Study of Software Industry Using Porters Five Forces Model free essay sample

Porter’s model supports analysis of the driving forces in an industry. Based on the information derived from the Five Forces Analysis, management can decide how to influence or to exploit particular characteristics of their industry. A strategic Business manager seeking to develop an edge over rivals can use this model to understand the industry context in which the firm operates. Software industry is a growing industry and there are many potential new entrants to the industry. A study of the Software industry using Porter’s five forces model provides key insights into the industry trends. The study provides key challenges faced by the industry, and throws up some great opportunities that are present in the industry. Overall, the studies done through this paper reveal that software industry is a great industry to get into, for those who have the capability to create opportunities out of challenges. Introduction Software Industry is considered to be a very profitable industry. This perception attracts many players to this field. Many of the new entrants to the industry do not do any scientific analysis before they get into the field. This some times result into failures and uncertainties in the industry. A lot of new entrants fail to correctly assess and analyse the competitive strength and position of the firm in this industry. Michael Porter’s (1980) famous Five Forces of Competitive Position model provides a very effective way of doing this assessment for any industry, and can be used in the software industry too. This paper does a detailed study of the software industry using Porter’s model and the findings will help new entrepreneurs and existing ones to arrive at the right strategies for being unique and addressing the competition. This paper attempts to analyse the software industry based on Porter’s five forces model. Literature Review Porters Five Forces No organization is an island unto itself. Its ability to thrive is affected by many factors, including its competition. Michael Porter (1980), of the Harvard Business School, has developed the five forces model to describe and analyze these factors. Apart from Porters Book Competitive Strategy: Techniques for Analyzing Industries and Competitorsâ€Å" in 1980, there are very many internet resources and articles which provide insight into the model. Some of them are www. themanager. org , www. businessballs. com, www. quickmba. com etc In this model, there are five competitive forces that interactively shape the dynamic environment of any industry. Rivalry Among Existing Firms All companies strive to improve their position with respect to their rivals. Companies use a variety of tactics to secure advantage; for example, product innovation and differentiation, patents, pricing, distribution systems, and advertising. In many industries, the use of one or more of these tactics by one company provokes a response by its competitors. Over time, this action-reaction dilemma can damage both the companies and the industry at large. This happened in the semiconductor industry: when one company began to build up production capacity for RAM (random-access memory) chips, the others followed suit, and the resultant overcapacity gave buyers an inordinate amount of leverage, precipitating a crash in prices. There are other factors that promote rivalry and competition: †¢Large increases in production capacity †¢Many competitors or relatively balanced competition †¢High exit barriers †¢Slow industry growth †¢High fixed costs Low switching costs Industries in which the competition is intense are often referred to as cutthroat, warlike, and bitter. The soft-drink industry is a well-known example of this. The more competitive the industry, the more difficult it is to generate profits. Threat of Potential Entrants New competitors in an industry bring with them additional resources and production capacity and a desire to gain market share. Their entrance can result in a collapse in prices, loss of suppliers, and increased costs (for example, in more advertising or a bigger sales force)—all of which reduce profitability. This has happened repeatedly in the discount department store sector, beginning in the early 20th century when the first â€Å"five-and-ten-cent stores† began to compete with smaller specialty shops. The likelihood of new entrants depends on the barriers to entry that are inherent to the industry and on the responses of the existing competitors. There are five major barriers to entry: a) Economies of scale In industrial economies, the most efficient level of production is called the minimum efficient scale (MES), which is the production level needed to achieve the lowest production costs. All industries have an MES. The higher the MES, the more production capability a new entrant must build in order to enter without an initial cost disadvantage. New entrants must then capture a share of the market proportional to their capacity or they will be at a long-term disadvantage. The bigger the market share they need to capture, the higher this barrier to entry is. One example of where it is extremely high is the automobile industry. b) Access to distribution channels In some industries, the distribution channels are controlled by existing companies through distributor contracts and preferred relationships. This can be seen in the light bulb industry, where the biggest manufacturers have exclusive contracts with the biggest retailers. New entrants will have to break into the current distribution system or find other alternatives. Both choices may be expensive, creating a high barrier to entry. c) Capital requirements Entering a new market can involve creating new capacity, aggressive advertising, acquisition of licenses, and so on. All of these activities require investment capital. The higher the capital needs, the greater the barrier to entry. An extreme case here is the building of jet aircraft, where even an established company can spend over a billion dollars (U. S. ) to bring one new model into production. d) Switching costs In some cases, entry into a new market can be achieved by retooling existing production machinery at relatively low costs. It is also possible, however, that the retooling costs are substantial, hence, a greater barrier to entry. Oftentimes, highly specialized capacity for which there is no alternative use must be created. This is a potential switching cost and constitutes another barrier to entry. Integrated circuit manufacturing equipment, for instance, cannot be used for anything else, while the machines used to make hardware and small metal parts can be reconfigured fairly easily. e) Cost disadvantages independent of scale Some industries have unique features that create high barriers to entry. These include: †¢Proprietary knowledge and patents not