EXTERNAL ASSESSMENT

EXTERNAL ASSESSMENT
INDUSTRY ANALYSIS

I. INDUSTRY TAXONOMY
A. The Problem of Classification

The most confusing aspect about industry analysis is defining what constitutes an industry in the first place. A development manager looking at the agricultural sector might define industries according to crops produced (e.g., rice, corn, coconuts, sugar) and regard all downstream activities as tributaries of those industries. A businessman in the food business might regard that same agricultural sector merely as the provider of ingredients to his culinary delights and define his enterprise to be in the restaurants industry. Within this food industry, businessmen might differentiate their companies as belonging to the fast food industry, or to the raw food wholesaling and retailing industry, or even to the gourmet industry. Still another group of food businessmen might be into the dehydration, pureeing or squeezing of various food products and identify themselves with the cereal, soup or juice industries. Some businessmen who buy agricultural crops might not even be in the food industry at all. For example, coconuts could be converted to cooking oil, soap, activated carbon, coir mattresses, handicrafts and a myriad other things which have nothing to do with food nutrition as such.

Industries could therefore be defined according to raw material supply sources (basic ingredients like crops or chemicals), according to intermediate products processed (like flour which can come from various crops like wheat, rice cassava) and according to end consumer usage (e.g., wallets, umbrellas, tables) or consumer satisfaction (e.g., relaxation, enjoyment).

Industries also include types of service establishments such as the hotel or hospital industries. A hotel may even refuse to define itself as being in the hotel business. It might prefer to be under the “leisure” industry classification especially if it is located in some tropical island complete with a golf course, sailboats, tennis courts, bowling alleys, health spas, fine restaurants and tourist sceneries. Certainly, that differentiation would be in stark contrast to a lodging motel which just provides nocturnal sleeping quarters sans all the frills and service amenities.

The classification of industries is important if one’s intention is to define who are the relevant customers, who are the competitors, what are the critical characteristics or attributes that make the industry tick and what are the expectations of the market as to the quality of products or service to be delivered. A business hotel, for example, would require specific services quite distinct from those demanded by the lodging or the leisure hotels. Consumer needs would simply be different.

In defining an industry, there would be also some difficulty in having a very broad or a very narrow scope of industry classification. On the other hand, defining an airline company as being in the broader transportation industry would not be as useful as classifying that company in the narrower airline industry. Trains and cars (or even boats) would not be considered competition at all by airlines if people are deciding about trans Pacific travel. On the other hand, narrowly defining an industry might have very limiting effects. For example, to simply classify all those using coconuts in their production process as being in the coconut industry per se might not be too useful. The reason is that most of the coconuts harvested are processed into coconut oil which is just one of the many substitutes in the fats and vegetable oils industry trade worldwide. In fact, while the Philippines controlled two-thirds of the world coconut oil traded in 1986, it only comprised 4% of the vegetables oil and fats trade. Classifying coconut oil into its own industry would make one erroneously conclude that it has a virtual monopoly position. However, classifying it into the fats and oil industry would suggest that coconut oil is just a minor player in the bigger scheme of things.

An Illustrative Industry Classification Process: Coconut

For purposes of illustrating an industry taxonomy process, let us continue to use the “coconut industry.” Classifying the coconut industry according to the tree crop itself is about the simplest one can go. Beyond that, the industry diverges into as many different taxonomies as there are parts of the coconut tree. The “tree of life” indeed has the potential for a thousand industries to bloom. However, given its present position as just one of the many substitutes in the fats and vegetable oils industry, it has become a sunset industry that has forsaken millions of Philippine coconut farmers to lives of relative and absolute poverty. In a way, one could hypothesize that the actual consumption of coconut products and by-products is still way below its full potentials. However, tapping those potentials might be easier hypothesized than done. There are problems of technology, problems of market and product development and problems of economics and financial viability in those potentials. The coconut industry has always been one of those "promising"” prospects that has somehow managed to remain just a promise.

Breaking down the coconut tree into its parts – the most commercially exploited is the fruit itself. The coconut meat from the fruit is dried into “copra” which is converted into coconut oil. It is also processed into dessicated coconut for use by the confectionary industry. As coconut oil, it is transformed into edible oil while its residue, copra meal, is used as feeds for livestock. The coconut oil is also used for soap making. Other applications of the meat include conversion into coconut milk which is used for cooking or for drinking purposes, especially if mixed with other fruit juices.

