Porter’s five forces model

Exam rehearsal question – From September 2018

You are Hoi Lui, a management consultant leading a small team which has been commissioned to prepare a consultancy report for the Data Communications Services (DCS) Company directors to help them plan for the next three years. DCS Company has two product areas. The largest area is the manufacture of data communications components which it mainly sells to original equipment manufacturers (OEM). The other smaller and less developed area is based on supply and support contracts for specialist IT management network systems, mainly to domestic medium-sized enterprises. You are a qualified accountant and your colleagues are Danny Leman, a company researcher, and Freddie Lithium who is a part-qualified finance professional. You and your team have collected and analysed the following information about DCS Company to help you prepare the consultancy report.

Required:

From the information you have collated, draft a section of the consultancy report for the directors of DCS Company to include an analysis of the industry and market which DCS Company is competing in, using an appropriate model.

(15 marks)

Professional Skills marks are available for demonstrating evaluation skills relating to DCS Company’s environment and performance. (4 marks)

Exhibit:

Exhibit 1:

Organisational overview

Data Communications Systems (DCS), a publicly listed company on the small companies’ capitalisation (SmallCap) index of a national stock exchange, used to be a privately owned high technology company established in 1997 by computer engineer, Java Peraya. Due to a rapid expansion over the following years, DCS needed to source additional capital to fund its future growth and was floated on the national stock exchange in 2006. This allowed Java Peraya to realise his majority shareholding in the private company. 30% of the flotation was purchased by institutional investors and DCS also borrowed long-term funds to leverage the newly issued share capital. Before flotation, the company was almost exclusively financed from the founders’ share capital, retained earnings and short-term finance.

External environment

DCS has its headquarters in Prydain, a prosperous developed nation with a stable and well established political system and which has highly developed labour laws including a national minimum wage and a newly introduced obligatory contributory pension scheme. The government, like many governments worldwide, has invested heavily in a national telecommunications infrastructure which has led to a significant growth in social media and where virtually 75% of the population are connected to the internet through a range of devices including mobile technology. The government is also proposing a new carbon tax which will affect companies which manufacture and provide IT network services such as data communications components and systems. The electronics and IT industry has recently been identified as a sector with an increasing carbon footprint caused by their applications, such as component cooling devices, complex telecommunications network components and cloud computing technology. Although DCS Company can approximately estimate its total carbon footprint from the manufacture and supply of components from its factory, it has not yet developed formal systems and processes to manage its carbon footprint throughout the value chain.

Business model

DCS has two distinct product/service areas – data communications components manufacture and the supply and maintenance of network management systems, including technical support.

The DCS employees are a mixture of technically qualified engineers, working in research and development (R&D), factory staff manufacturing and assembling products and an IT sales and service support team. Since the flotation of the company, 60% of production employees in the data communications components factory joined a major trade union. In 2012 the country suffered an economic downturn which led many companies to postpone technological investment and by then DCS employed 150 full-time employees.

The main revenue source for DCS is the high-volume low cost data communications component manufacture part of the business and it has 1% of the total market share, which accounts for approximately 65% of DCS’s total turnover. DCS mainly sells and supplies large volumes of data communications components to original equipment manufacturers (OEMs), 30% of which are based outside Prydain on a continent which has a single currency which is devaluing against the Prydain dollar. Success in the data communications components sector comes from the economies of scale achieved by producing high volumes of reliable components and keeping prices low. DCS Company has achieved this despite producing components in a country where there is significant employment legislation setting minimum wage rates and conditions.

The second product area is much smaller and is based on supply and support contracts for specialist IT management network management systems, mainly to domestic medium-sized enterprises, which currently yields a relatively higher gross profit margin than the data communications component products. A key aspect of this second product area is the installation and support of big data analytics capability along with cloud computing storage, which can be used to replace existing costly IT architectures such as unsophisticated data warehouses to allow business clients to collect and analyse more targeted and timely data about their own customers and purchasing patterns. Much of this can be obtained from data held within social and business networking software.

Quote 4 from a sales support engineer:

‘We are rushed off our feet. Due to key staff leaving, our sales areas are getting larger and it is difficult to get around to all our customers. This means we have difficulty getting our orders in on time and are often late to appointments. Although sales productivity might be improving, because fewer of us are covering a greater geographical area, customers are not as satisfied as they used to be and are making more complaints.’ – 10% of orders delivered late in 2015.

Supplier:

DCS currently manufactures approximately 50% of all data communications components used in its own products.