available to entrants †¢Access to raw materials limited to or controlled by existing firms †¢Favorable locations already secured by existing firms †¢Government regulations or subsidies †¢A relatively long learning/experience curve Similarly, barriers to exit make it difficult for firms to leave an industry. In industries that are difficult to exit, existing firms will tend to put more into the competition for retaining their market share than if they had an easy-exit option. Low Barrier to Entry Standard technology Low capital investment Low switching costs Little government restriction Fragmented or open distributionHigh Barrier to Entry Critical patents High capital investment High switching costs Considerable government regulation Controlled distribution Low Barrier to Exit Separate SBUs Incidental to core strategy Assets easy to sell Common technologyHigh Barrier to Exit Interdependent SBUs Part of core strategy Assets difficult to sell Specialized technology not applicable to other industries The Power of Buyers In some circumstances, the buyers or customers in an industry contribute to its competitiveness. Customers in competitive industries are able to force down prices, bargain for higher quality or more services, and play competitors against each other. Customers can exert significant pressure on an industry when †¢They have full information. They consider the products they purchase to be standard or undifferentiated. †¢The products are a significant portion of the buyers’ costs. †¢The products are unimportant to the quality of the buyers’ products. †¢The industry faces low switching costs. An industry that is severely limited by the power of buyers is pharmaceuticals: insurance companies, health maintenance organizations, and even governments (e. g. , through Medicare) limit their profits on prescription medications. The Power of Suppliers Suppliers also influence the competitiveness of an industry. Powerful suppliers can raise prices, restrict access to supplies, and lower the quality of supplies and services. If competitors are unable to pass along increased costs to their customers, their profits decrease. Suppliers are powerful when: †¢They pose a threat of forward integration. †¢Their product is an important input to the final product. †¢The industry overall is not an important customer of the supplier. †¢They are few in number and are more concentrated than their customers. †¢There are no competing substitutes. Their products are differentiated and/or the customers have significant switching costs. Suppliers are extremely powerful in the oil business, where a company that operates refineries but does not own its own wells is completely dependent on the producers. The Threat of Substitutes Usually, the firms in one industry are, broadly speaking, also competing with industries that produce substitute products. Substitutes can place a ceiling on the prices an industry can charge, thus limiting its profit potential. The more favorable the price/performance ratio of alternatives, the stronger the ceiling. Identifying viable substitute products is a matter of searching for other products that can meet customer needs. Some examples are: †¢High fructose /low calorie sweetener for sugar †¢LEDs for incandescent lights †¢Cellular phones for landline phones †¢Real estate investing for equity investing †¢Public transportation for automobiles All of these factors together shape the dynamics of an industry. After establishing how attractive an industry sector is, companies can then determine the key industry success factors, the investment needed, and the potential for return on those investments. Methodology First, the requirements and the nature of software industry were studied. The industry experience of the author of this paper came in handy for the study. Discussions were held with various experts in the industry. Various stages of setting up and sustaining a software industry were evaluated. Extensive study of already existing research was carried out. Various research information were considered while arriving at conclusions. A number of secondary sources are used in this paper Results and Discussion What are the threats of entry in this industry? Let us look at this with reference to the five aspects of †¢Economies of scale †¢Access to distribution channels †¢Capital requirements †¢Switching costs †¢Cost disadvantages independent of scale Economies of Scale Gerard Jackson (June 1998) argues that the concept of economies of scale do not apply to soft ware industry, simply due to the very nature of the industry where once we have invested in the development of the product the production costs are virtually nil and hence the economies of scale concept cannot be applied here. There of course are costs associated with packaging, shipping and marketing the product, but they are so minimal compared to the overall cost that the argument appears logical. So for the big players this is not an advantage at all. Any small player can threaten the big players, if they have the right brains behind their products. I do not consider this to be a serious entry barrier for new entrants to this field. Access to Distribution Channels Access to distribution channel is a big threat of entry in the software industry. The internet is a virtually free distribution channel available for any one to pump their products into. Any new entrant can have the same access as the big players to the distributions channels. However this is easily said than done for large software products like middle ware or operating systems, or huge data base management systems. Overall, this is not a serious barrier for new entrants. Capital Requirements The Capital requirements in this industry are of a different nature. According to the Reserve Bank of India (India’s Apex Bank) Notification (August, 1998) the working capital requirements of the software industry are basically the development costs. To quote their report â€Å"These products are prepared to meet standard requirements of end-users and are sold as packaged units comprising software manual and other user aids (tutorials). The development of these products involve fairly large scale investment, the return on which can be realised only after the product is fully developed and sufficient demand is generated therefore. By and large, no payment by the buyers would be involved at any stage of development and the developer would be receiving payments only when the products are purchased by interested buyers. In such cases, working capital requirements would be mainly for meeting expenditure such as salaries and expenses of the professionals associated with the development of the products. The period required for development would vary and, in some cases, may extend up to 24 months. â€Å" Depending on the scale of the proposed product, the new entrants would need to muster this capital