Coconut water can be drunk as “juice” or made into vinegar. The coconut shell is used as fuel either directly or converted into activated carbon. The husk is made up of fibers and dust. The former is used for coir and the latter for wallboards.

The coconut fruit can also be the ingredients for various chemical products including “coco diesel,” glycerine, etc. Last but not the least, the coconut meat is eaten as a tropical fruit or frozen into ice cream products.

The coconut tree trunk is used for construction and furniture, while the leaves are used for brooms, roofing, handicraft and the like.

The chemicals and materials extracted from coconuts comprise the ingredients for a host of other products too numerous to mention.

What this “dissection” of the coconut industry does is illustrate the complexities and potentials of the products derivable from the tree. Obviously, analyzing it as “an industry” by itself cannot find merit from the perspective of the end consumers who see the different coconut parts transformed into their final products. The “coconut industry” as such only becomes analyzable as a separate industry from the point of view of the farmers who rely on the coconut tree and the traders who exploit the marketing of its parts. It also becomes relevant as a separate industry to the Philippine coconut processors who have no alternative major sources of raw materials for oils and fats since the country does not really have coconut substitutes in large quantities like soybeans, palm oil, ground nuts, olive oil, and others. These are grown by other countries.

For the purpose of the industry analysis, coconuts are the main supply ingredients of the local coconut oil/soap manufactures but not so for the world market. Coconut are just minor supply ingredients for the world vegetable oils and fats industry. The two markets (local and international) would therefore have to be realized separately if one is to assess the demand and supply situation attendant to the “coconut industry.”


II. MARKET ANALYSIS OF AN INDUSTRY

A. Actual Supply and Demand Analysis
Measuring the demand and supply of any product is easiest when there are only a few manufacturers who can be monitored as to what they actually produce, how much of that production remains in their own inventory or in their distributors’ warehouse and how much they sell in any given period. With almost perfect information from these few manufacturers, there is a clearly definable supply (what is produced) and quantifiable demand (what is sold). When the producers experience excess inventory, there is an oversupply and when they experience stockout, there is an unmet demand or a demand supply gap. Using the often-used phrase of “ceteris paribus” or “all things being equal”, the manufacturers can plot their supply and demand conditions to project future requirements. (Care should be taken to make sure that wastage or losses are factored in to the computations). However, nothing ever remains equal. Tastes of consumers change. Substitutes come along. Economic cycles, booms and recessions alter the situation significantly. Competitors forge ahead technologically or close shop. All these change the demand and supply parameters.

If the manufacturers or producers are many, then it is more difficult to quantify the production and consumption of a product unless the consumers source most of the product through large wholesalers who funnel the goods through their warehouses. Then these wholesalers or “product funnel” can be used to measure the flow of goods from suppliers to consumers. Beyond these wholesalers, there may be large retailers (like supermarkets) who account for most of the products sales. Supply and demand monitoring can then be done through these large retailers.

Sometimes, the product’s production and consumption cannot be measured through any of the means cited above. The producers, distributors and consumers may just be too numerous to monitor. The next best thing is to conduct a survey of either producers or consumers or both and use extrapolation mechanism to estimate supply and demand. Survey and extrapolation techniques will not be discussed here. However, an example will be given. The producers of the product (like rice) are oftentimes concentrated in certain areas of the country. Agriculture production surveyors can focus on these areas, knowing that they account for a certain percentage of total production historically. The surveyors can interview farmers (who should be randomly selected) as to their yields, given the hectarages that they till. The weighted average yield of all the farmers interviewed could then be extrapolated over the estimated total hectarage planted to rice. The estimation of the total hectarage planted has to be verified also by physical survey and audit.

Next to be interviewed are the distributors both for verification purposes (as to supply of rice received) and to find out how much of the rice delivered to them got sold and how much was retained as inventory. Lastly, the end-consumers can be surveyed as to how much they have actually consumed. This is difficult because rice consumers may vary in their daily consumption but, on the whole, they can ascertain how many kilos of rice they have bought from the market over a certain period of time.

