Dear International Strategic Management Executives:
Please read from our attached  Textbook 1 Case 26: PROCTER & GAMBLE, the following Strategic Management case assigned for this Learning Module and please analyze and answer the following questions:
Answer Question 1-4
1. * What’s this Strategic Management Business Case about? I.E Executive Summary 
 Executive Summaries are much like any other summary in that their main goal is to provide a condensed version of the content of a longer report. The executive summary is usually no longer than 10% of the original document. It can be anywhere from 1-10 pages long, depending on the report’s length. Executive summaries are written literally for an executive who most likely DOES NOT have the time to read the original [document].Executive summaries make a recommendation. Accuracy is essential because decisions will be made based on your summary by people who have not read the original.
 2. * Detailed Financial Analysis  refer to attached  pdf Financial Ratio Tutorial 
  Please explain, analyze, and discuss in great detail your Financial Analysis section …  
3. * Industry Analysis (PESTEL Analysis and Porter 5 Forces)
        At LEAST 3 to 5 Bullet Points for EACH PESTEL section and Porter Forces
        Please explain why? and analyze, and discuss in great detail EACH Bullet Point …
Refer to attached Porter Five Forces Chpt 003 ppt.  and The Five Forces pdf
4. * Business SWOT Analysis
        At LEAST 3 to 5 Bullet Points for EACH SWOT Analysis Section …
        Please explain why? and analyze, and discuss in great detail EACH Bullet Point  …
Refer to attached SWOT Analysis pdf example.

Due Sat June 11 @ 11:00pm



On February 14, 2017, The Wall Street Journal reported that Trian Fund Management, one of the biggest activist investors has built up a more than $3 billion stake in Procter & Gamble, a leading global consumer products firm. The move added urgency to P&G’s efforts to turn around its business and boost its stock price. The firm’s closely watched organic sales growth, which excludes acquisitions or divestments as well as currency swings, has been stuck between 1% and 3% in recent years (see Exhibits 1 and 2). It has struggled to boost sales growth as it has confronted a sluggish global economy and competition from global competitors and Internet upstarts.

Since its founding 175 years ago, P&G had risen to the status of an American icon with well-known consumer products such as Pampers, Tide, Downy and Crest (see Exhibit 3). In fact, the firm has long been admired for its superior products, its marketing brilliance, and the intense loyalty of its employees who have respectfully come to be known as Proctoids. But a downward spiral in the 1990’s led the firm to turn to Alan G. Lafley to try and turn things around. He spent $70 billion over his tenure scooping up brands such as Gillette razors, Clairol cosmetics and Iams pet food. With 25 brands that generated more than $1 billion in sales, P&G became the largest consumer products company in the world.

Under Lafley’s chosen successor, Bob McDonald, however, P&G’s growth stalled as recession-battered consumers abandoned the firm’s premium-priced products for cheaper alternatives. More significantly, the firm’s vaunted innovation machine stalled with no major product success during his tenure. P&G’s decline eroded morale among employees, with many managers taking early retirement or bolting to competitors. Says Ed Artzt, who was CEO from 1990 to 1995: “The most unfortunate aspect of this whole thing is the brain drain. The loss of good people is almost irreparable when you depend on promotion from within to continue building the company.”1
EXHIBIT 1 Income Statement (in millions of $)

Year Ending

June 30, 2017

June 30, 2016

June 30, 2015

Total Revenue




Operating Income








Net Income




Source: P&G.

EXHIBIT 2 Balance Sheet (in millions of $)

Year Ending

June 30,2017

June 30, 2016

June 30 2015

Current Assets




Total Assets




Current Liabilities




Total Liabilities




Stockholder Equity




EXHIBIT 3 Significant Innovations

· Tide was the first heavy-duty laundry detergent

· Crest was the first fluoride toothpaste clinically proven to prevent tooth decay

· Downy was the first ultra-concentrated rinse-add fabric softener

· Pert Plus was the first 2-in-1 shampoo and conditioner

· Head & Shoulders was the first pleasant-to-use shampoo effective against dandruff

· Pampers was the first affordable, mass-marketed disposable diaper

· Bounty was the first three-dimensional paper towel

· Always was the first feminine protection pad with an innovative, dry-weave topsheet

· Febreze was the first fabric and air care product that actually remove odors from fabrics and the air

· Crest White Strips was the first patented in-home teeth whitening technology

Source: P&G.

Pressure from the board forced Lafley to back come out of retirement in May 2013 to make another attempt to pull P&G out of its doldrums. Soon after he took back the helm of the firm, Lafley announced that he would get rid of more than half of its brands. Over the next three years, the firm sold off many of the brands that it had acquired, capped by the $11.6 billion sale of dozens of beauty brands to Coty. He announced that the company would narrow its focus to 65 or 70 of its biggest brands such as Tide, Crest, and Pampers. “Less will be more,” Lafley told analysts. “The objective is growth and much more reliable generation of cash and profit.”2

David S. Taylor, who had spent years managing P&G’s businesses finally took over as chairman and CEO of the firm in November 2015. He has been confident that he can resurrect the firm but has opted against launching new brands or making new acquisitions. “I understand the desire for faster growth and for a single-minded short-term objective, but we’ve seen this movie before” he said at a meeting with analysts last November.3

Fighting off a Decline

For most of its long history, P&G has been one of America’s preeminent companies. The firm has developed several well-known brands such as Tide, one of the pioneers in laundry detergents, which was launched in 1946 and Pampers, the first disposable diaper, which was introduced in 1961. P&G also built its brands through its innovative marketing techniques. Nevertheless, by the 1990s, P&G was in danger of becoming another Eastman Kodak or Xerox, a once-great company that might have lost its way. Sales on most of its eighteen top brands were slowing as it was being outhustled by more focused rivals such as Kimberly-Clark and Colgate-Palmolive.

In 1999, P&G decided to bring in Durk I. Jaeger to try and make the big changes that were obviously needed to get P&G back on track. However, the moves that he made generally misfired, sinking the firm into deeper trouble. He introduced expensive new products that never caught on while letting existing brands drift. He also put in place a company-wide reorganization that left many employees perplexed and preoccupied. During the fiscal year when he was in charge, earnings per share showed an anemic rise of just 3.5%, much lower than in previous years. In addition, during that time, the share price slid 52%, cutting P&G’s total market capitalization by $85 billion.

In 2000, the board of P&G asked Lafley to take charge of the troubled firm. He began his tenure by breaking down the walls between management and the employees. Since the 1950s, all of the senior executives at P&G used to be located on the eleventh floor at the firm’s corporate headquarters. Lafley changed this setup, moving all five division presidents to the same floors as their staff. He replaced more than half of the company’s top 30 managers, more than any P&G boss in memory, and trimmed its work force by as many as 9,600 jobs. Moreover, he moved more women into senior positions. In fact, Lafley skipped over 78 general managers with more seniority to name 42-year-old Deborah A. Henretta to head P&G’s then-troubled North American baby-care division.

In fact, Lafley was simply acknowledging the importance of developing people, particularly those in managerial roles at P&G. For years, the firm has been known to dispatch line managers rather than human resource staffers to do much of its recruiting. For the few that get hired, their work life becomes a career long development process. At every level, P&G has a different ‘college’ to train individuals and every department has its own ‘university.’ The general manager’s college holds a weeklong school term once a year when there are a handful of newly promoted managers.

Under Lafley, P&G also continued with its efforts to maintain a comprehensive database of all of its more than 130,000 employees, each of which is tracked carefully through monthly and annual talent reviews. All managers are reviewed not only by their bosses but also by lateral managers who have worked with them, as well as on their own direct reports. Every February, one entire board meeting is devoted to reviewing the high-level executives, with the goal of coming up with at least three potential candidates for each of the 35 to 40 jobs at the top of the firm.

page C191 

Gambling on its Brands

Above all, however, Lafley had been intent on shifting the focus of P&G back to its consumers. At every opportunity that he got, he tried to drill his managers and employees not to lose sight of the consumer. He felt that P&G has often let technology dictate its new products rather than consumer needs. He wanted to see the firm work more closely with retailers, the place where consumers first see the product on the shelf. In addition, he placed a lot of emphasis on getting a better sense of the consumer’s experience with P&G products when they actually use them at home.

Over the decade of Lafley’s leadership, P&G managed to update all of its 200 brands by adding innovative new products. It begun to offer devices that build on its core brands, such as Tide StainBrush, a battery-powered brush for removing stains and Mr. Clean AutoDry, a water pressure powered car-cleaning system that dries without streaking. P&G also begun to approach its brands more creatively. Crest, for example, which used to be marketed as a toothpaste brand, was redefined an oral care brand. The firm now sells Crest-branded toothbrushes and tooth whiteners.

In order to ensure that P&G continues to come up with innovative ideas, Lafley had also confronted head-on the stubbornly held notion that everything must be invented within P&G, asserting that half of its new products should come from the outside. Under the new ‘Connect and Develop’ model of innovation, the firm pushed to get almost 50% of its new product ideas from outside the firm. This could be compared to the 10% figure that existed at P&G when Lafley had taken charge.

A key element of P&G’s strategy, however, was to move the firm away from basic consumer products such as laundry detergents, which can be knocked off by private labels, to higher-margin products. Under Lafley, P&G made costly acquisitions of Clairol and Wella to complement its Cover Girl and Oil of Olay brands. The firm had even moved into prestige fragrances through licenses with Hugo Boss, Gucci and Dolce & Gabbana. When he stepped down, beauty products had risen to account for about a quarter of the firm’s total revenues.

But P&G’s riskiest moves had been its expansion into services, starting with car washes and dry cleaning. The car washes build on Mr. Clean, P&G’s popular cleaning product. In expanding the brand to car washes, the firm expected to distinguish its outlets from others by offering additional services such as Febreze odor eliminators, lounges with Wi-Fi and big screen televisions and spray guns that children can aim at cars passing through the wash. Similarly, P&G’s dry cleaning outlets are named after Tide, its bestselling laundry detergent. The stores will include drive-through services, 24-hour pickup and environmentally benign cleaning methods.

Losing the Momentum

On July 1, 2009, Lafley passed the leadership of P&G to McDonald, who had joined the firm in 1980 and worked his way up through posts in Canada, Japan, the Philippines and Belgium to become chief operating officer. McDonald took over after the start of a calamitous recession, and had to deal with various emerging problems. Even as consumers in U.S. and Europe were not willing to pay premium prices, the firm’s push to expand in emerging markets was also yielding few results in the face of stiff competition from Unilever and Colgate-Palmolive, who already had a strong presence. Furthermore, commodity prices were surging, even as P&G’s products were already too expensive for the struggling middle-class that it was targeting everywhere.

In order to deal with all of these challenges, McDonald replaced Lafley’s clear motto of “the consumer is boss” with his own slogan of “purpose-inspired growth.” In his own words, this meant that P&G was “touching and improving more consumers’ lives, in more parts of the world, more completely.” “Purpose” was an undeniably laudable ambition, but many employees simply could not fathom how to translate this rhetoric into action. Dick Antoine, P&G’s head of HR from 1998 to 2008 commented: “‘Purpose-inspired growth’ is a wonderful slogan, but it doesn’t help allocate assets.”4

The new focus seemed to fit well with McDonald, who seemed more comfortable with the details of P&G’s operations. Even when McDonald tried to broaden his scope, McDonald found it difficult to establishing priorities for P&G. Given the wide range of problems that he faced, in terms of pushing for growth across several different businesses across many markets, he made some effort to try and address all of them at the same time. Ali Dibadj, a senior analyst at Sanford Bernstein commented on this multi-pronged effort by P&G: “The strategic problem was that they decided to go after everything. But they ran out of ammo too quickly.”5

By the middle of 2012, it was becoming obvious that P&G was struggling under McDonald’s leadership. Known for its reliable performance, the firm was forced to lower its profit guidelines three times in six months frustrating analysts and investors alike. Even within the firm, many executives realized that McDonald would not be able to take the bold moves that may allow the firm to recover from its slump. Activist investor Bill Ackerman commented: “We’re delighted to see the company’s made some progress. But P&G deserves to be led by one of the best CEO’s in the world.”6

Striving for Agility

Shareholder dissatisfaction with lack of improvement in performance led P&G to push McDonald out and bring back Lafley in May 2013. As soon as he stepped back in, Lafley was under pressure to respond to investor concerns that P&G had become too large and bloated to respond quickly to changing consumer demands. In April 2014, he began the process of streamlining the firm by selling of most of its pet food brands—including Iams and Eukanuba—to Mars for $2.9 billion. A few months later, in August 2014, Lafley took a bolder step. He announced that the firm would unload as many as 100 of its brands in order to better focus on 60 to 70 of its biggest ones—such as Tide detergent and Pampers diapers—that generate about 90% of its $83 billion in annual sales and over 95% of its profit (see Exhibits 4 and 5). Lafley did not specify which ones would be sold off or shut down, but the company owns scores of lesser brands such as Cheer laundry detergent and Metamucil laxatives.

