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Risk of Entry

Force Two: The Risk of Entry by Potential Competitors

Profitable industries are like chum in the water for new competitors. The smell of money to be made will attract potential competitors to circle an industry, try to enter it and look for an easy meal. The only thing stopping a myriad of potential competitors from entering an industry are barriers to entry – a business version of a steel shark cage.

Profitable industries attract new market entrants – potential competitors. Potential competitors are companies that are not currently competing in an industry, but possess the ability to do so if they choose. Theoretically, if it cost nothing to form a company and enter an industry serving a profitable market, new firms would flood into that industry until the industry’s average profit margin shrank to zero. But we don’t live in a frictionless, theoretical world and different industries have wildly different levels of profitability. Barriers of entry are what discourages new companies from entering a profitable market and making a killing.

Barriers of entry benefit established companies within an industry by protecting them from new competition and preserving their profit margins. Low barriers of entry leave an industry wide open to new market entrants. The results to an industry with low barriers of entry are lower profits for the companies within that industry will inevitably result.

Therefore, established firms within an industry have great incentive to erect barriers of entry to keep the number of potential rivals to a minimum. Some barriers of entry are passive and a natural result of the industry’s operations. An example of this is economies of scale. But companies often take active steps to discourage new companies from entering their industries. Examples of this are when companies create brand loyalty or try to purposely raise their customers’ switching costs. The reason is simple – the more companies that enter the industry, the more difficult it is for the established companies to maintain their market share and protect their profits.

The risk of entry by potential competitors is a function of the industry’s profitability and the height of its barriers to entry. The higher an industry’s average profit margin, the more enticing it is for new competitors to jump into the fray and wrestle market share from the incumbent companies. High barriers to entry can deter potential competitors from trying to enter an industry and serve its market segments. The higher the cost of entry into an industry, the weaker the competitive force (the risk of entry by potential competitors) is and generally translates into higher average industry profits. Important barriers to entry include the following:

Capital Requirements – If it takes a great amount of money or assets to enter the industry, this can be a significant barrier of entry for firms who wish to enter it. Usually industries with high fixed costs have high capital requirements (i.e. factories, warehouses, computing assets…).

Economies of Scale – Economies of scale is where the companies in an industry enjoy diminishing per unit costs for their value propositions as the volume produced increases.

Brand Loyalty – Consumers often have preferences for the value propositions offered by established companies due to familiarity and reputation.

Absolute Cost Advantages – Other entrants cannot hope to match the established firms within the industry’s cost structure. Absolute cost advantages arise from three sources: 1) possessing unique and critical resources (patents, trade secrets, or accumulated experience), 2) control of particular inputs of production (i.e. fertile farm land, a prime piece of commercial real estate…), 3) access to cheaper funds because existing companies represent lower risks than new entrants.

Customer Switching Costs – High customer switching costs occur when customers resist spending the time, money and energy to switch from the current supplier of a value proposition to one offered by a different company, even though that alternative value proposition may be of greater value.

Government Regulation – Government regulations, and the lack of them, can be a significant barrier of entry for potential new entrants into an industry. An example of this would be environmental regulations placed on coal mining companies and their operations.

We will now dig deeper into how to identify and analyze these potential barriers of entry, and ultimately understand how they affect the competitive rivalry within an industry.

Capital Costs

Capital costs mean the startup costs of your business idea that must be incurred before you can commence operations. Basically, this is the total amount of money you need to spend (on equipment, employees, facilities, legal, accounting….) before you can hang your “Were Open!” sign in your shop window. For some asset intensive businesses, such as a full service health club or a golf course, initial capital costs can be extensive. For other businesses that use relatively few assets, such as an internet marketing business or a hotdog stand, initial capital costs can be relatively small.