On a rapid appraisal basis, we can look at how rice prices have been moving vis-a-vis other commodities. If rice prices are rising faster than the others, then there would be a high probability of rice shortage. If prices are falling, then there may be a glut or over supply. As to what extent, the analysts can use past data (if available) of how prices moved in relation to shortages or gluts. Usually there is a pattern, provided of course that there are no price manipulators who are artificially restricting supply or distributors who are deliberately dumping goods in the market to drive prices down. (This is likely if competitors are being eased out of the market.) Unfortunately, in the Philippines, the large rice traders do control the rice market and have been known to resort to hoarding or dumping practices.

B. Potential Supply and Demand Analysis
Going beyond actual production and consumption, there is the need to measure potential supply and demand. A lot of creativity and critical thinking goes into this because the variables that effect supply and demand can be many.

To begin with potential supply, one could start looking at short run and long run production capacities and capabilities. Manufacturers may be operating at less than full capacity or farmers may not be selling all the available hectarage due to certain constraints. This undercapacity represents potential supply that could be harnessed. Additional supply can also come from new producers entering the industry. Sometimes, this information is known, sometimes not. The new ones would add to total capacity, and hence to supply. Supply potential could also be enlarged by the advent of new technologies. A process might be discovered that would reduce previous supply constraints (i.e., producers need lesser raw materials or incur less costs thereby encouraging them to manufacture more). More difficult to measure, potential supply can come from substitute products, especially those newly discovered.

Potential demand can be influenced by several key factors. The first is income. A rise in the income of consumers would increase their ability to consume more and might increase their demand. Some products experience faster increases in demand than the rise in consumer’s income. Some rise proportionately with income increase and some do not rise as much as income. Some products are even not consumed when income becomes very high. At the other extreme, certain products only get consumed when income is very high. This behavior of demand vis-à-vis income is known as the income elasticity of demand. The second factor that influences potential demand is price. Movements in the prices of goods affect demand in the same way income does. This is called the price elasticity of demand. A third factor that determines potential demand is “taste”, whether acquired through consumer sophistication or mass media advertisements, whether developed through improved product quality or reduced resistance. Technology, culture, fads and fashion all affect consumer tastes, therefore potential demand. A fourth factor is availability and accessibility of the product demanded due to sheer abundance, effective distribution systems and low cost (time, money and effort) of securing the supply. Pizzas delivered at your front door and ordered easily by telephone would increase the demand for the product. One product may suddenly experience high demand because the substitutes are made obsolete, banned or discredited. Thus, the status of product substitutes also influences demand.

Given the dynamics involved in assessing potential supply and demand, it would be naïve to say that there is one true figure in calculating the demand-supply gap. Many industry or market analysis fall into this convenient trap in their feasibility studies. Like economists who simplify their economic models by assuming “ceteris paribus”, which never happens, they jump to tenuous conclusions. Even if these analysis conduct sensitivity analyses to measure varying gaps, they do so mechanically by adding or subtracting percentage points from supply and demand without really analyzing the key factors that affect them. As they say, garbage in, garbage out. If the assumptions are faulty, then the conclusions are not worthy.

C. Product Substitutes and Market Implications
Going back to the coconut industry, its biggest setback is the presence of many substitutes, hence its rather volatile and unreliable performance. Its price is not determined by demand and supply in the Philippines but the demand and supply for vegetable oils and fats in the world. Leading the pack, in terms of production output, is soybean oil. In terms of world trade, Malaysia’s palm oil has the largest market share. A good or bad year of soybean harvest in the United States could send vegetable oil prices skyrocketing or plummeting. In fact, the prices of all vegetable oils and fats in the world are very highly correlated (i.e., They move in the same direction at roughly the same degree of downward or upward mobility).

In the long run, the competitiveness of the coconut industry is going to be eroded further by the rapid advances in bio-genetics which could dramatically change the productivity of soybeans. Being an annual crop, soybean farmers could well shift to better and better hybrids every year while coconut farmers are stuck with their trees for decades. The Philippines spends very little on research and development to do the farmers any good.

Obviously, if the Philippines merely relied on world trade to catapult the coconut industry back to its former years of plenty, the future would be dim. The answer seems to lie in for alternatives: 1) shifting away from coconuts; 2) maximizing the inter-planting of other crops and the raising of animals in coconut lands; 3) developing new but large markets for various coconut products; and 4) developing new commercial products out of coconuts. At this point, planting more and more hectarages of coconuts would not really save the Philippines from the threat of robust substitutes which would tend, in the long run, to wipe out their weaker competitors.