EXHIBIT 4 Business Segments, 2016

Source: P&G Annual Report 2016.
Lafley insisted that sales would not be the only criteria for shedding brands. He stated that some large brands would be jettisoned if they didn’t fit with the firm’s core business: “If it’s not a core brand—I don’t care whether it’s a $2 billion brand—it will be divested.”7 He demonstrated this by the decision to spin off its Duracell into a standalone company. Although batteries have been generating $2.2 billion annually in sales, their sluggish growth did not fit with Lafley’s push for a more focused company.

Although analysts have been receptive to the reduction of brands, they have pointed out that P&G has already sold off more than 30 established brands over the past 15 years which were supposedly hindering growth. Many of these sold off brands have been performing well with other firms. J.M. Smucker, for example, that brought Crisco shortening, Folgers coffee and Jif peanut butter, has had 50 percent sales growth since 2009. Some critics charge that P&G, which was once was most successful in building and managing brands, has lost its touch.

In large part, the focus is on the cumbersome centralized and bureaucratic structure that has developed at P&G. Unlike many of its newer competitors, the firm still tends to rely less on working with outside partners. The ‘Connect and Develop’ program that had been started by Lafley to bring in new ideas from outsiders has led to 50 percent of its new technologies coming from outside, but these are then reworked or modified by P&G’s internal R&D group. This has stifled innovation, with most of the firm’s growth coming from line extensions of existing brands or from costly acquisitions.

On November 1, 2015, Lafley stepped down, passing the reins to David Taylor, who had built his career at P&G. He had most recently been assigned to take over the firm’s struggling beauty unit. Taylor continued with Lafley’s strategy of cutting back on P&G’s brands. The sale of 43 of the firm’s beauty brands to Coty in a $12 billion deal was completed in October 2016. A few months earlier, P&G had completed the transfer of Duracell to Berkshire Hathaway through an exchange of shares.

EXHIBIT 5 Financial Breakdown 2016

Source: P&G Annual Report 2016.

Fighting for Its Iconic Status

For years, P&G had spent heavily to build on its success with legacy soap and detergent brands to acquire hundreds of additional brands in new businesses that it hoped could also become part of consumers’ daily routines. The latest effort to jettison over half of its brands indicated that the strategy was not working anymore. In particular, P&G has been struggling with its push to place more emphasis on products that carry higher margins in order to move it away from its dependence on household staples.

The firm’s aggressive push into beauty, for example, has struggled to show much growth. Lafley had tried to build the firm’s presence in this business for years, regarding it as a high margin, faster growing complement to the firm’s core household products. The firm has struggled to show growth in this business and it has been generating the lowest profit margins. Sales of Olay skin care products and Pantene hair care products have mostly sagged in recent years. Its efforts to build a line of perfumes around licenses with Dolce & Gabbana, Gucci and Hugo Boss were also running into problems.

page C194 

Having discarded more than half of its brands over the past two years, P&G was optimistic that its turnaround efforts were starting to show results. On January 20, 2017, the firm offered a more upbeat outlook for sales growth in the coming year. “We are essentially on track with where we hoped we would be,” finance chief Jon Moeller said in a call with analysts.8 Yet a half-dozen analysts have cut their downgraded P&G’s stock over the past month. “Cosmetics, household and personal care stocks are no longer in vogue,” wrote Barclays analyst Lauren Lieberman in a recent report.9

1Jennifer Reingold & Doris Burke. Can P&G’s CEO hang on? Fortune, February 25, 2013, p. 69.

2Alex Coolridge. P&G plans to unload more than its brands. Cincinnati Enquirer, August 2, 2014, p. 1.

3David Benoit & Sharon Terlep. Activist Builds $3 Billion Stake in P&G. Wall Street Journal, February 15, 2017, p. A1.

4Fortune, February 25, 2013, p. 70.

5Fortune, February 25, 2013, p. 70.

6Fortune, February 25, 2013, p. 75.

7Cincinnati Enquirer, August 2, 2014, p. 1.

8Sharon Terlep. Procter & Gamble’s Outlook Improves. Wall Street Journal, January 21, 2017, p. B3.

9Alexander Coolridge. 4 Things That Could Sink P&G in 2017. Cincinnati Enquirer, January 15, 2017, p. G2.
* Case prepared by Jamal Shamsie, Michigan State University, with the assistance of Professor Alan B. Eisner, Pace University. Material has been drawn from published sources to be used for purposes of class discussion. Copyright © 2017 Jamal Shamsie and Alan B. Eisner

Financial ratio analysis
A reading prepared by Pamela Peterson Drake


1. Introduction
2. Liquidity ratios
3. Profitability ratios and activity ratios
4. Financial leverage ratios
5. Shareholder ratios

1. Introduction
As a manager, you may want to reward employees based on their performance. How do you know
how well they have done? How can you determine what departments or divisions have performed
well? As a lender, how do decide the borrower will be able to pay back as promised? As a manager of
a corporation how do you know when existing capacity will be exceeded and enlarged capacity will be
needed? As an investor, how do you predict how well the securities of one company will perform
relative to that of another? How can you tell whether one security is riskier than another? We can
address all of these questions through financial analysis.

Financial analysis is the selection, evaluation, and interpretation of financial data, along with other
pertinent information, to assist in investment and financial decision-making. Financial analysis may be
used internally to evaluate issues such as employee performance, the efficiency of operations, and
credit policies, and externally to evaluate potential investments and the credit-worthiness of
borrowers, among other things.

The analyst draws the financial data needed in financial analysis from many sources. The primary
source is the data provided by the company itself in its annual report and required disclosures. The
annual report comprises the income statement, the balance sheet, and the statement of cash flows,
as well as footnotes to these statements. Certain businesses are required by securities laws to
disclose additional information.

Besides information that companies are required to disclose through financial statements, other
information is readily available for financial analysis. For example, information such as the market
prices of securities of publicly-traded corporations can be found in the financial press and the
electronic media daily. Similarly, information on stock price indices for industries and for the market
as a whole is available in the financial press.

Another source of information is economic data, such as the Gross Domestic Product and Consumer
Price Index, which may be useful in assessing the recent performance or future prospects of a
company or industry. Suppose you are evaluating a company that owns a chain of retail outlets.
What information do you need to judge the company’s performance and financial condition? You
need financial data, but it doesn’t tell the whole story. You also need information on consumer

Financial ratios, a reading prepared by Pamela Peterson Drake 1

spending, producer prices, consumer prices, and the competition. This is economic data that is
readily available from government and private sources.

Besides financial statement data, market data, and economic data, in financial analysis you also need
to examine events that may help explain the company’s present condition and may have a bearing on
its future prospects. For example, did the company recently incur some extraordinary losses? Is the
company developing a new product? Or acquiring another company? Is the company regulated?
Current events can provide information that may be incorporated in financial analysis.

The financial analyst must select the pertinent information, analyze it, and interpret the analysis,
enabling judgments on the current and future financial condition and operating performance of the
company. In this reading, we introduce you to financial ratios — the tool of financial analysis. In
financial ratio analysis we select the relevant information — primarily the financial statement data —
and evaluate it. We show how to incorporate market data and economic data in the analysis and
interpretation of financial ratios. And we show how to interpret financial ratio analysis, warning you
of the pitfalls that occur when it’s not used properly.

We use Microsoft Corporation’s 2004 financial statements for illustration purposes throughout this
reading. You can obtain the 2004 and any other year’s statements directly from Microsoft. Be sure to
save these statements for future reference.

Classification of ratios

A ratio is a mathematical relation between one quantity and another. Suppose you have 200 apples
and 100 oranges. The ratio of apples to oranges is 200 / 100, which we can more conveniently
express as 2:1 or 2. A financial ratio is a comparison between one bit of financial information and
another. Consider the ratio of current assets to current liabilities, which we refer to as the current
ratio. This ratio is a comparison between assets that can be readily turned into cash — current assets
— and the obligations that are due in the near future — current liabilities. A current ratio of 2:1 or 2
means that we have twice as much in current assets as we need to satisfy obligations due in the near

Ratios can be classified according to the way they are constructed and their general characteristics.
By construction, ratios can be classified as a coverage ratio, a return ratio, a turnover ratio, or a
component percentage:

1. A coverage ratio is a measure of a company’s ability to satisfy (meet) particular obligations.

2. A return ratio is a measure of the net benefit, relative to the resources expended.

3. A turnover ratio is a measure of the gross benefit, relative to the resources expended.

4. A component percentage is the ratio of a component of an item to the item.

When we assess a company’s operating performance, we want to know if it is applying its assets in
an efficient and profitable manner. When we assess a company’s financial condition, we want to
know if it is able to meet its financial obligations.

There are six aspects of operating performance and financial condition we can evaluate from financial

1. A liquidity ratio provides information on a company’s ability to meet its short−term,
immediate obligations.

2. A profitability ratio provides information on the amount of income from each dollar of

Financial ratios, a reading prepared by Pamela Peterson Drake 2

3. An activity ratio relates information on a company’s ability to manage its resources (that is,
its assets) efficiently.

4. A financial leverage ratio provides information on the degree of a company’s fixed
financing obligations and its ability to satisfy these financing obligations.

5. A shareholder ratio describes the company’s financial condition in terms of amounts per
share of stock.

6. A return on investment ratio provides information on the amount of profit, relative to the
assets employed to produce that profit.

We cover each type of ratio, providing examples of ratios that fall into each of these classifications.

2. Liquidity Ratios
Liquidity reflects the ability of a company to meet its short-term obligations using assets that are
most readily converted into cash. Assets that may be converted into cash in a short period of time
are referred to as liquid assets; they are listed in financial statements as current assets. Current
assets are often referred to as working capital because these assets represent the resources needed
for the day-to-day operations of the company’s long-term, capital investments. Current assets are
used to satisfy short-term obligations, or current liabilities. The amount by which current assets
exceed current liabilities is referred to as the net working capital.1

The role of the operating cycle

How much liquidity a company needs depends on its operating cycle. The operating cycle is the
duration between the time cash is invested in goods and services to the time that investment
produces cash. For example, a company that produces and sells goods has an operating cycle
comprising four phases:

(1) purchase raw material and produce goods, investing in inventory;

(2) sell goods, generating sales, which may or may not be for cash;

(3) extend credit, creating accounts receivables, and

(4) collect accounts receivables, generating cash.

The operating cycle is the length of time it takes to convert an investment of cash in inventory
back into cash (through collections of sales). The net operating cycle is the length of time it takes to
convert an investment of cash in inventory and back into cash considering that some purchases are
made on credit.

The number of days a company ties up funds in inventory is determine by:

(1) the total amount of money represented in inventory, and

(2) the average day’s cost of goods sold.

The current investment in inventory — that is, the money “tied up” in inventory — is the ending
balance of inventory on the balance sheet. The average day’s cost of goods sold is the cost of goods

1 You will see reference to the net working capital (i.e., current assets – current liabilities) as simply working
capital, which may be confusing. Always check the definition for the particular usage because both are common
uses of the term working capital.

Financial ratios, a reading prepared by Pamela Peterson Drake 3

sold on an average day in the year, which can be estimated by dividing the cost of goods sold found
on the income statement by the number of days in the year.