The rest of the complete components, including semiconductors and microprocessors, are bought in from two multi-national global suppliers. These suppliers have since 2006 become the key players in the market through a succession of acquisitions and mergers, where previously there were many more suppliers, all with a much smaller market share. Recently, serious production problems have resulted from periodic component shortages from these key suppliers, creating significant delays in manufacturing, assembly and customer deliveries. One of our recently acquired OEM customers accounts for 40% of our sales in this area.

Labour:

For the supply and support of contracts for specialist IT network management systems, we are now finding it increasingly difficult and costly to maintain the required level of network support. It is getting harder to recruit high calibre staff to DCS.

Suggested Answer:

Introduction

The first part of this report analyses DCS Company’s market and the industry using the Porter’s Five Forces model.

Bargaining power of buyers

DCS is competing in two markets. In the data communications component market which is more mature and where it has less than 1% of the market share, it is a supplier of marginal significance, despite 65% of its gross profit or cash contribution being generated in this segment. Its customers in the neighbouring single market (30%) with its own currency are likely to demand low prices, high quality and reliability. They may not accept late delivery of orders. It appears that alternative sources of supply are readily available and that switching costs are relatively low. Multinational OEMs have significant bargaining power in this market, particularly the OEM which accounts for 40% of DCS’s current data communications component sales.

In the second market, where network management systems are supplied to mainly domestic, SMEs and a few larger companies, the buyers appear to have less bargaining power. DCS is catering for each customer’s specific needs and so each solution is, to some degree, a bespoke solution. This makes it much harder for buyers to compare products and prices of potential suppliers. Alternative sources of supply are much more difficult to find as there only three companies (including DCS) in this specialist marketplace.

The bargaining power of suppliers

Although DCS manufactures 50% of all components used in its data communications products, reducing its overall reliance on suppliers in this sector, it seems unlikely that DCS will be able to exert much influence on its suppliers, which provide the other 50%. As a relatively small player in the data communications market, the company does not have the power to exert buyer pressure on its two large suppliers, either in terms of price or delivery. Current problems associated with the delivery of components are having a significant impact on the company’s ability to meet customer deadlines and expectations.

Suppliers of financial capital, namely lenders, have gained more bargaining power as DCS has had to borrow more to sustain their recent growth.

If labour is seen as a supplier, then evidence again suggests that DCS is in a relatively weak position particularly since there has been a limited trade union membership since 2006. However, the union members are mainly in the data communications components division where employee remuneration and employment rights are already compliant with Prydain’s national employment laws. The scenario also indicates the difficulty of finding high calibre network staff with DCS’s small size and location making it difficult to attract the key personnel necessary for future growth in this sector.

Threats from new entrants

DCS is operating in an industry where the costs of entry are significant because it is capital and knowledge intensive. Economies of scale compel new entrants to enter at significant output levels or suffer a cost disadvantage. Furthermore, the need to offer comprehensive aftersales support, although a problem for DCS, does also create a significant barrier to new entrants. Finally, the exit costs and barriers such as industry-specific knowledge, skills and assets, reduce the attractiveness of the marketplace to new entrants.

Threats from substitutes

There is evidence that large, successful, high technology companies are particularly vulnerable to ignoring the challenge from disruptive new technologies which can replace the need for certain high technology products and services overnight. However, the relatively small size of DCS may give it a competitive advantage in its ability to respond quickly and flexibly to change, as long as it can attract the right calibre of expertise to achieve this.

Rivalry amongst competitors

Very different levels of competition are being experienced in the two market places DCS is operating in. It is clear that the high volume, low-margin component business offers intense competition with buyers who are able to use their size to extract favourable prices. DCS only has 1% of this market. The ability of DCS to generate better market share and volumes through product innovation in this market seems highly unlikely.

The intensity of rivalry in the network management systems sector is significantly less in this specialist market. DCS is dealing with a smaller number of large and medium-sized users, designing products specific to their needs. In Porter’s terms, DCS is adopting a focused differentiation strategy. In these low-volume high-margin markets, the emphasis has to be on increasing the volume side of the business, but at the same time making sure that they have the resources to attract and support new customers.

Conclusions

DCS needs to be aware of the dynamics relating to its market and industry, particularly the power of key customers and over reliance on two main suppliers. It must also be aware of and manage the threats from substitutes and new entrants in its two main business segments.

Marking scheme:

Up to four marks per element of Porter’s five forces affecting DCS. (Up a maximum of 15 marks in total)

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