputs. They then enter into exclusive contracts with independent bottlers to produce their products.
Use the five forces framework and your knowledge of the soft drink industry to explain how Coca–Cola
and Pepsi are able to retain most of the profits in this industry.
While consumers perceive an intensely competitive relationship between Coke and Pepsi, these
major players in the soft drink industry have structured their businesses to retain most of the profits
Coca-Cola and Pepsi compete primarily on brand image rather than on price. They sell their syrup
to independent bottlers who have exclusive contracts to distribute soft drinks and other company
products within a specific geographic area. (While other syrup producers exist, they are typically
The threat of new entrants at the syrup level is restricted by limited access to adequate distribution
channels and by the valuable brand names that have been created by both Coke and Pepsi. While
The main ingredients of syrup are sugar and flavoring, and the markets for these inputs are
Chapter 2 Strategy Analysis 7
Coke and Pepsi switched to corn syrup. Thus, Coke and Pepsi are able to retain profits rather than
pay them out to their suppliers.
The production and distribution of soft drinks at the retail level is likely to be less profitable than is
syrup production for several reasons. First, despite tremendous amounts of advertising designed to
7. All major airlines offer frequent flier programs. Originally seen as a way to differentiate their
providers in response to excess capacity in the industry, these programs have long since become
ubiquitous. Many industry analysts believe that these programs have met with only mixed success in
accomplishing their goal. Use the competitive advantage concepts to explain why.
Initially, frequent flier programs had only limited success in creating differentiation among airlines.
Airlines tried to bundle frequent flier mileage programs with regular airline transportation to
increase customer loyalty and to create a differentiated product. Furthermore, the airlines
8. What are the ways that a firm can create barriers to entry to deter competition in its business? What
factors determine whether these barriers are likely to be enduring?
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Barriers to entry allow a firm to earn profits while at the same time preventing other firms from
entering the market. The primary sources of barriers to entry include economies of scale, absolute
costs advantages, product differentiation advantages, and government restrictions on entry of
competitors. Firms can create these barriers through a variety of means.
1. A firm can engineer and design its products, processes, and services to create economies of
1. A firm can engineer and design its products, processes, and services to create economies of
scale. Because of economies of scale, larger plants can produce goods at a lower cost that
4. Firms often try to persuade governments to impose entry restrictions through patents,
regulations, and licenses. AT&T fought with the government for many years to prevent other
Several factors influence how long specific barriers to entry are effective at preventing the entry of
competitors into an industry.
• Economies of scale depend on the size and growth of the market. If a market is growing quickly,
a competitor could build a larger plant capable of producing at a cost lower than the incumbent.
Chapter 2 Strategy Analysis 9
9. Explain why you agree or disagree with each of the following statements:
a. It’s better to be a differentiator than a cost leader, since you can then charge premium prices.
Disagree. While it is true that differentiators can charge higher prices compared to cost leaders, both
strategies can be equally profitable. Differentiation is expensive to develop and maintain. It often
requires significant company investment in research and development, engineering, training, and
b. It’s more profitable to be in a high-technology industry than a low– technology one.
Disagree. There are highly profitable firms in both high technology and low technology industries.
The argument presumes that high technology always creates barriers to entry. However, high
technology is not always an effective entry barrier and can be associated with high levels of
c. The reason why industries with large investments have high barriers to entry is because it is costly to
raise capital.
Disagree. The cost of raising capital is generally related to risk of the project rather than the size of
the project. As long as the risks of the project are understood, the costs of raising the necessary
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10. There are very few companies that are able to be both cost leaders and differentiators. Why? Can you
think of a company that has been successful at both?
Cost leadership and differentiation strategies typically require a different set of core competencies
and a different value chain structure. Cost leadership depends on the firm’s ability to capture
economies of scale, scope, and learning in its operations. These economies are complemented by
11. Many consultants are advising diversified companies in emerging markets such as India, South Korea,
Mexico, and Turkey to adopt corporate strategies proven to be of value in advanced economies like the
U.S. and the U.K. What are the pros and cons of this advice?
Corporate strategy involves making choices regarding the scope of a firm’s business activities. As
the chapter discusses, firm scope is a function of transaction costs in the market place. If the