We compute the number of days of inventory by calculating the ratio of the amount of inventory on
hand (in dollars) to the average day’s Cost of Goods Sold (in dollars per day):

365 / sold goods ofCost

sold goods ofcost sday’ Average

inventory days ofNumber ==

If the ending inventory is representative of the inventory throughout the year, the number of days
inventory tells us the time it takes to convert the investment in inventory into sold goods. Why worry
about whether the year-end inventory is representative of inventory at any day throughout the year?
Well, if inventory at the end of the fiscal year-end is lower than on any other day of the year, we
have understated the
number of days of

Indeed, in practice most
companies try to choose
fiscal year-ends that
coincide with the slow
period of their business.
That means the ending
balance of inventory would
be lower than the typical
daily inventory of the year.
We could, for example,
look at quarterly financial
statements and take
averages of quarterly
inventory balances to get
a better idea of the typical
inventory. However, here
for simplicity in this and
other ratios, we will make
a note of this problem and
deal with it later in the
discussion of financial

We can extend the same
logic for calculating the
number of days between a
sale — when an account
receivable is created — to
the time it is collected in
cash. If the ending
balance of receivables at
the end of the year is
representative of the
receivables on any day throughout the year, then it takes, on average, approximately the “number of
days credit” to collect the accounts receivable, or the number of days receivables:

Try it!

Wal-Mart Stores, Inc., had cost of revenue of $219,793 million for the fiscal
year ended January 31, 2005. It had an inventory balance of $29,447 million
at the end of this fiscal year. Using the quarterly information, Wal-Mart’s
average inventory balance during the fiscal year is $29,769.25:

Inventory balance, in millions

$28,320 $27,963









April July October January

Source: Wal-Mart Stores 10-K and 10-Q filings

Based on this information, what is Wal-Mart’s inventory turnover for fiscal year
2004 (ending January 31, 2005)?


Using the fiscal year end balance of inventory:

= =
$29,447 $29, 447

Number of days inventory = 48.9 days
$219,793/365 $602.173

Using the average of the quarterly balances:

= =
$29,769.25 $29, 769.25

Number of days inventory = 49.436 days
$219,793/365 $602.173

In other words, it takes Wal-Mart approximately 50 days to sell its
merchandise from the time it acquires it.

= =
Accounts receivable Accounts receivable

Number of days receivables
Average day’s sales on credit Sales on credit / 365

Financial ratios, a reading prepared by Pamela Peterson Drake 4

What does the operating cycle have to do with liquidity? The longer the operating cycle, the more
current assets needed (relative to current liabilities) because it takes longer to convert inventories
and receivables into cash. In other words, the longer the operating cycle, the more net working
capital required.

We also need to look at the liabilities on the balance sheet to see how long it takes a company to pay
its short-term obligations. We can apply the same logic to accounts payable as we did to accounts
receivable and inventories. How long does it take a company, on average, to go from creating a
payable (buying on credit) to paying for it in cash?

= =
Accounts payable Accounts payable

Number of days payables
Average day’s purchases Purchases / 365

First, we need to determine the amount of an average day’s purchases on credit. If we assume all
purchases are made on credit, then the total purchases for the year would be the Cost of Goods Sold,
less any amounts included in this Cost of Goods Sold that are not purchases.2

The operating cycle tells us how long it takes to convert an investment in cash back into cash (by
way of inventory and accounts receivable):

Number of days Number of days
Operating cycle

of inventory of receivables
= +

The number of days of purchases tells us how long it takes use to pay on purchases made to create
the inventory. If we put these two pieces of information together, we can see how long, on net, we
tie up cash. The difference between the operating cycle and the number of days of payables is the
net operating cycle:

Net operating cycle = Operating Cycle – Number of days of purchases

or, substituting for the operating cycle,

purchases of
days ofNumber

sreceivable of

inventory of

cycle operatingNet −+=

The net
operating cycle
therefore tells
us how long it
takes for the
company to get
cash back from
its investment
in inventory
and accounts
considering that
purchases may be made on credit. By not paying for purchases immediately (that is, using trade
credit), the company reduces its liquidity needs. Therefore, the longer the net operating cycle, the
greater the company’s need for liquidity.

Microsoft’s Number of Days Receivables


Average day’s receivables = $36,835 million / 365 = $100.9178 million

Number of days receivables = $5,890 million / $100.9178 million = 58.3643 days

Now try it for 2005 using the 2005 data from Microsoft’s financial statements.

Answer: 65.9400 days

Source of data: Income Statement and Balance Sheet, Microsoft Corporation Annual Report 2005

2 For example, depreciation is included in the Cost of Goods Sold, yet it not a purchase. However, as a quite
proxy for purchases, we can use the accounting relationship: beginning inventory + purchases = COGS + ending

Financial ratios, a reading prepared by Pamela Peterson Drake 5

Measures of liquidity

Liquidity ratios provide a measure of a company’s ability to generate cash to meet its immediate
needs. There are three commonly used liquidity ratios:

1. The current ratio is the ratio of current assets to current liabilities; Indicates a company’s
ability to satisfy its current liabilities with its current assets:


ratioCurrent =

2. The quick ratio is the ratio of quick assets (generally current assets less inventory) to
current liabilities; Indicates a company’s ability to satisfy current liabilities with its most
liquid assets

Inventory – assetsCurrent

ratio Quick =

3. The net working capital to sales ratio is the ratio of net working capital (current assets
minus current liabilities) to sales; Indicates a company’s liquid assets (after meeting
short−term obligations) relative to its need for liquidity (represented by sales)

sliabilitieCurrent – assetsCurrent

ratio sales to capital workingNet =

Generally, the larger these liquidity ratios, the better the ability of the company to satisfy its
immediate obligations. Is there a magic number that defines good or bad? Not really.

Consider the current ratio. A large amount of current assets relative to current liabilities provides
assurance that the company will be able to satisfy its immediate obligations. However, if there are
more current assets than the company needs to provide this assurance, the company may be
investing too heavily in these non- or low-earning assets and therefore not putting the assets to the
most productive use.

Another consideration is the
operating cycle. A company
with a long operating cycle
may have more need to
liquid assets than a
company with a short
operating cycle. That’s
because a long operating
cycle indicate that money is

tied up in inventory (and then receivables) for a longer length of time.

Microsoft Liquidity Ratios — 2004

Current ratio = $70,566 million / $14,696 million = 4.8017

Quick ratio = ($70,566-421) / $14,696 = 4.7731

Net working capital-to-sales = ($70,566-14,969) / $36,835 = 1.5515

Source of data: Balance Sheet and Income Statement, Microsoft Corporation Annual
Report 2005

Financial ratios, a reading prepared by Pamela Peterson Drake 6

3. Profitability ratios
Profitability ratios (also referred to as profit margin ratios) compare components of income with sales.
They give us an idea of what makes up a company’s income and are usually expressed as a portion
of each dollar of sales. The profit margin ratios we discuss here differ only by the numerator. It’s in
the numerator that we reflect and thus evaluate performance for different aspects of the business:

The gross profit margin is the ratio of gross income or profit to sales. This ratio indicates how
much of every dollar of sales is left after costs of goods sold:

Gross income
Gross profit margin


The operating profit margin is the
ratio of operating profit (a.k.a. EBIT,
operating income, income before
interest and taxes) to sales. This is a
ratio that indicates how much of each
dollar of sales is left over after operating

Microsoft’s 1998 Profit Margins

Gross profit margin = ($14,484 – 1,197)/$14,484 = 91.736%

Operating profit margin = $6,414 / $14,484 = 44.283%

Net profit margin = $4,490 / $14,484 = 31%

Source of data: Microsoft Corporation Annual Report 1998


Microsoft’s 2004 Profit Margins

Gross profit margin = ($36,835 – 6,716)/$36,835 = 81.767%

Operating profit margin = $9,034 / $36,835 = 24.526%

Net profit margin = $8,168 / $36,835 = 22.175%

Source of data: Income Statement, Microsoft Corporation Annual Report

Operating income
Operating profit margin =

The net profit margin is the ratio of
net income (a.k.a. net profit) to sales,
and indicates how much of each dollar
of sales is left over after all expenses:

Net income
Net profit margin

= .

4. Activity ratios
Activity ratios are measures of how well assets are used. Activity ratios — which are, for the most
part, turnover ratios — can be used to evaluate the benefits produced by specific assets, such as
inventory or accounts receivable. Or they can be use to evaluate the benefits produced by all a
company’s assets collectively.

These measures help us gauge how effectively the company is at putting its investment to work. A
company will invest in assets – e.g., inventory or plant and equipment – and then use these assets to
generate revenues. The greater the turnover, the more effectively the company is at producing a
benefit from its investment in assets.

The most common turnover ratios are the following:

1. Inventory turnover is the ratio of cost of goods sold to inventory. This ratio indicates how
many times inventory is created and sold during the period:

sold goods ofCost

turnover Inventory =

2. Accounts receivable turnover is the ratio of net credit sales to accounts receivable. This
ratio indicates how many times in the period credit sales have been created and collected on:

Financial ratios, a reading prepared by Pamela Peterson Drake 7

receivable Accounts
credit on Sales

turnover receivable Accounts =

3. Total asset turnover is the ratio of sales to total assets. This ratio indicates the extent that
the investment in total assets results in sales.

assets Total

turnover asset Total =

4. Fixed asset turnover is the ratio of sales to fixed assets. This ratio indicates the ability of
the company’s management to put the fixed assets to work to generate sales:

assets Fixed

turnover asset Fixed =

Microsoft’s Activity Ratios – 2004

Accounts receivable turnover = $36,835 / $5,890 = 6.2538 times

Total asset turnover = $36,835 / $92,389 = 0.3987 times

Source of data: Income Statement and Balance Sheet, Microsoft Corporation Annual
Report 2005

Turnovers and numbers of days

You may have noticed that there is a relation between the measures of the operating cycle and
activity ratios. This is because they use the same information and look at this information from
different angles. Consider the number of days inventory and the inventory turnover:


Number of days inventory
Average day’s cost of goods sold

sold goods ofCost

turnover Inventory =

The number of days inventory is how long the inventory stays with the company, whereas the
inventory turnover is the number of times that the inventory comes and leaves – the complete cycle
– within a period. So if the number of days inventory is 30 days, this means that the turnover within
the year is 365 / 30 = 12.167 times. In other words,

= =
365 365 Cost of goods sold

Inventory turnover =
InventoryNumber of days inventory Inventory

Cost of goods sold / 365

Financial ratios, a reading prepared by Pamela Peterson Drake 8

Try it!

Wal-Mart Stores, Inc., had cost of revenue of $219,793 million for the fiscal year ended January 31, 2005. It
had an inventory balance of $29,447 million at the end of this fiscal year.

Source: Wal-Mart Stores 10-K

Wal-Mart’s number of days inventory for fiscal year 2004 (ending January 31, 2005) is

= =
$29,447 $29, 447

Number of days inventory = 48.9 days
$219,793/365 $602.173

Wal-Mart’s inventory turnover is:


Inventory turnover = 7.464 times

And the number of days and turnover are related as follows:

Inventory turnover = 365 / 48.9 = 7.464 times

Number of days inventory = 365 / 7.464 = 48.9 days

5. Financial leverage ratios
A company can finance its assets either with equity or debt. Financing through debt involves risk
because debt legally obligates the company to pay interest and to repay the principal as promised.
Equity financing does not obligate the company to pay anything — dividends are paid at the
discretion of the board of directors. There is always some risk, which we refer to as business risk,
inherent in any operating segment of a business. But how a company chooses to finance its
operations — the particular mix of debt and equity — may add financial risk on top of business risk
Financial risk is the extent that debt financing is used relative to equity.

Financial leverage ratios are used to assess how much financial risk the company has taken on. There
are two types of financial leverage ratios: component percentages and coverage ratios. Component
percentages compare a company’s debt with either its total capital (debt plus equity) or its equity
capital. Coverage ratios reflect a company’s ability to satisfy fixed obligations, such as interest,
principal repayment, or lease payments.

Component-percentage financial leverage ratios

The component-percentage financial leverage ratios convey how reliant a company is on debt
financing. These ratios compare the amount of debt to either the total capital of the company or to
the equity capital.