For many aspiring entrepreneurs without a lot of financial resources, capital costs can be the most daunting barrier of entry of all. Many industries are able to maintain decent profit margins simply because the capital costs required to enter the industry are significant and insurmountable for many. Also, your time can be thought of as a capital asset too. Your investment of time in pursuing a business endeavor represents an opportunity cost on your part – you are giving up time that you could be working for someone else (and the income that entails) in exchange for pursuing your entrepreneurial ambitions. For example, it may take $100,000 and one year of full time work to create and open a business. If you had to give up a $50,000 per year job in order to pursue the endeavor, the real capital cost for you to start your business would be $150,000, not $100,000.

Another example of this would be opening a law practice. Legal services, in the United States, is a fragmented industry that has an average industry profit of 19.5%. This is a very attractive profit margin. Furthermore, the capital cost required to start a legal practice – purely from creating the actual legal services business – is relatively small. A lawyer needs a laptop, access to research materials, a place to meet clients, and some office equipment. This may cost as little as $10,000 in initial startup capital. But this does not represent the actual capital cost to start a law firm. To actually open a law firm and practice law, a lawyer would have needed to: 1) obtain a law degree (lets estimate $120,000), not work for three years while going to law school (lets estimate $150,000 for three cumulative years), get a state bar card ($3,500 for the test and the study course), and not work for three months while studying for the bar (lets estimate $12,500). Then, an only then, a lawyer could spend $10,000 on opening a legal practice. The real cost of this venture, both in absolute capital costs and opportunity costs, would be $296,000.

So the real capital cost of opening a law firm and practicing law (and being in an industry with an attractive 19.5% profit margin) may be at least nearly $300,000. This capital cost represents a serious barrier of entry to many people who would want to enter this industry, but balk at the $300,000 price tag that it requires.

  Level of Industry’s Barriers of Entry Level of Industry Competitive Rivalry Average Industry Profit Margin
High Capital Costs Higher Barriers of Entry Lower Industry Competitive Rivalry Higher Average Industry Profit Margins
Low Capital Costs Lower Barriers of Entry Higher Industry Competitive Rivalry Lower Average Industry Profit Margins

Key Questions:

  • What are the average total capital costs for entering the industry you proposing to enter?
  • Is the average profit margin for the industry you are proposing to enter enough to service the capital costs required from a typical new market entrant?

Economies of Scale

Economies of scale arise when unit costs fall as a firm expands its output. In other words, the more of a value proposition a company produces, the less per unit the company pays to produce those value propositions. Sources of scale economies include 1) cost reductions gained by efficiently creating a massed produced output, 2) discounts on bulk purchases of raw materials, and 3) cost benefits gained from spreading production costs and marketing and advertising over a large production volume. Some industries benefit greatly from economies of scale (i.e. the beer industry, the auto industry…). Other industries do not enjoy economies of scale much at all (i.e. nail salons, massage therapy, dry cleaners…).

The following are examples of economies of scale: 1) when the creator of a product gets bulk discounts on the purchases of raw materials for their products, 2) spreading fixed production costs over a large production volume, 3) cost reductions through mass-producing a standardized output, 4) cost savings associated with spreading marketing and advertising costs over a large volume of output. Most manufacturing industries, such as pulp and paper products or textiles, are examples of industries with economies of scale. If economies of scale are a factor in an industry, then many small producers are at a disadvantage because their per-unit costs will be higher than that of their larger competitors.

An industry whose rivals have significant economies of scale creates powerful barriers to entry for an aspiring new entrant to overcome. First, the established firms will have a substantial cost advantage over a new rival. Second, because high economies of scale imply high fixed costs (equipment, facilities), it is critical that these companies protect their market share at all costs. If their sales volumes decrease, this can render them incapable of sustaining their high fixed costs.

Companies, who try to match the existing industry competitors’ economies of scale, must enter the industry as a large producer to overcome this problem. But to do so, it must raise enough capital (to purchase the necessary assets and facilities) to match its competitors’ economies of scale. This becomes another barrier of entry in itself. Furthermore, if a new company enters an industry with a large capital investment (to match current industry competitors’ economies of scale), the increased supply of products the new company brings to the market risks depressing prices and may trigger a price war with established industry competitors.