The stark lesson provided by the coconut industry highlights the importance of product substitutes and their demand-supply implications. For far too long, the government and the industry participants have neglected to confront the real issues quite apparent in the world marketplace. Instead, they have focused on internal bickering to solve what is basically an external problem.

D. Trend Analysis and Determination of Critical Variables
From the previous discussion, it is quite easy to conclude that the most critical variable determining the performance of the coconut industry is the status of soybean crop production in the United States. An industry analyst could very well concentrate on charting this variable and predict what would happen to the Philippine coconut industry.

For other industries, one should search for the variables that affect industry performance the most. The furniture industry, for example, relies on the level of housing investments made, which in turn relies on the availability of long term credit at low interest rates. The toy industry finds its biggest sales during Christmas while school supplies surge when schools open their semestral offerings. Ice cream sells on hot days and umbrellas on rainy days. If one were successful in isolating these variables and determining their impact on an industry, then one could easily make a forecast of the future.

Most trend analyses use historical data on which they apply mathematical models to come up with projects. The basic consumption is that the conditions of the past will remain valid for the future. Therefore, plotting past trends and trending into tomorrow becomes a mechanical exercise. The more astute industry analysts would examine the critical variables first and assess how they would vary. They would then try to estimate the degree of change such variations would produce. Finally, they would make a calculated guess. If the variations in the variables were not all that predictable or precisely quantifiable, the analysts could intuitively draw “freehand” projections, which might turn out to be more accurate than any sophisticated mathematical model.

E. Market Characteristics and Consumer Behavior
A vital component of industry analysis is to get a good profile of the industry’s markets. These markets can be industrial users or product/service consumers. They can be reached directly or through distribution channels.

Industrial users are those who utilize raw or semi-processed materials for conversion into other industrial products or consumer goods. Their purchasing patterns are highly determined by the availability of sufficient volumes at specified quality levels within an acceptable price range and time frame. Investment levels, technology adopted, production processes applied, people productivity and delivery efficiency are therefore essential to the industry that caters to industrial users. If they were deficient in these attributes, their competitiveness would be impaired in what is essentially a mass production game.

Product or service consumers are office and home-use buyers. They purchase in smaller quantities. Their quality needs and price sensitivities are affected by their purchasing power and their tastes. Their values, customs, mores, attitudes, interests and buying behaviors are watched carefully by market analysts. These factors may differ from country to country and even village to village. They may differ according to sex, religion or race. They swing from fad to fad and fashion to fashion. They are influenced highly by seasons of the year and particular dates of the month. In order to monitor these myriad factors, many producers of consumer goods or services conduct meticulous market studies of consumer behavior. They have to ensure that their products or services meet the grade as to the functionality, aesthetics and price parameters of the customers.

III. INDUSTRY STRUCTURE

Industry structure can be looked at from several points of view. One could determine its chain of products, tracing the industry from its most basic raw material down to its various consumer applications. We saw how this can get rather complicated in the coconut industry. The coconut tree divides into very many components (trunk, shell, meat, husk, leaves) that find their way to all types of products (edible oil, soap, handicraft, oleochemical oils, furniture, wallboards, coir, etc.) In the product chain the volume produced (or converted) at each link of the chain is determined.

Another way of tracing industry structure is through its value added and earnings chains. The two follow the product chain but concentrate on examining the money rather than the volume aspect. Value added from one stage of the product to the other is given by the market price differential between stages. The differential would include the additional costs of processing the product from one stage to the next and the profit margins slapped at each stage by the processor (or distributor).

A third way of analyzing industry structure is to focus on the business earnings of each participant in the product chain. Usually, those who control the economic “choke points” (i.e., where the demand and/or supply are primarily determined by the decisions of a particular participant in the industry) earn the most money. Earnings are defined here as the profit margins per transaction multiplied by the number of transactions during a given period of time. One group (say, farmers) may earn a lot per harvest when compared to the investment they made but the “velocity” or number of transactions per year may be low, resulting in poor annual income on the whole. Another group (say, traders) may earn a little per transaction when compared to investments made but the velocity of their transactions may be very high, leading to large returns on investments for the year.