1. The total debt to assets ratio indicates the proportion of assets that are financed with
debt (both short−term and long−term debt):

assets Total
debt Total

ratio assets todebt Total =

Remember from your study of accounting that total assets are equal to the sum of total debt
and equity. This is the familiar accounting identity: assets = liabilities + equity.

2. The long−term debt to assets ratio indicates the proportion of the company’s assets that
are financed with long−term debt.

assets Total
debt term-Long

ratio assets todebt term-Long =

Financial ratios, a reading prepared by Pamela Peterson Drake 9

3. The debt to equity ratio (a.k.a. debt-equity ratio) indicates the relative uses of debt and
equity as sources of capital to finance the company’s assets, evaluated using book values of
the capital sources:

equity rs’shareholde Total
debt Total

ratioequity todebt Total =

One problem (as we shall see)
with looking at risk through a
financial ratio that uses the book
value of equity (the stock) is that
most often there is little relation
between the book value and its
market value. The book value of
equity consists of:

• the proceeds to the
company of all the stock
issued since it was first
incorporated, less any
treasury stock (stock
repurchased by the
company); and

• the accumulation of all
the earnings of the
company, less any
dividends, since it was
first incorporated.

Let’s look at an example of the
book value vs. market value of
equity. IBM was incorporated in
1911. So its book value of equity
represents the sum of all its stock
issued and all its earnings, less all dividends paid since 1911. As of the end of 2003, IBM’s book value
of equity was approximately $28 billion and its market value of equity was approximately $162 billion.
The book value understates its market value by over $130 billion. The book value generally does not
give a true picture of the investment of shareholders in the company because:

Note that the debt-equity ratio is related to the debt-to-total assets
ratio because they are both measures of the company’s capital
structure. The capital structure is the mix of debt and equity that
the company uses to finance its assets.

Let’s use short-hand notation to demonstrate this relationship. Let D
represent total debt and E represent equity. Therefore, total assets
are equal to D+E.

If a company has a debt-equity ratio of 0.25, this means that is debt-
to-asset ratio is 0.2. We calculate it by using the ratio relationships
and Algebra:

D/E = 0.25

D = 0.25 E

Substituting 0.25 E for D in the debt-to-assets ratio D/(D+E):

D/(D+E) = 0.25 E / (0.25 E + E) = 0.25 E / 1.25 E = 0.2

In other words, a debt-equity ratio of 0.25 is equivalent to a debt-to-
assets ratio of 0.2

This is a handy device: if you are given a debt-equity ratio and need
the debt-assets ratio, simply:

D/(D+E) = (D/E) / (1 + D/E)

Why do we bother to show this? Because many financial analysts
discuss or report a company’s debt-equity ratio and you are left on
your own to determine what this means in terms of the proportion of
debt in the company’s capital structure.

• earnings are recorded according to accounting principles, which may not reflect the true
economics of transactions, and

• due to inflation, the dollars from earnings and proceeds from stock issued in the past do not
reflect today’s values.

The market value, on the other hand, is the value of equity as perceived by investors. It is what
investors are willing to pay, its worth. So why bother with the book value of equity? For two reasons:
first, it is easier to obtain the book value than the market value of a company’s securities, and
second, many financial services report ratios using the book value, rather than the market value.

We may use the market value of equity in the denominator, replacing the book value of equity. To do
this, we need to know the current number of shares outstanding and the current market price per
share of stock and multiply to get the market value of equity.

Financial ratios, a reading prepared by Pamela Peterson Drake 10

Coverage financial leverage ratios

In addition to the leverage ratios that use information about how debt is related to either assets or
equity, there are a number of financial leverage ratios that capture the ability of the company to
satisfy its debt obligations. There are many ratios that accomplish this, but the two most common
ratios are the times interest coverage ratio and the fixed charge coverage ratio.

The times-interest-coverage ratio, also referred to as the interest coverage ratio, compares the
earnings available to meet the interest obligation with the interest obligation:

taxes andinterest before Earnings

ratio coverage-interest-Times =

The fixed charge coverage ratio expands on the obligations covered and can be specified to include
any fixed charges, such as lease payments and preferred dividends. For example, to gauge a
company’s ability to cover its interest and lease payments, you could use the following ratio:

payment Lease Interest
payment Lease taxes andinterest before Earnings

ratio coverage charge- Fixed


Coverage ratios are often used in debt covenants to help protect the creditors.

Microsoft’s Financial Leverage Ratios – 2004

Total debt to total assets = ($94,368 – 74,825) / $94,368 = 0.20709 or 20.709%

Debt to equity ratio = ($94,368 – 74,825) / $74,825 = 0.26118 or 26.118%

Source of data: Balance sheet, Microsoft Corporation Annual Report 2005

6. Shareholder ratios
The ratios we have explained to this point deal with the performance and financial condition of the
company. These ratios provide information for managers (who are interested in evaluating the
performance of the company) and for creditors (who are interested in the company’s ability to pay its
obligations). We will now take a look at ratios that focus on the interests of the owners — shareholder
ratios. These ratios translate the overall results of operations so that they can be compared in terms
of a share of stock:

Earnings per share (EPS) is the amount of income earned during a period per share of common

goutstandin shares ofNumber
rsshareholde to available incomeNet

shareper Earnings =

As we learned earlier in the study of Financial Statement Information, two numbers of earnings per
share are currently disclosed in financial reports: basic and diluted. These numbers differ with respect
to the definition of available net income and the number of shares outstanding. Basic earnings per
share are computed using reported earnings and the average number of shares outstanding.
Diluted earnings per share are computed assuming that all potentially dilutive securities are
issued. That means we look at a “worst case” scenario in terms of the dilution of earnings from
factors such as executive stock options, convertible bonds, convertible preferred stock, and warrants.

Suppose a company has convertible securities outstanding, such as convertible bonds. In calculating
diluted earnings per share, we consider what would happen to both earnings and the number of

Financial ratios, a reading prepared by Pamela Peterson Drake 11

shares outstanding if these bonds were converted into common shares. This is a “What if?” scenario:
what if all the bonds are converted into stock this period. To carry out this “What if?” we calculate
earnings considering that the company does not have to pay the interest on the bonds that period
(which increases the numerator of earnings per share), but we also add to the denominator the
number of shares that would be issued if
these bonds were converted into shares.3

Another source of dilution is executive
stock options. Suppose a company has 1
million shares of stock outstanding, but
has also given its executives stock options
that would result in 0.5 million new shares
issued if they chose to exercise these
options. This would not affect the
numerator of the earnings per share, but
would change the denominator to 1.5
million shares. If the company had
earnings of $5 million, its basic earnings
per share would be $5 million / 1 million
shares = $5.00 per share and its diluted
earnings per share would be $5 million /
1.5 million shares = $3.33 per share.

What’s a convertible security?

A convertible security is a security – debt or equity – that
gives the investor the option to convert—that is, exchange –
the security into another security (typically, common stock).
Convertible bonds and convertible preferred stocks are

Suppose you buy a convertible bond with a face value of
$1,000 that is convertible into 100 shares of stock. This
means that you own the bond and receive interest, but you
have the option to exchange it for 100 shares of stock. You
can hold the bond until it matures, collecting interest
meanwhile and then receiving the face value at maturity, or
you can exchange it for the 100 shares of stock at any time.
Your choice. Once you convert your bond into stock,
however, you no longer receive any interest on the bond.

Some issuers will limit conversion such that the bond cannot
be converted for a fixed number of years from issuance.

As an example, consider Yahoo!’s earnings per share reported in their 2004 annual report:

Item 2003 2004
Basic EPS $0.19 $0.62
Diluted EPS $0.18 $0.58

The difference between the basic and diluted earnings per share in Yahoo!’s case is attributable to its
extensive use of stock options in compensation programs.

Book value equity per share is the amount of the book value (a.k.a. carrying value) of common
equity per share of common stock, calculated by dividing the book value of shareholders’ equity by
the number of shares of stock outstanding. As we discussed earlier, the book value of equity may
differ from the market value of equity. The market value per share, if available, is a much better
indicator of the investment of shareholders in the company.

The price−earnings ratio (P/E or PE ratio) is the ratio of the price per share of common stock to
the earnings per share of common stock:

Market price per share
Price-earnings ratio =

Earnings per share

Though earnings per share are reported in the income statement, the market price per share of stock
is not reported in the financial statements and must be obtained from financial news sources. The

3 A “catch” is that diluted earnings per share can never be reported to be greater than basic earnings per share.
In some cases (when a company has many convertible securities outstanding), we may calculate a diluted
earnings per share greater than basic earnings per share, but in this case we cannot report diluted earnings per
share because it would be anti-dilutive.

Financial ratios, a reading prepared by Pamela Peterson Drake 12

P/E ratio is sometimes used as a proxy for investors’ assessment of the company’s ability to generate
cash flows in the future. Historically, P/E ratios for U.S. companies tend to fall in the 10-25 range, but
in recent periods (e.g., 2000-2001) P/E ratios have reached much higher. Examples of P/E ratios (P/E
ratios at the end of 2004): 4


P/E ratio AMZN 57
Time Warner Inc. TWX 29
Coca-Cola KO 22
Microsoft MSFT 36
Yahoo! YHOO 98
3M Co. MMM 23
General Electric GE 24

We are often interested in the returns to shareholders in the form of cash dividends. Cash
dividends are payments made by the company directly to its owners. There is no requirement that
a company pay dividends to its shareholders, but many companies pay regular quarterly or annual
dividends to the owners. The decision to pay a dividend is made by the company’s board of
directors. Note that not all companies pay dividends.

Dividends per share (DPS) is the dollar amount of cash dividends paid during a period, per share

of common stock:

Dividends paid to shareholders
Dividends per share

Number of shares outstanding

The dividend payout ratio is the ratio of cash dividends paid to earnings for a period:

Dividend payout ratio =


The complement to the dividend payout ratio is the retention ratio or the plowback ratio:

Earnings – Dividends
Retention ratio =


We can also convey information about dividends in the form of a yield, in which we compare the
dividends per share with the market price per share:

Dividends per share
Dividend yield =

Market price per share

The dividend yield is the return to shareholders measured in terms of the dividends paid during the

We often describe a company’s dividend policy in terms of its dividend per share, its dividend payout
ratio, or its dividend yield. Some companies’ dividends appear to follow a pattern of constant or

4 Source: Yahoo! Finance

Financial ratios, a reading prepared by Pamela Peterson Drake 13

constantly growing dividends per share. And some companies’ dividends appear to be a constant
percentage of earnings.

You’ve been introduced to a few of the financial ratios that a financial analyst has in his or her toolkit.
There are hundreds of ratios that can be formed using available financial statement data. The ratios
selected for analysis depend on the type of analysis (e.g., credit worthiness) and the type of
company. You’ll see in the next reading how to use these ratios to get an understanding of a
company’s condition and performance.

Financial ratios, a reading prepared by Pamela Peterson Drake 14

1. Introduction
Classification of ratios
2. Liquidity Ratios

The role of the operating cycle
Measures of liquidity
3. Profitability ratios
4. Activity ratios

Turnovers and numbers of days
5. Financial leverage ratios

Component-percentage financial leverage ratios
Coverage financial leverage ratios
6. Shareholder ratios


Crafting A Business

Industry Ana

Bargaining Power

Suppliers are POWER
− There is a credibl

− Suppliers are con
− There is a signifi
− The customers ar

What does the bargai



lysis Model

of Suppliers

FUL if…
e forward integration threat by

cant cost to switch suppliers.
e powerful.

Suppliers are WEAK if…
− The product is standardized. There are many

competitive suppliers.
− They are supplying commodity products.
− There is a credible backward integration threat by

− There are concentrated purchasers.
− The customers are weak.

ning power of suppliers in your industry look like?

Online eLearning Classroom

Crafting A Business Plan

Threat of New Entrants

Threat of new entrants is LOW if…
− There is patented or proprietary know-how.
− There is difficulty in brand switching.
− There are restricted distribution channels.
− There is a high scale threshold.

Threat of new entrants is HIGH if…
− There is common technology.
− There is little brand franchise.
− Distribution channels are easily accessible.
− There is a low scale threshold.