requirement, and take the risk of success or failure once the product is launched. Hence this could be a high barrier Switching Costs Switching cost could well be the most important entry barrier for new firms into the software industry. Steve Kahl (Spring 2004) has done some extensive study on the switching costs related with Software industry. The total cost of ownership to implement a software package typically is much higher than the purchase price of software, sometimes as high as twelve times the price. Integrating software with the pre-existing technical architecture, changing business processes, training new users on the system, and maintenance costs for the software make it difficult for customers to replace software products. These high switching costs can lock customers in and increase the value of the installed base. As a result, the size of the installed base is an important performance measure for the software industry. The installed base, in turn, impacts competitive strategy. A firm such as Microsoft with a significant installed base may deter entry from new firms. Cost Disadvantages Independent of Scale include proprietary product technology, favorable access to talent and raw material, favorable locations, learning or experience curve etc. In the context of the software industry this could be a low barrier, since the software as a product is a function of the human intelligence and really one cannot make it proprietary, and history proves this where start up companies became giants in this field. To what threats of substitutes are you vulnerable in this industry? The threats of substitutes could be of a different nature in the software industry. There is always the big fight between patents and open source. But the major threat for software industry in this account is the threat of piracy. All major software players struggle with this and a lot of efforts and money is spent on preventing , detecting and acting on piracy. I would say that the industry has still not figured out the right and fool proof way of preventing this threat. The proliferation of piracy requires us to constantly re-evaluate how people can ensure they are getting the real thing when they see the Microsoft name, says Jackie Carriker, group manager of anti-piracy efforts for Microsoft (Microsoft press release Feb 2000). It seems we are in a perpetual cat-and-mouse game with counterfeiters. But hopefully these features will make it more challenging for would-be pirates to make a quick buck while making it easier for customers and resellers to differentiate between genuine and counterfeit software. Microsoft published data confirms this problem. To Quote Microsoft â€Å"Software piracy, or the illegal copying and distribution of software, is both an individual and a worldwide problem that takes a toll on the global economy. In 1998, software piracy caused the loss of more $11 billion in revenue worldwide, according to the Business Software Alliance (BSA). That same year, software piracy cost 109,000 jobs in the U. S. lone. There are currently approximately 2 million auction and warez sites pushing pirated or counterfeit goods, compared to 100,000 in 1997, according to BSA estimates. In short, software piracy is a problem for everyone at every level of the distribution channel from honest resellers to consumers. As per Douglas Heingartner (January, 2004) internet pirac y is the latest threat in software piracy, and organisations are struggling to bring this under control. To what pressures from suppliers are you vulnerable in this industry? This is probably an industry which is not too dependent on â€Å"suppliers† in the conventional manner. However, the right skill sets in employees could be treated as a major supply source. Sourcing the right employees and having strategies and policies which attract them to stay on, is a major challenge that every software industry player . The war of talent as it is called is all too well known. According to Steve Schifferes (January 2007) ,Nasscom, the Indian software industry association, estimates that by 2010, the Indian outsourcing industry could have $60bn worth of global sales, up from $23bn in 2006 and that would still only be 10% of the potential market. But if the industry is to triple its revenues, urgent action is needed now to increase the supply of skilled labour, Nasscom says. According to Mary Hayes Weier (February 2007) Accenture plans to increase its India staff this year by 8,000 people to 35,000, surpassing its U. S. employee base. IBM s India staff has jumped from 43,000 to 53,000 in six months, and it expects to continue growing at that pace. Both Infosys and Tata Consultancy Services are hiring about 2,000 people a month. At that pace, thats more than 35,000 new hires for these four companies alone the next six months, and dozens of other tech companies are rushing to add staff in India. So where will all this talent come from? Thats a question businesses should be asking their suppliers of India-based IT and business process services. The country still offers the best talent-to-price ratio of any place in the world, but suppliers admit its getting increasingly difficult to find and keep the right peopleespecially at the management level. To what pressures from customers are you vulnerable in this industry? Customers or clients as they are called currently in our industry, have a great power as they always have had. They have choices, they continue to ask for better quality at lower costs. More importantly they are asking the software vendors to add business value to their business. It is no more a sell and walk out policy. According to the Software 2006 Industry report put together by McKinsey Company, in collaboration with the Sand Hill Group, the entire eco system of software business is undergoing major changes and customers are driving that change aggressively. The report says, â€Å"Two major business models are vying for an growing share of software spend: Software as a Service and Open Source. Software as a Service (SaaS) has become increasingly relevant to both Enterprise and SMB customers and has the potential to impact the entire IT landscape. Although the market size for SaaS was relatively small ~$6 billion in 2005, it is poised to grow more than 20 percent annually. Several factors are driving this large shift in preferred model: vendors are seeking attractive annuity revenue streams, customers are pushing for more affordable and lower TCO alternatives to packaged software, and critical technology enablers like broadband wireless and universal access are coming online. SaaS has already gained traction in number of application areas – such as payroll, human capital management, CRM, conferencing, procurement, logistics, information services, and e-commerce) – and should make gains across a much broader cross-section of applications over the next 3 years.