A fourth method of industry structure analysis is to gauge the relative bargaining power and competitiveness of various participants in the industry. Within an industry, any one participant’s relative strength or weakness is dependent upon the power of importance of other forces affecting that participant.

According to Michael E. Porter [1] of the Harvard Business School, “the nature and degree of competition in an industry hinge of five forces: the threat of new entrants [to the industry], the bargaining power of customers [buyers and users], the bargaining power of suppliers, the threat of substitute products or services (where applicable) and the jockeying among current contestants.”


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[1] Michael E. Porter, How Competitive Forces Shape Strategy, Harvard Business Review.

Porter claims that the “essence of strategy formulation is coping with competition….. The corporate strategist’s goal is to find a portion of the industry where his or her company can best defend itself against these forces or can influence them in its favor.” He goes on to say that “knowledge of these underlying sources of competitive pressure provides the groundwork for a strategic agenda of action. They highlight the critical strengths and weaknesses of the company … clarify the areas where strategic changes may yield the greatest payoff…..”


The first force is the threat of entry of new competition. The higher the barriers to entry, the less competitive pressure on the industry and its players. There are six major barriers to entry: the cost deterrence of economies of scale; existing customer loyalties brought about by high product differentiation; the intimidating burden of large capital requirements; the built-in advantages provided by experience, proprietary technology, access to raw materials, subsidies, rights patents, et al; crowding out by closely-guarded distribution channels; and, regulatory impediments imposed by government.

The second force is the power of suppliers who can achieve greater bargaining power if they are: composed of a few companies (cartel); possess “unique” product characteristics; are not forced to compete with other products available to their buyers; can integrate forward as their own buyers; and have many other buyers aside from just one industry grouping.

Buyers’ power is the third force. They can be strong if: they procure in very large, concentrated volumes; they purchase undifferentiated products; the supplier provide only a small fraction of their input costs and which costs do not produce much savings for them; make too little money to get fleeced; the items that they purchase would not seriously affect their quality; and they can easily integrate backward.

Substitute products compose the fourth force. The more substitutes there are (in terms of both number and degree of substitutability) to any industry’s product, the lesser the industry’s competitiveness.

Lastly, there is the intensity of rivalry among existing competitors. The less the rivalry, the more “cartelized” and oligopolistic the behavior can become. Rivalry is a function of the presence of numerous competitors of roughly equal size and power. It is also influenced by: lack of differentiation (as in staple products); slow industry growth (leaving little room for maneuvering); high exit barriers (forcing many to keep on competing); chronic oversupply due to huge investments in large capacity increments; the need to sell the product fast (due to perishability); and personalities involved in the industry, their relationships, character traits and competitiveness.

Using Porter’s model, it would not be too difficult to see why coconut traders possess considerable power. The supplier (farmers) are many compared to a few traders. The farmers’ products are undifferentiated and have many substitutes. It is quite easy to enter coconut farming. The farmers have very few alternative markets for their products given their location, financial capabilities and indebtedness to the traders. What can increase the power of the farmers is if they could aggregate in associations or federations and find new alternative markets with cheap financing provided by government or other private sources. But this is easier said than done because the solution requires massive mobilization of people and resources.

IV. INDUSTRY STATUS
Industry analysis also entails an examination of its current condition, state of the art and various measures of performance. This analysis of the industry status could follow the following checklist:

A. Technology Levels and Processes Utilized

Within an industry there would be micro, small, medium and large enterprises employing various processes and different technology levels. In the food processing industry for example, the very small firms use pans and kettles and rely mainly on labor for many of the food preparation and packaging phases. As firms become bigger, larger steel-jacketed kettles are employed along with more mechanized processes of preparation and packaging. Finally, fully automatic and aseptic cleaning, slicing, grinding, pureeing and vacuum-packing technologies are adopted with minimal usage of labor.

B. Investments, Capital Intensity and Employment

The investments made, capital intensity and employment per unit of investment generated can be monitored to gauge new entrants, existing players and departees from an industry. Industry usage of fixed assets versus working capital and ability to generate jobs are other status parameters.