What does the threat of new entrants within your industry look like?

Competitive Rivalry Within Industry

Competitive rivalry within an industry is LOW if…
− There are few players in the industry.
− Players have different strategies.
− Differentiation between competitors and their

products are high.
− There is little to no price competition
− There are high market growth rates.
− Barriers for exit are low.

Competitive rivalry within an industry is HIGH if…
− There are many players of about the same size.
− Players have similar strategies.
− There is not much differentiation between players

and their products.
− There is much price competition
− Low market growth rates (growth of a particular

company is possible only at the expense of a

− Barriers for exit are high (e.g. expensive and
highly specialized equipment).

What does the bargaining power of customers in your industry look like?

Crafting A Business Plan

Threat of Substitutes

Threat of substitutes will be LOW if…
− There is strong brand loyalty.
− There are tight or strong customer relationships.
− Switching costs for customers are high.
− The relative price compard to performance of

substitutes is high.

Threat of substitutes will be HIGH if…
− There is little to no brand loyalty.
− There are loose customer relationships.
− Switching costs for customers are low.
− The relative price compard to performance of

substitutes is low.

What does the bargaining threat of substitutes within your industry look like?

Bargaining Power of Customers

Customers are POWERFUL if…
− There are a few buyers with significant market

− Buyers purchase a significant proportion of the

− Buyers possess a credible backward integration


Customers are WEAK if…
− Producers can threaten forward integration, taking

over customers’ position.
− There are significant buyer switching costs.
− There are many customers – significant influence

on a particular product or price is small.
− Producers supply critical portions of the

customers’ input.

What does the competitive rivalry within your industry look like?


Industry Analysis: The Five Forces
Cole Ehmke, Joan Fulton, and Jay Akridge
Department of Agricultural Economics

Kathleen Erickson, Erickson Communications

Sally Linton
Department of Food Science

Assessing Your Marketplace
The economic structure of an industry is not an accident.
Its complexities are the result of long-term social trends and
economic forces. But its effects on you as a business manager
are immediate because it determines the competitive rules
and strategies you are likely to use. Learning about that
structure will provide essential insight for your business

Michael Porter has identified five forces that are widely used to
assess the structure of any industry. Porter’s five forces are the:

• Bargaining power of suppliers,

• Bargaining power of buyers,

• Threat of new entrants,

• Threat of substitutes, and

• Rivalry among competitors.

Together, the strength of the five forces determines the profit
potential in an industry by influencing the prices, costs, and
required investments of businesses—the elements of return
on investment. Stronger forces are associated with a more
challenging business environment. To identify the important
structural features of your industry via the five forces, you
conduct an industry analysis that answers the question,
“What are the key factors for competitive success?”

Using This Publication
This publication describes five forces that influence an
industry. The publication includes a set of application
questions that will help you evaluate the structure of the
industry you are in or are considering entering. The more you
understand about the strength of each force, the better able
you will be to respond.

The forces affecting profitability are often beyond your
control, so you must choose tactics to respond to the forces
rather than try to change the business environment. This
publication offers insight on specific tactics you need for
success when facing competitive situations. While you may
assess any one force individually, you will gain the most value
by assessing all five of the forces

With each force, a “Perspective” feature illustrates the force
for an Indiana wine entrepreneur by evaluating that market-
place. To avoid repetition, we use the word “product” to mean
either a product or a service. Read more about the five forces
in Porter’s book, Competitive Strategy.

Audience: Business managers seeking to assess
the nature of their marketplace

Content: Presents five forces that influence the
profitability of an industry

Outcome: Reader should understand the forces
and be able to counter them with appropriate

2 Purdue Extension • Knowledge to Go

Bargaining Power of Suppliers

How Much Power Do Your
Suppliers Have Over You?
Any business requires inputs—labor, parts, raw materials,
and services. The cost of your inputs can have a significant
effect on your company’s profitability. Whether the strength of
suppliers represents a weak or a strong force hinges on the
amount of bargaining power they can exert and, ultimately,
on how they can influence the terms and conditions of
transactions in their favor. Suppliers would prefer to sell to
you at the highest price possible or provide you with no more
services than necessary. If the force is weak, then you may be
able to negotiate a favorable business deal for yourself.
Conversely, if the force is strong, then you are in a weak
position and may have to pay a higher price or accept a lower
level of quality or service.

Factors Affecting the
Bargaining Power of Suppliers
Suppliers have the most power when:

• The input(s) you require are available only from a
small number of suppliers. For instance, if you are
making computers and need microprocessors, you will
have little or no bargaining power with Intel, the
world’s dominant supplier.

• The inputs you require are unique, making it costly to
switch suppliers. If you use a certain enzyme in a food
manufacturing process, changing to another supplier
may require you to change your entire manufacturing
process. This may be very costly to you, thus you will
have less bargaining power with your supplier.

• Your input purchases don’t represent a significant
portion of the supplier’s business. If the supplier does
not depend on your business, you will have less power
to negotiate. Of course the opposite is true as well.
Wal-Mart has significant negotiating power over its
suppliers because it is such a large percentage of
suppliers’ business.

• Suppliers can sell directly to your customers,
bypassing the need for your business. For example, a
manufacturer could open its own retail outlet and
compete against you.

• It is difficult for you to switch to another supplier. For
example, if you recently invested in a unique
inventory and information management system to
work effectively with your supplier, it would be
expensive for you to switch suppliers.

• You do not have a full understanding of your
supplier’s market. You are less able to negotiate if you
have little information about market demand, prices,
and supplier’s costs.

Reducing the Bargaining Power of
Most businesses don’t have the resources to produce their own
inputs. If you are in this position, then you might consider
forming a partnership with your supplier. This can result in a
more even distribution of power. For instance, Dell Computer
uses partnering with its components suppliers as a key
strategy to be the low-cost/high-quality leader in the market.
This can be mutually beneficial for both supplier and buyer if
they can:

• Reduce inventory costs by providing just-in-time

• Enhance the value of goods and services supplied by
making effective use of information about customer
needs and preferences, and

• Speed the adoption of new technologies.

Another option may be to increase your power by forming a
buying group of small producers to buy as one large-volume
customer. If you have the resources, you may choose to
integrate back and produce your own inputs by purchasing
one of your key suppliers or doing the production yourself.

3 Purdue Extension • Knowledge to Go

1. Are there a large number of potential input
suppliers? The greater number of suppliers of
your needed inputs, the more control you will

2. Are the products that you need to purchase
for your business ordinary? You have more
control when the products you need from a
supplier are not unique.

3. Do your purchases from suppliers represent a
large portion of their business? If your
purchases are a relatively large portion of
your supplier’s business, you will have more
power to lower costs or improve product






4. Would it be difficult for your suppliers to
enter your business, sell directly to your
customers, and become your direct
competitor? The easier it is to start a new
business, the more likely it is that you will
have competitors.

5. Can you easily switch to substitute products
from other suppliers? If it is relatively easy to
switch to substitute products, you will have
more negotiating room with your suppliers.

6. Are you well informed about your supplier’s
product and market? If the market is
complicated or hard to understand, you have
less bargaining power with your suppliers.

Self Assessment—Bargaining Power of Suppliers
This i
“Yes” or “No” in the space provided. “Yes” indicates a favorable competitive environment for your business. “No” indicates a
negative situation. Use the insight you gain to develop effective tactics for countering or taking advantage of the situation.

Perspective on Bargaining Power of Suppliers

For an Indiana winery, one of the main supply decisions lies
with the key product ingredients—winegrapes and juice.
Wineries have several options, including owning the
vineyard, purchasing grapes, or purchasing juice. An
overabundance of winegrapes and juice from the West Coast
of the U.S., for instance, enhances Indiana wineries’
negotiating power with grape and juice suppliers. However,
the bargaining power of Indiana wineries is generally
weakened due to lack of winegrape growing experience.

If the winery needs a specific grape variety for a particular
wine, then the manager needs to be concerned about the
supply and demand for the product. As supply becomes
short, the manager will find that suppliers have increasing
bargaining power.

Raw materials for wine production are commodity items that
are very cyclical in price, quality, and availability. There are
times when high-quality grapes can be bought for low prices
(over supply) and other times when particular grape varieties

or juice are almost non-existent. This can have a
significant effect on a winery. And it is something the
manager has no control over. For example, if a late spring
frost hits the New York vineyards, the tender varieties will
not produce enough grapes to satisfy demand for the year.

Small wineries are particularly challenged because they
do not have the leverage associated with volume that the
larger wineries have. As a result, the force of suppliers on
a small winery can be viewed as relatively strong.
However, a manager of an Indiana winery could decrease
the effect by cooperating with other small players to
make collective purchases.

Contracts and positive relationships with suppliers and
producers are another way a small winery can manage
the uncertainty and power of suppliers. Recognizing the
power of suppliers and the influence of outside factors
(e.g., knowledge and weather) is an important
consideration as a small winery finds a place in the market.

4 Purdue Extension • Knowledge to Go

Many small customers acting as a group can create a strong
force. For instance, because of their size, health maintenance
organizations (HMOs) can purchase health care from
hospitals and doctors at much lower cost than can individual

Note that not all buyers will have the same degree of bargain-
ing power with you or be as sensitive to price, quantity, or
service. For example, apparel makers face significant buyer
power when selling to large retailers like Wal-Mart or
department stores, but face a much more favorable situation
when selling to smaller specialty shops.

Factors Influencing the
Bargaining Power of Buyers
Buyers have more power when:

• Your industry has many small companies supplying
the product and buyers are few and large. For
example, you may have little negotiating power if you
and several competing companies are trying to sell
similar products to one large buyer.

• The products represent a relatively large expense for
your customers. Customers may not price shop for a
quart of oil, but they will price shop if purchasing a
new vehicle.

Bargaining Power of Buyers

How Much Negotiating Power Do
Your Buyers Have?
The power of buyers describes the effect that your customers
have on the profitability of your business. The transaction
between the seller and the buyer creates value for both parties.
But if buyers (who may be distributors, consumers, or other
manufacturers) have more economic power, your ability to
capture a high proportion of the value created will decrease,
and you will earn lower profits.

How Much Power Do Your Buyers
Have Over You?
Buyers have the most power when they are large and purchase
much of your output. If your business sells to a few large
buyers, they will have significant leverage to negotiate lower
prices and other favorable terms because the threat of losing
an important buyer puts you in a weak position. Buyers also
have power if they can play suppliers against each other. In
the automotive supply industry, the large car manufacturers
have significant power. There are only a few large buyers, and
they buy in large quantities. But, when there are many
smaller buyers, you will have greater control because each
buyer is a small portion of your sales.

List the major inputs
needed for your business.

For each input,
list possible suppliers.

How can you best work with this supplier
to maximize your bargaining power?






Further Assessment
Using a pencil and sheet of paper, examine in greater detail how the bargaining power of suppliers will affect your business.

5 Purdue Extension • Knowledge to Go

• Customers have access to and are able to evaluate
market information. You have less room for
negotiation if buyers know market demand, prices,
and your costs.

• Your product is not unique and can be purchased
from other suppliers. If your brand is homogenous or
similar to all of the others, buyers will base their
decision mainly on price.

• Customers could possibly make your product
themselves. Anheuser-Busch, Coors, and Heinz are
examples of companies that have integrated back into
metal can manufacturing to fill the balance of their
container needs.

• Customers can easily, and with little cost, switch to
another product. For example, IBM customers might
switch to Gateway or Dell, but it may be inconvenient
for them to consider Macintosh.

Reducing the Bargaining Power of
You can reduce the bargaining power of your customers by
increasing their loyalty to your business through partnerships
or loyalty programs, selling directly to consumers, or increas-
ing the inherent or perceived value of a product by adding
features or branding. In addition, if you can select the
customers who have little knowledge of the market and have
less power, you can enhance your profitability.

Perspective on Bargaining Power of Buyers

Indiana wineries have three types of buyers—direct
consumers, wholesalers, and retail outlets. Direct
consumers are mostly tourists out for the day, weekend, or
even a weeklong vacation. In this situation, competition for
those buyers is actually any travel destination in the area
competing for their leisure time. Would the buyers rather
visit a state park or a museum than a winery? A winery
can reduce the bargaining power of these customers by
offering unique products and events that offer high value.