  Level of Industry’s Barriers of Entry Level of Industry Competitive Rivalry Average Industry Profit Margin
High Economies of Scale Higher Barriers of Entry Lower Industry Competitive Rivalry Higher Average Industry Profit Margins
Low Economies of Scale Lower Barriers of Entry Higher Industry Competitive Rivalry Lower Average Industry Profit Margins

Key Questions:

  • Does the industry you propose to enter have significant economies of scale (where the per-unit costs for producing a good or service decrease significantly as the volume of production increases)?
  • Does the industry you propose to enter have high fixed costs (equipment, facilities, or significant R&D requirements)?
  • Do the suppliers of the industry you propose to enter give significant volume discounts and payment terms to large volume buyers?
  • Within the industry you are proposing to enter, do its company’s marketing and sales budgets increase, on a per unit basis, proportionally to sales of its value propositions, or do the costs of its company’s sales and marketing budgets decrease, on a per unit basis, with an increase in the sales volume of its value propositions?

Brand Loyalty

Brand loyalty is when consumers develop and hold a preference for a particular company’s brand of value propositions. Significant brand loyalty makes it difficult for new market entrants to wrestle market share away from the established industry brands. Examples of value propositions with strong brand loyalty are mass consumer products such as beer (Budweiser, Coors and Miller), soft drinks (Coca Cola and Pepsi), or tobacco products (Marlborough and Winston-Salem’s).

A company can also cultivate brand loyalty by developing innovative value propositions. Probably the most successful major company over the last decade that has leveraged innovative value propositions into brand loyalty has been Apple.

A venture may be able to sidestep an industry’s brand loyalty barriers of entry by entering the premium category of product markets. An example would be Dry Soda or small craft micro-brewers.

Significant brand loyalty makes it difficult for new entrants to take market share away from established industry brands. A company faces the daunting task of not only convincing consumers to buy its value propositions, but also to choose not to buy value propositions they already like and feel comfortable with.

  Level of Industry’s Barriers of Entry Level of Industry Competitive Rivalry Average Industry Profit Margin
High Brand Loyalty Higher Barriers of Entry Lower Industry Competitive Rivalry Higher Average Industry Profit Margins
Low Brand Loyalty Lower Barriers of Entry Higher Industry Competitive Rivalry Lower Average Industry Profit Margins

Key Questions:

  • Are the value propositions in the industry you propose to enter highly branded?
  • How strong is the brand loyalty in the industry you are proposing to enter?

Absolute Cost Advantages

Absolute Cost Advantages are when an established venture has an insurmountable cost advantage, meaning that new entrants cannot possibly hope to match the incumbent companies’ lower cost structure. Absolute cost advantages can arise from: 1) superior production operations and processes due to access to unique assets (i.e. patents, copyrights, or fertile farmland), 2) accumulated skill and expertise, 3) exclusive or relatively favorable control of their value propositions’ inputs (labor, materials, equipment, or management skill), and 4) access to cheaper capital due to their lower business risk when compared to a new market entrant. Also, access to superior distribution channels could be considered an absolute cost advantage. If established companies have absolute cost advantages, then the threat of entry as a competitive force will be weaker.

A new market entrant must be especially careful in attempting to directly compete with entrenched industry competitors that have absolute cost advantages. If a new entrant enters an industry where there are established competitors who have lower cost structures, the established firms can lower the price of their value propositions to eliminate the new entrant. This could erase any ability for the new market entrant to ever earn a profit. If this threat is credible, it can be a barrier of entry for new market entrants.

  Level of Industry’s Barriers of Entry Level of Industry Competitive Rivalry Average Industry Profit Margin
High Absolute Cost Advantages Higher Barriers of Entry Lower Industry Competitive Rivalry Higher Average Industry Profit Margins
Low Absolute Cost Advantages Lower Barriers of Entry Higher Industry Competitive Rivalry Lower Average Industry Profit Margins

Key Questions:

  • Do the major competitors in the industry you are proposing to enter possess absolute cost advantages? If so, will you be able to acquire these absolute cost advantages before you begin directly competing with them?
  • If the major competitors within the industry you are proposing to enter possess absolute cost advantages over your business idea, are there any steps or actions you can take to mitigate those absolute cost advantages?