C. Operating Costs, Profitability Indeces and Efficiency Measures

The fixed and variable costs (total, percentage or unit costs) of an industry or firms within the industry (according to size or performance) can be evaluated to determine contribution margins and economies of scale. On profitability, various return measures like profits as a percentage of sales, of total assets, of fixed assets, of project investments and of equity can be made the basis of performance. Gross and operating margins can be evaluated. Discounted cash flow, internal rates of return or net present values in relation to cost of capital measures can be used. On gauging efficiency, capacity utilization, product input-output transformations (conversion and extraction rates), capital to sales ratios, wastage and reject levels, power consumption rates and others can be employed.

D. Product Quality, Attributes, Characteristics

The products of an industry can be classified and assessed according to their ability to meet local or international standards (quality specifications); attractiveness, taste and appearance, storage and shelf life; weight, size and shape; and other attributes/characteristics sought by the market.

E. Capital Structure and Financial Leverage

Different industries exhibit different capital structures and usage of financial leverage depending on business and other risks involved. Utilities, for example, usually have more debt than less predictable industries. The availment of various financing schemes like suppliers’ credit, short term credit, long term loans and preferred or common stock likewise vary from industry to industry.

F. Market Status and Sophistication

As discussed earlier, both the volume (supply and demand) and price trends of industries can be monitored. Consumer tastes, preferences, values, attitudes and interests are also important parameters of current market conditions.

V. STRATEGIC DIMENSIONS

The strategic dimensions and policy implications of industry analysis depend on the point of view taken. Top public officials may have to balance conflicting interests of farmers, traders, processors and other industry participants. What is needed by the macro-intervenor is a highly-developed sense of what is good for the many for both the present and the future. Sometimes, certain groups may lose out in the interim while a long term perspective is being taken. The greater problem actually lies in succumbing to immediate concerns without considering long run consequences. Opting for one strategy or another should be premised on the preferred development objectives (pro-agricultural versus pro-industrial, pro-equity versus pro-growth, pro-environment versus pro-exploitation) and on available resources, existing constraints, viability standards and potentials manifested.

Industry intervention at the strategic or policy level may have implications on other industries and sectors of the economy particularly if the industry has high linkages to others. This is true for the energy, chemical, machinery, equipment and food industries. Chain reactions and repercussions should be assessed to avoid creating problems greater than the solutions the strategic intervention sought to realize.

At the micro or business level of industry strategizing, there should be full appreciation of prevailing competitive forces and forthcoming scenarios in order to position the firm (or groups of firms) at a clear vantage point. Critical factors, such as market, technological and economic forces impinging upon the industry’s performance should be watched carefully. In the end, the industry battle may not even be won by the fittest today but the strategist who anticipates, creates and innovates for tomorrow.

VI. GUIDE QUESTIONS FOR INDUSTRY EVALUATION
In analyzing an industry, one can go through a few process questions that may be helpful in providing a deeper understanding of the industry, its logic, dynamics and directions.
A. Industry Definition

What business is the firm or the enterprise really in? How should we define its industry? What constitute the industry’s basic logic or essence? How does the industry survive and thrive?

B. Critical Thinking Questions

What are the relative magnitudes of the different market segments of the industry? Where are these magnitudes headed? Determine the actual and potential supply and demand for particular products or market segments.
What market segments in the industry would be the most relevant or appropriate for a particular industry participant given the objective of becoming a more viable competitor or collaborator?
What critical variables have the most important influence on the industry? Enumerate and defend.
In the immediate future, what are the most urgent concerns/prospects that an industry participant (or participants) must address in order to survive or prosper?

C. Problem Identification and Analysis, Risk Assessment

Define the issues,problems and confronting the industry. What are the causes or underlying factors behind them? How can they be overcome ?

D. Examine the traits and characteristics of the industry’s consumers or users. Trace and extrapolate any changes in behavior and preferences. What are the biggest opportunities and threats in the industry? How can one participant best tap those opportunities and overcome/prevent those threats?
F. Using the Porter model, evaluate the five industry forces that affect the bargaining power and competitiveness within an industry, taking the point of view of a particular manufacturer or distributor (or manufacturers/distributors).

Who has relative power? Relate this power to the performance of a participant (or participants).
Analyze and form conclusions. Where are the economic choke points?
G. Industry Status

Go to checklist provided in assessing industry status. What are the trends? What are your significant observations? What are your conclusions on the industry’s future prospects? Who will survive and who will die among the industry participants?