Wholesalers have a significant amount of bargaining power
because they are few in number and have a considerable
influence over the wines that are sold on the retail shelf.
Thus, the bargaining power of small wineries is weak

compared to that of the wholesalers. In Indiana,
counteracting legislation allows small wineries to sell
directly to retail outlets without using a wholesaler.
While the bargaining power of one of these wineries
with retail outlets is still weak, the winery has the
benefit of offering a local Indiana product that is in
demand with consumers.

Overall for Indiana wineries, buyers have more power
than the entrepreneurs. This is due to the fact that direct
consumers have multiple options for entertainment, and
wholesalers and retail outlets have thousands of wine
brands to choose from. Therefore, a small winery owner
must be creative in dealings with consumers, usually by
offering loyalty programs and increasing perceived value.

6 Purdue Extension • Knowledge to Go

List the types of customers that
you have or expect to have.

What alternatives might these
customers have for your product?

How can you build loyalty for your product
or service to reduce customer bargaining power?






Further Assessment
Using a pencil and sheet of paper, examine in greater detail how the bargaining power of buyers will affect your business.

Self Assessment—Bargaining Power of Buyers
respond with “Yes” or “No” in the space provided. “Yes” indicates a favorable competitive environment for your business. “No” indicates
a negative situation. Use the insight you gain to develop effective tactics for countering or taking advantage of the situation.

1. Do you have enough customers such that
losing one isn’t critical to your success? The
smaller the number of customers, the more
dependent you are on each one of them.

2. Does your product represent a small expense
for your customers? If your product is a
relatively large expense for your customers,
they’ll expend more effort negotiating with
you to lower price or improve product

3. Are customers uninformed about your
product and market? If your market is
complicated or hard to understand, buyers
have less control.




4. Is your product unique? If your product is
homogenous or the same as your competitors’,
buyers have more bargaining power.

5. Would it be difficult for buyers to integrate
backward in the supply chain, purchase a
competitor providing the products you provide,
and compete directly with you? The less likely
a customer will enter your industry, the more
bargaining power you have.

6. Is it difficult for customers to switch from
your product to your competitors’ products?
If it is relatively easy for your customers to
switch, you will have less negotiating power
with your customers.




7 Purdue Extension • Knowledge to Go

Threat of New Entrants
How Easy Is It for Businesses to
Enter Your Market?
You may have the market cornered with your product, but
your success may inspire others to enter the business and
challenge your position. The threat of new entrants is the
possibility that new firms will enter the industry. New entrants
bring a desire to gain market share and often have significant
resources. Their presence may force prices down and put
pressure on profits.

Analyzing the threat of new entrants involves examining the
barriers to entry and the expected reactions of existing firms
to a new competitor. Barriers to entry are the costs and/or
legal requirements needed to enter a market. These barriers
protect the companies already in business by being a hurdle
to those trying to enter the market. In addition to up-front
barriers, a new competitor may inspire established companies
to react with tactics to deter entry, such as lowering prices or
forming partnerships. The chance of reaction is high in
markets where firms have a history of retaliation, excess cash,
are committed to the industry (see Rivalry Among Competitors),
or the industry has slow growth.

Unique Barriers
Entry barriers are unique for each industry and situation,
and can change over time. Most barriers stem from irrevers-
ible resource commitments you must make in order to enter
a market. For example, if the existing businesses have well-
established brand names and fully differentiated products,
as a potential market entrant you will need to undertake an
expensive marketing campaign to introduce your products.
Barriers to entry are usually higher for companies involved
in manufacturing than for companies that provide a service
because there is often a significant expense in setting up a
production facility.

Another type of entry barrier is regulatory. To produce organic
food there is a three-year wait before land may be certified.
During the waiting period, producers must raise the crop as
organic, but may not market it as organic until the three-year
“cleansing process” of the land is completed.

Overcoming barriers to entry may involve expending signifi-
cant resources over an extended period of time. Industries
based on patentable technology may require an especially
long-term commitment, with years of research and testing,
before products can be introduced and compete.

Factors Affecting the Threat of
New Entrants
The threat of new entrants is greatest when:

• Processes are not protected by regulations or patents.
In contrast, when licenses and permits are required to
do business, such as with the liquor industry, existing
firms enjoy some protection from new entrants.

• Customers have little brand loyalty. Without strong
brand loyalty, a potential competitor has to spend
little to overcome the advertising and service
programs of existing firms and is more likely to enter
the industry.

• Start-up costs are low for new businesses entering the
industry. The less commitment needed in advertising,
research and development, and capital assets, the
greater the chance of new entrants to the industry.

• The products provided are not unique. When the
products are commodities and the assets used to
produce them are common, firms are more willing to
enter an industry because they know they can easily
liquidate their inventory and assets if the venture fails.

• Switching costs are low. In situations where customers
do not face significant one-time costs from switching
suppliers, it is more attractive for new firms to enter
the industry and lure the customers away from their
previous suppliers.

• The production process is easily learned. Just as
competitors may be scared away when the learning
curve is steep, competitors will be attracted to an
industry where the production process is easily

• Access to inputs is easy. Entry by new firms is easier
when established firms do not have favorable access to
raw materials, locations, or government subsidies.

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• Access to customers is easy. For instance, it may be
easy to rent space to sell produce at a farmer’s market,
but nearly impossible to get shelf space in a grocery store.
You are more likely to find new entrants in the food
business using the farmer’s market distribution system
over grocery stores.

• Economies of scale are minimal. If there is little
improvement in efficiency as scale (or size) increases,
a firm entering a market won’t be at a disadvantage if
it doesn’t produce the large volume that an existing
firm produces.

Reducing the Threat of
New Entrants
Enhancing your marketing/brand image, utilizing patents,
and creating alliances with associated products can minimize
the threat of new entrants. Important tactics you can follow
include demonstrating your ability and desire to retaliate to
potential entrants and setting a product price that deters entry.
Because competitors may enter the industry if there are excess
profits, setting a price that earns positive but not excessive
profits could lessen the threat of new entry in your industry.

Perspective on Threat of New Entrants

The threat of new entrants has a unique twist in the
winery business. A winery is not an easy business to start
because it is capital intensive and market entry can take
multiple years due to licensing requirements and initial
production time for vineyards and wine. A strong
knowledge base is also required in order to make high-
quality wine and understand the complexities of the
industry. Thus, there are significant barriers to entry.

However, in at least one respect, competitors are
complementary for Indiana wineries. When several
wineries exist in close proximity, it becomes beneficial

for all wineries involved. People may not travel an hour
from home to visit only one winery, but they would view
the trip as worthwhile if they had the opportunity to visit
four wineries. This clustering effect enhances the
attractiveness and profitability of all wineries involved.

Barriers to entry in the local wine market are high due to
capital investments, licensing, and knowledge
requirements. However, having competition close to a
business does not necessarily have a negative effect on
the bottom line. Therefore, some industries may actually
encourage and support new entrants up to a point.

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1. How would a new entrant
affect your business?

Further Assessment
Using a pencil and sheet of paper, examine in greater detail how the threat of new entrants might affect your business.

2. What will your competitors
do if there is a new entrant
into your marketplace?

3. How will you respond to a
new competitor?

Self Assessment—Threat of New Entrants
respond with “Yes” or “No” in the space provided. “Yes” indicates a favorable competitive environment for your business. “No” indicates

1. Do you have a unique process that has been
protected? For example, if you are a
technology-based company with patent
protection for your research investments, you
enjoy some barriers to entry.

2. Are customers loyal to your brand? If your
customers are loyal to your brand, a new
product, even if identical, would face a
formidable battle to win over loyal customers.

3. Are there high start-up costs for your
business? The greater the capital
requirements, the lower the threat of
new competition.

4. Are the assets needed to run your business
unique? Others will be more reluctant to
enter the market if the technology or
equipment cannot be converted into other
uses if the venture fails.




5. Is there a process or procedure critical to your
business? The more difficult it is to learn the
business, the greater the entry barrier.

6. Will a new competitor have difficulty
acquiring/obtaining needed inputs? Current
distribution channels may make it difficult
for a new business to acquire/obtain inputs
as readily as existing businesses.

7. Will a new competitor have any difficulty
acquiring/obtaining customers? If current
distribution channels make it difficult for a
new business to acquire/obtain new customers,
you will enjoy a barrier to entry.

8. Would it be difficult for a new entrant to have
enough resources to compete efficiently? For
every product, there is a cost-efficient level of
production. If challengers can’t achieve that
level of production, they won’t be competitive
and therefore won’t enter the industry.






10 Purdue Extension • Knowledge to Go

Threat of Substitutes

What Products Could Your
Customers Buy Instead of Yours?
Products from one business can be replaced by products from
another. If you produce a commodity product that is undiffer-
entiated, customers can easily switch away from your product
to a competitor’s product with few consequences. In contrast,
there may be a distinct penalty for switching if your product is
unique or essential for your customer’s business. Substitute
products are those that can fulfill a similar need to the one
your product fills.

As an example, a family restaurant may prefer to buy the
packaged poultry produced at your plant, but if given a better
deal, they may go to another poultry supplier. If you grow
free-range organically grown chickens, though, and you are
selling to upscale restaurants, they may have few substitutes
for the product that you are providing.

Substitutes Can Come in
Many Forms
Be aware that substitute products can come in many shapes
and sizes, and do not always come from traditional competi-
tors. Pork and chicken can substitute in consumer diets for
beef or lamb. Aluminum beverage cans battle in the market
against glass bottles and plastic containers. Cotton competes
with polyester from the petroleum industry. Barnes and Noble
retail bookstores compete with Internet retailer Amazon.
Postal services compete with e-mail and fax machines.

When developing a business plan, it is critical to assess the
other options your customers have to satisfy their needs. To do
this, look for products that serve the same function as yours. A
threat exists if there are alternative products with lower prices
or better performance or both.

How Substitutes Affect the
Substitutes essentially place a price ceiling on products.
Market analysts often talk about “wheat capping corn.” This
occurs because wheat and corn are substitutes in animal feed.

If wheat prices are low, corn prices will also be low, because,
as corn prices rise, livestock feeders will quickly shift to wheat
to keep ration costs low. This reduces the demand and
ultimately the price of corn.

It’s more difficult for a firm to try to raise prices and make
greater profits if there are close substitutes and switching costs
are low. But, in some cases, customers may be reluctant to
switch to another product even if it offers an advantage.
Customers may consider it inconvenient or even risky to change
if they are accustomed to using a certain product in a certain
way, or they are used to the way certain services are delivered.

Factors Affecting the Threat of
Substitutes are a greater threat when:

• Your product doesn’t offer any real benefit
compared to other products. What will hold your
customers if they can get an identical product from
your competitor?

• It is easy for customers to switch. A grocer can easily
switch from paper to plastic bags for its customers,
but a bottler may have to reconfigure its equipment
and retrain its workers if it switches from aluminum
cans to plastic bottles.

• Customers have little loyalty. When price is the
customer’s primary motivator, the threat of substitutes
is greater.

Reducing the Threat of Substitutes
You can reduce the threat of substitutes by using tactics such
as staying closely in tune with customer preferences and
differentiating your product by branding. In some cases, the
advertising required to differentiate is more than one firm can
bear. In that case, collective advertising for an industry may
be more effective.

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Perspective on Threat of Substitutes

In the wine business, there’s a common misconception.
When considering substitutes, many would make the easy
assumption that the substitute for wine is beer. There are
many other options that need to be considered, however.
In addition to selling an alcoholic beverage, a winery is a
destination, an entertainment and educational source,
and a part of world history and culture.

There’s a saying in the wine-making business, “Taste the
experience of Indiana wine”—taste the wine, taste the
events, taste the education, etc.

Due to the diversification of offerings in addition to wine,
substitutes must be carefully considered and evaluated.
Competing against the other travel destinations for
limited customer leisure time is one of the biggest

In order to decrease the threat of substitutes in the
market and encourage customers, managers of Indiana
wineries must carefully consider these alternatives and
strategically address all the other options facing a
prospective buyer.