Customer Switching Costs

Customer switching costs are the time, energy, and money necessary for them to switch from the value propositions offered by an established company to those of a new market entrant. If switching costs are high, customers will be unlikely to change even if the new product is superior to other market substitutes and alternatives. An example would be the switching costs associated with leaving the Microsoft Windows operating system or the QWERTY keyboard. Other value propositions in the market may be better/faster, but consumers often find themselves resistant to change because the time or hassle of switching to a better product or service proves prohibitive.

  Level of Industry’s Barriers of Entry Level of Industry Competitive Rivalry Average Industry Profit Margin
High Switching Costs Higher Barriers of Entry Lower Industry Competitive Rivalry Higher Average Industry Profit Margins
Low Switching Costs Lower Barriers of Entry Higher Industry Competitive Rivalry Lower Average Industry Profit Margins

 Key Questions:

  • In the industry you are proposing to enter, do the value propositions the industry produces have high switching costs? If they do, can you think of a way your business idea can mitigate this obstacle?
  • If the industry you are proposing to enter doesn’t typically have high switching costs, can you think of a way for your business to raise the switching costs for your proposed value propositions?

Laws & Regulation

Government regulations create politically and legally defined barriers of entry for many industries. Government regulations can increase barriers of entry for market entrants and potentially reduce competition. An example would be food safety regulations or anti-pollution laws. Also, in industries where economies of scale are a powerful force, the absence of regulations can lead to an intense concentration of market share in the hands of a few firms. This can create barriers of entry that are extremely difficult for a new market entrant to overcome. To sum up, high regulation within an industry usually leads to higher barriers of entry, but not always.

  Level of Industry’s Barriers of Entry Level of Industry Competitive Rivalry Average Industry Profit Margin
High Regulation Generally Higher Barriers of Entry Generally Lower Industry Competitive Rivalry Generally Higher Average Industry Profit Margins
Low Regulation Generally Lower Barriers of Entry Generally Higher Industry Competitive Rivalry Generally Lower Average Industry Profit Margins

Key Questions:

  • Does the industry you propose to enter require government licenses or strict adherence to statutory codes (construction, health care, lending money, real estate rental, restaurant & food preparation…)?
  • To what degree are the industry’s regulations beneficial to the incumbent industry competitors?

To Summarize

Below is a chart that summarizes how the six types of barriers of entry affects industry attractiveness from both the perspective of a new market entrant and an industry incumbent.

Barrier of Entry Factor

High

Low

Capital Requirements New Market Entrant Generally Unattractive for New Entrant Generally Attractive for New Entrant
Incumbent Industry Competitor Beneficial for Incumbents A Threat for Incumbents
Economies of Scale New Market Entrant Generally Unattractive for New Entrant Generally Attractive for New Entrant
Incumbent Industry Competitor Beneficial for Incumbents A Threat for Incumbents
Brand Loyalty New Market Entrant Generally Unattractive for New Entrant Generally Attractive for New Entrant
Incumbent Industry Competitor Beneficial for Incumbents A Threat for Incumbents
Absolute Cost Advantages New Market Entrant Generally Unattractive for New Entrant Generally Attractive for New Entrant
Incumbent Industry Competitor Beneficial for Incumbents A Threat for Incumbents
Customer Switching Costs New Market Entrant Generally Unattractive for New Entrant Generally Attractive for New Entrant
Incumbent Industry Competitor Beneficial for Incumbents A Threat for Incumbents
Government Regulation New Market Entrant Generally Unattractive for New Entrant Generally Attractive for New Entrant
Incumbent Industry Competitor Beneficial for Incumbents A Threat for Incumbents