Self Assessment—Threat of Substitutes
This is a short scorecard to help you assess your business’ position in your marketplace. Read each of the following questions and
respond with “Yes” or “No” in the space provided. “Yes” indicates a favorable competitive environment for your business. “No” indicates
a negative situation. Use the insight you gain to develop effective tactics for countering or taking advantage of the situation.

1. Does your product compare favorably to
possible substitutes? If another product offers
more features or benefits to customers, or if
their price is lower, customers may decide
that the other product is a better value.

2. Is it costly for your customers to switch to
another product? When customers experience
a loss of productivity if they switch to another
product, the threat of substitutes is weaker.



3. Are customers loyal to existing products?
Even if switching costs are low, customers
may have allegiance to a particular brand. If
your customers have high brand loyalty to
your product you enjoy a weak threat of


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Rivalry Among Competitors

How Intense Is Your Competition?
Competition is the foundation of the free enterprise system,
yet with small businesses even a little competition goes a long
way. Because companies in an industry are mutually depen-
dent, actions by one company usually invite competitive
retaliation. An analysis of rivalry looks at the extent to which
the value created in an industry will be dissipated through
head-to-head competition.

Intensity of Rivalry Among
Rivalry among competitors is often the strongest of the five
competitive forces, but can vary widely among industries. If
the competitive force is weak, companies may be able to raise
prices, provide less product for the price, and earn more
profits. If competition is intense, it may be necessary to
enhance product offerings to keep customers, and prices may
fall below break-even levels.

Rivalries can occur on various “playing fields.” In some
industries, rivalries are centered on price competition—
especially companies that sell commodities such as paper,

gasoline, or plywood. In other industries, competition may be
about offering customers the most attractive combination of
performance features, introducing new products, offering
more after-sale services or warranties, or creating a stronger
brand image than competitors. In some cases the presence of
more rivals can actually be a positive—for instance in a
shopping area, where attracting customers may hinge on having
enough stores and attractions to make it a worthwhile stop.

Factors Influencing Rivalry Among
The most intense rivalries occur when:

• One firm or a small number of firms have incentive to
try and become the market leader. In some cases, an
industry with two or three dominant firms may
experience intense rivalry when these firms are
battling to achieve market leader status. In other
situations, when competitors with diverse strategies
and relationships have different goals and the “rules
of the game” are not well established, rivalry will be
more intense.

• The market is growing slowly or shrinking. When the
potential to sell products is stagnant or declining,

List possible substitutes that your customers
could use in place of your product.

How easy would it be for your
customer to consider this alternative?

How can you differentiate your products or build
customer loyalty to manage the threat of substitutes?






Further Assessment
Using a pencil and sheet of paper, examine in greater detail how the threat of substitutes will affect your business.

13 Purdue Extension • Knowledge to Go

existing firms are unable to grow their market without
taking market away from competitors. In this
situation rivalry is more likely.

• There are high fixed costs of production. When a large
percentage of the cost to produce products is
independent of the number of units produced,
businesses are pressured to produce larger volumes.
This may tempt companies to drastically cut prices
when there is excess capacity in the industry in order
to sell greater volumes of product.

• Products are perishable and need to be sold quickly.
Sellers are more likely to price aggressively if they risk
losing inventory due to spoilage or if storage costs are

• Products are not unique or homogenous.
Undifferentiated products (commodities) compete
mainly on price, because consumers receive the same
value from the products of different firms. Because
firms do not experience any insulation from price
competition, there is more likely to be active rivalry.

Perspective on Rivalry Among Competitors

Head-to-head competition is rivalry. For a winery, the
various interactions with competition create a dynamic,
multifaceted situation. It boils down to “how does a
winery compete for business.” Porter’s argument is that
the more businesses compete on price, the lower the
profit of the market.

The Indiana wine industry is similar in scope to other
industries. There are a handful of large wineries with the
majority of market share and many smaller wineries
rounding out the industry. There are currently 31 wineries
in the state selling 1.8 million bottles of wine per year.
A small winery would sell approximately 7,500 bottles
per year.

On a global scope, the wine industry is very competitive.
Wineries compete for shelf space and “share of mouth”
with regard to consumer tastes. In the state, however,
competition at the local level is important to the
industry’s success. A small winery competes for customers

through the winery tasting room, rather than on the
external retail shelf. This means the winery competes
against all other tourism destinations in the state offering
similar entertainment, not just the other Indiana wineries.

As a result, the overall quality offered to customers is
very important. The first purchase is generally based on
the look of the wine package and customer service. To
retain these customers for the long-term, product quality
is essential. Future purchases are based on consumers’
perception of taste, not just how nice the bottle looks or
the friendliness of the staff. A winery manager needs to
offer a total package that goes above and beyond what
others in the state are offering.

The Indiana industry is not saturated at this point. There
is still room for wineries to grow without having to
capture customers from direct competitors. The demand
is growing, offering opportunities for industry growth
without extreme rivalry. However, staying ahead of the
game—the rivals—is the key for future success.

• Customers can easily switch between products. Intense
rivalry is likely when customers in a given industry
can easily switch to other suppliers. In these
situations, the businesses in the industry will be vying
for market share.

• There are high costs for exiting the business. If
liquidation would result in a loss, businesses that
invested heavily in their facilities will try hard to pay
for them and may resort to extreme methods of

Reducing the Threat of Rivals
Threats of rivals can be reduced by employing a variety of
tactics. To minimize price competition, distinguish your
product from your competitors’ by innovating or improving
features. Other tactics include focusing on a unique
segment of the market, distributing your product in a novel
channel, or trying to form stronger relationships and build
customer loyalty.

14 Purdue Extension • Knowledge to Go

Self Assessment—Rivalry Among Competitors
This is a short scorecard to help you assess your business’ position in your marketplace. Read each of the following questions and
respond with “Yes” or “No” in the space provided. “Yes” indicates a favorable competitive environment for your business. “No” indicates
a negative situation. Use the insight you gain to develop effective tactics for countering or taking advantage of the situation.

1. Is there a small number of competitors?
Often the greater the number of players, the
more intense the rivalry. However, rivalry can
occasionally be intense when one or more
firms are vying for market leader positions.

2. Is there a clear leader in your market? Rivalry
intensifies if companies have similar shares
of the market, leading to a struggle for
market leadership.

3. Is your market growing? In a growing
market, firms are able to grow revenues
simply because of the expanding market. In a
stagnant or declining market, companies
often fight intensely for a smaller and smaller

4. Do you have low fixed costs? With high fixed
costs, companies must sell more products to
cover these high costs.

5. Can you store your product to sell at the best
times? High storage costs or perishable
products result in a situation where firms
must sell product as soon as possible,
increasing rivalry among firms.



6. Are your competitors pursuing a low growth
strategy? You will have more intense rivalries
if your competitors are more aggressive. In
contrast, if your competitors are following a
strategy of milking profits in a mature
market, you will enjoy less rivalry.

7. Is your product unique? Firms that produce
products that are very similar will compete
mostly on price, so rivalry is expected to be

8. Is it easy for competitors to abandon their
product? If exit costs are high, a company
may remain in business even if it is not

9. Is it difficult for customers to switch between
your product and your competitors’? If
customers can easily switch, the market will
be more competitive and rivalry is expected to
be high as firms vie for each customer’s








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Final Comment
Not all of these forces are equally important when assessing
the overall attractiveness of an industry. In some industries, it
is easy to gain entry, but very difficult to get out. Not surpris-
ingly, these industries tend to be mediocre investments.

A full-fledged industry analysis would require extensive
research, talking with customers, suppliers, competitors,

and industry experts. However, as a general overview, the
five forces concept provides entrepreneurs with an excellent
tool to examine the profit potential in a particular industry.
Gaining an understanding of the way in which each of the
five forces influences your profitability will provide you with
tactics for countering the strength of the forces.

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Agricultural Innovation & Commercialization Center
New Ventures Team
Center for Food & Agricultural Business

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New Ventures Team

Further Assessment
Using a pencil and sheet of paper, examine in greater detail how rivalry among competitors affects your business.

What business and growth
strategies does this competitor use?

How will this competitor affect
your business?

What actions will you take in response
to your competitors’ actions?









List your major competitors.

16 Purdue Extension • Knowledge to Go


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Learn how to assess how well a company’s strategy is working.
Understand why a company’s resources and capabilities are central to its strategic approach and how to evaluate their potential for giving the company a competitive edge over rivals.
Discover how to assess the company’s strengths and weaknesses in light of market opportunities and external threats.
Grasp how a company’s value chain activities can affect the company’s cost structure and customer value proposition.
Understand how a comprehensive evaluation of a company’s competitive situation can assist managers in making critical decisions about their next strategic moves.


How well is the firm’s present strategy working?
What are the firm’s competitively important resources and capabilities?
Is the firm able to take advantage of market opportunities and overcome external threats to its external well-being?
Are the firm’s prices and costs competitive with those of key rivals, and does it have an appealing customer value proposition?
Is the firm competitively stronger or weaker than key rivals?
What strategic issues and problems merit front-burner managerial attention?

Best indicators of a well-conceived,
well-executed strategy:
The firm is achieving its stated financial and strategic objectives.
The firm is an above-average industry performer.


Identifying the Components of a Single-Business Company’s Strategy


Growth in firm’s sales and market share
Acquisition and retention of customers
Strengthening image and reputation with customers
Increasing profit margins, net profits and ROI
Growing financial strength and credit rating
Leadership in factors relevant to marketindustry success
Continuing improvement in key measures of operating performance

Sluggish financial performance and second-rate market accomplishments almost always signal weak strategy, weak execution, or both.


Key Financial Ratios


Key Financial Ratios


Key Financial Ratios


Key Financial Ratios


Competitive Assets
Are the firm’s resources and capabilities.
Are the determinants of its competitiveness and ability to succeed in the marketplace.
Are what a firm’s strategy depends on to develop sustainable competitive advantage over its rivals.

A resource is a competitive asset that is owned or controlled by a firm
A capability or competence is the capacity of a firm to perform and internal activity competently through deployment of a firm’s resources.
A firm’s resources and capabilities represent its competitive assets and are big determinants of its competitiveness and ability
to succeed in the marketplace.


A Resource
Is a productive input or competitive asset that is owned or controlled by a firm (e.g., a fleet of oil tankers).
A Capability
Is the capacity of a firm to perform some activity proficiently (e.g., superior skills in marketing).

Resource and capability analysis is a powerful tool for sizing up a company’s competitive assets and determining if they can support a sustainable competitive advantage over market rivals.


Types of Company Resources

Tangible Resources

Physical resources

Financial resources

Technological assets

Organizational resources

Intangible Resources

Human assets and intellectual capital

Brands, company image, and reputational assets

Relationships: alliances, joint ventures, or partnerships

Company culture and incentive system


An Organizational Capability
Is the intangible but observable capacity of a firm to perform a critical activity proficiently using a related combination (cross-functional bundle) of its resources.
Is knowledge-based, residing in people and in a firm’s intellectual capital or in its organizational processes and functional systems, which embody tacit knowledge.

A resource bundle is a linked and closely integrated set of competitive assets centered around one or more cross-functional capabilities.
The VRIN tests for sustainable competitive advantage ask if a resource is Valuable, Rare, Inimitable, and Non-substitutable.


Identifying the firm’s resources and capabilities by testing the competitive power of its resources and capabilities:
Is the resource (or capability) competitively Valuable?
Is the resource Rare—is it something rivals lack?
Is the resource hard to copy (Inimitable)?
Is the resource invulnerable to the threat of substitution from different types of resources and capabilities (Non-substitutable)?

Social complexity (company culture, interpersonal relationships among managers or R&D teams, trust-based relations with customers or suppliers) and causal ambiguity are two factors that inhibit the ability of rivals to imitate a firm’s most valuable resources and capabilities.
Causal ambiguity makes it very hard to figure out how a complex resource contributes to competitive advantage and therefore
exactly what to imitate.


A company requires a dynamically evolving portfolio of resources and capabilities to sustain its competitiveness and help drive improvements in its performance.


A dynamic capability is the ongoing capacity of a firm to modify its existing resources and capabilities or create new ones by:
Improving existing resources and capabilities incrementally
Adding new resources and capabilities
to the firm’s competitive asset portfolio



Threats to Resources and Capabilities:
Rivals providing better substitutes over time
Capabilities decaying from benign neglect
Disruptive competitive environment change
Managing Capabilities Dynamically
Attending to the ongoing modification
of existing competitive assets.
Taking advantage of any opportunities to develop totally new kinds of capabilities.

SWOT Analysis
Is a powerful tool for sizing up a firm’s:
Internal strengths (the basis for strategy)
Internal weaknesses (deficient capabilities)
Market opportunities (strategic objectives)
External threats (strategic defenses)

SWOT analysis is a simple but powerful tool for sizing up a company’s strengths and weaknesses, its market opportunities, and the external threats to its future well-being.


Basing a company’s strategy on its most competitively valuable strengths gives the company its best chance for market success.


A Competence
Is an activity that a firm has learned to perform with proficiency—a capability.
A Core Competence
Is a proficiently performed internal activity that is central to a firm’s strategy and competitiveness.
A Distinctive Competence
Is a competitively valuable activity that a firm performs better than its rivals.

A competence is an activity that a firm has learned to perform with proficiency—a capability, in other words.
A core competence is an activity that a firm performs proficiently that is also central to its strategy and competitive success.
A distinctive competence is a competitively important activity that a firm performs
better than its rivals—it thus represents
a competitively superior internal


A Weakness (Competitive Deficiency)
Is something a firm lacks or does poorly (in comparison to others) or a condition that puts it
at a competitive disadvantage in the marketplace.
Types of Weaknesses:
Inferior skills, expertise, or intellectual capital
Deficiencies in physical, organizational, or intangible assets
Missing or competitively inferior capabilities
in key areas

A firm’s strengths represent its competitive assets.
A firm’s weaknesses are shortcomings that constitute competitive liabilities.


Characteristics of Market Opportunities:
An absolute “must pursue” market
Represents much potential but is hidden
in “fog of the future.”
A marginally interesting market
Presents high risk and questionable profit potential.
An unsuitablemismatched market
Is best avoided as the firm’s strengths are not matched to market factors.

A company is well advised to pass on a particular market opportunity unless it has or can acquire the competencies needed to capture it.


Types of Threats:
Normal course-of-business threats
Sudden-death (survival) threats
Considering Threats:
Identify the threats to the firm’s future prospects.
Evaluate what strategic actions can be taken to neutralize or lessen their impact.

What to Look for in Identifying a Firm’s Strengths, Weaknesses, Opportunities, and Threats


What to Look for in Identifying a Firm’s Strengths, Weaknesses, Opportunities, and Threats (cont’d)


Simply making lists of a company’s strengths, weaknesses, opportunities, and threats is not enough; the payoff from SWOT analysis comes from the conclusions about a company’s situation and the implications for strategy improvement that flow from the four lists.


SWOT Analysis Involves:
Drawing conclusions from the SWOT listings
about the firm’s overall situation.
Translating these conclusions into
strategic actions by the firm that:
Match its strategy to its internal strengths and
to market opportunities.
Correct important weaknesses and defend it
against external threats.

The Steps Involved in SWOT Analysis: Identify the Four Components of SWOT, Draw Conclusions, Translate Implications into Strategic Actions


What are the attractive aspects of the firm’s situation?
What aspects are of the most concern?
Are the firm’s internal strengths and competitive assets sufficiently strong to enable it to compete successfully?
Are the firm’s weaknesses and competitive deficiencies correctable, or could they be fatal if not remedied soon?
Do the firm’s strengths outweigh its weaknesses by an attractive margin?
Does the firm have attractive market opportunities
that are well suited to its internal strengths?
Does the firm lack the competitive assets (internal strengths) to pursue the most attractive opportunities?
Where on a scale of 1 to 10 (1 = weak and 10 = strong)
do the firm’s overall situation and future prospects rank?

Signs of A Firm’s Competitive Strength:
Its prices and costs are in line with rivals.
Its customer-value proposition is competitive
and cost effective.
Its bundled capabilities are yielding
a sustainable competitive advantage.

The higher a company’s costs are above those of close rivals, the more competitively vulnerable it becomes.
Conversely, the greater the amount of customer value that a company can offer profitably relative to close rivals, the less competitively vulnerable it becomes.


The Value Chain
Identifies the primary internal activities that create
and deliver customer value and the requisite related support activities.
Permits a deep look at the firm’s cost structure and ability to offer low prices.
Reveals the emphasis that a firm places on activities that enhance differentiation and support higher prices.

A company’s value chain identifies the primary activities and related support activities that create customer value.


A Representative Company Value Chain


Value Chain Analysis
Facilitates a comparison, activity-by-activity, of how effectively and efficiently a firm delivers value to its customers, relative to its competitors.
The Value Chain Analysis Process:
Segregate the firm’s operations into different types of primary and secondary activities to identify the major components of its internal cost structure.
Use activity-based costing to evaluate the activities.
Do the same for significant competitors.

A company’s cost competitiveness depends not only on the costs of internally performed activities (its own value chain) but also on costs in the value chains of its suppliers and distribution channel allies.


Industry Value Chain:
The firm’s internal value chain
The value chains of industry suppliers
The value chains of channel intermediaries
Effects of the Industry Value Chain:
Costs and margins of suppliers and channel partners can affect prices to end consumers.
Activities of channel partners can affect industry sales volumes and customer satisfaction.

A Representative Value Chain System


The Value Chain for KP MacLane,
a producer of Polo Shirts


Which activities in the value chain are primary activities? Which are secondary activities?
Which activities are linked to the value chain for the entire industry?
How could activity cost(s) could be reduced without harming the competitive strength of KP MacLane?
The Value Chain for KP MacLane,
a producer of Polo Shirts

A company’s cost competitiveness depends not only on the costs of internally performed activities (its own value chain) but also on costs in the value chains of its suppliers and distribution channel allies.


Benchmarking is a potent tool for improving a company’s own internal activities that is based on learning how other companies perform them and borrowing their “best practices.”


Involves improving a firm’s internal activities based on learning other companies’ “best practices.”
Assesses whether the cost competitiveness and effectiveness of a firm’s value chain activities are
in line with its competitors’ activities.
Sources of Benchmarking Information
Reports, trade groups, analysts and customers
Visits to benchmark companies
Data from consulting firms

Benchmarking the costs of company activities against rivals provides hard evidence of whether a company is cost-competitive.


Benchmarking and Ethical Conduct
Avoid discussions or actions that could lead to or imply an interest in restraint of trade, market and/or customer allocation schemes, price fixing, dealing arrangements, bid rigging, or bribery. Don’t discuss costs with competitors if costs are an element of pricing.
Refrain from the acquisition of trade secrets from another by any means that could be interpreted as improper, including the breach of any duty to maintain secrecy. Do not disclose or use any trade secret that may have been obtained through improper means or that was disclosed by another in violation of duty to maintain its secrecy or limit its use.
Be willing to provide to your benchmarking partner the same type and level of information that you request from that partner.
Communicate fully and early in the relationship to clarify expectations, avoid misunderstanding, and establish mutual interest in the benchmarking exchange.
Be honest and complete with the information submitted.
The use or communication of a benchmarking partner’s name with the data obtained or practices observed requires the prior permission of the benchmarking partner.
Honor the wishes of benchmarking partners regarding how the information that is provided will be handled and used.
In benchmarking with competitors, establish specific ground rules up-front. For example, “We don’t want to talk about things that will give either of us a competitive advantage, but rather we want to see where we both can mutually improve or gain benefit.”
Check with legal counsel if any information-gathering procedure is in doubt. If uncomfortable, do not proceed. Alternatively, negotiate and sign a specific nondisclosure agreement that will satisfy the attorneys representing each partner.

Places in the total value chain system for a firm to look for ways to improve its efficiency and effectiveness:
The firm’s own internal activity segments
The suppliers’ part of the overall value chain system
The forward channel portion of the value chain system.

Implement best practices throughout the firm, particularly for high-cost activities.
Eliminate some cost-producing activities altogether by revamping the value chain.
Relocate high-cost activities to areas where they can be performed more cheaply.
Outsource activities that can be performed by vendors or contractors more cheaply than if done in-house.
Invest in productivity enhancing, cost-saving technological improvements.
Find ways to detour around activities or items where costs are high.
Redesign products and/or components to facilitate speedier and more economical manufacture or assembly.

Implement best practices for quality for high-value activities.
Adopt best practices and technologies that spur innovation, improve design, and enhance creativity.
Implement the best practices in providing customer service.
Reallocate resources to activities having the most impact on value for the customer and their most important purchase criteria.
For intermediate buyers, gain an understanding of how the activities the firm performs impact the buyer’s value chain.
Adopt best practices for marketing, brand management, and enhancing customer perceptions.

Pressure suppliers for lower prices.
Switch to lower-priced substitute inputs.
Collaborate closely with suppliers to identify mutual cost-saving opportunities.
Work with suppliers to enhance the firm’s differentiation.
Select and retain suppliers who meet higher-quality standards.
Coordinate with suppliers to enhance design or other features desired by customers.
Provide incentives to suppliers to meet higher-quality standards, and assist suppliers in their efforts to improve.

Achieving Cost-Based Competitiveness:
Pressure forward channel allies to reduce their costs and markups so as to make the final price to buyers more competitive.
Collaborate with forward channel allies to identify win-win opportunities to reduce costs.
Change to a more economical distribution strategy, including switching to cheaper distribution channels.

Enhancing Differentiation:
Engage in cooperative advertising and promotions with forward channel allies.
Use exclusive arrangements with downstream sellers or other mechanisms that increase their incentives to enhance delivered customer value.
Create and enforce standards for downstream activities and assist in training channel partners in business practices.

Performing value chain activities with capabilities that permit the company to either outmatch rivals on differentiation or beat them on costs will give the company a competitive advantage.


Translating Company Performance of Value Chain Activities into Competitive Advantage


Translating Company Performance of Value Chain Activities into Competitive Advantage (cont’d)


Assessing the firm’s overall competitive strength:
How does the firm rank relative to competitors on each of the important factors that determine market success?
Does the firm have a net competitive advantage or disadvantage versus major competitors?

High-weighted competitive strength ratings signal a strong competitive position and possession of competitive advantage; low ratings signal a weak position and competitive disadvantage.


Step 1
Make a list of the industry’s key success factors and measures of competitive strength or weakness (6 to 10 measures usually suffice).
Step 2
Assign a weight to each competitive strength measure based on its perceived importance.
Step 3
Rate the firm and its rivals on each competitive strength measure and multiply by each measure by its corresponding weight.

A Representative Weighted Competitive Strength Assessment


A company’s competitive strength scores pinpoint its strengths and weaknesses against rivals and point directly to the kinds of offensive/defensive actions it can use to exploit its competitive strengths and reduce its competitive vulnerabilities.


The higher a firm’s overall weighted strength rating, the stronger its overall competitiveness versus rivals.
The rating score indicates the total net competitive advantage for a firm relative to other firms.
Firms with high competitive strength scores are targets for benchmarking.
The ratings show how a firm compares against rivals, factor by factor (or capability by capability).
Strength scores can be useful in deciding what strategic moves to make.

A good strategy must contain ways to deal with all the strategic issues and obstacles that stand in the way of the company’s financial and competitive success in the years ahead.


Strategic “How To” Issues:
How to meet challenges of new foreign competitors.
How to combat the price discounting of rivals.
How to both reduce high costs and prepare for price reductions.
How to sustain growth as buyer demand slows.
How to adapt to the changing demographics of the firm’s customer base.

Strategic “Should We” Issues:
Expand rapidly or cautiously into foreign markets.
Reposition the firm to move to a different strategic group.
Counter increasing buyer interest in substitute products.
Expand of the firm’s product line.
Correct the firm’s competitive deficiencies by acquiring a rival firm with the missing strengths.

Zeroing in on the strategic issues a company faces and compiling a list of problems and roadblocks creates a strategic agenda of problems that merit prompt managerial attention.