Porter Five Forces for Starbucks in India Essay Example

created by rivalry between established competitors, ultimately drives down the rate of return on invested capital toward what economists refer to as, “the industry floor rate of return,” which occurs when the market is perfectly competitive. (Grant, 2008, p. 69) The environment in which the specialty coffee industry had to compete during the late 1980s was made up of both product based competition and retail-based competition.

The product based competition was primarily with the basic coffee companies, who could attempt to enter the specialty coffee segment. Some of the larger basic coffee companies, who made most of their sales in grocery chains, could have responded to rapid growth in the specialty coffee industry by introducing their own upscale versions of already popular supermarket brands. (Koehn, 2005) These potential retaliatory threats were unlikely to materialize given the high risk an established, branded company would be taking by entering an industry with speculative growth prospects.

This conclusion follows based upon the much higher hurdle rates a major established company must surpass. Such established companies would have needed to achieve a far larger volume of sales than would a small company like Starbucks at that time in order to reap a sustainable and consequential profit margin. However, specialty coffee would have to confront product based competition from other non-coffee beverages, such as tea, juice, soft drinks, and alcohol. Harding, 2000)

In this context, specialty coffee was at an advantage because the consumption of most potentially competitive substitute products was declining relative to specialty coffee during the late 1980s. (Harding, 2000) The retail-based competition was divided between flavored specialty coffee retailers and non-flavored specialty coffee retailers.

Flavored specialty coffee came in a variety of flavors including hazelnut, amaretto, raspberry, pumpkin spice, and others that were infused into the coffee beans during the roasting process.

Although Starbucks offered its coffee in a variety of flavors, they never used flavored beans, instead adding concentrate syrup to the brewed coffee, because adding flavor to the beans themselves violated Starbucks’ definition of specialty coffee and, in their view, would degrade the quality of the Arabica beans. (Schrage, 2004) As defined by Starbucks, specialty coffee 10 has no defects and has a distinctive flavor originating from the microclimates in which the beans were produced. (Schrage, 2004)

Roughly 25% of all specialty coffee sold in 1987 was flavored. Schrage, 2004) Because the industry rivalry which existed within the specialty coffee industry consisted of differentiating a product that was once considered a commodity and involved many differences in both flavoring techniques and presentation, the consumption of specialty coffee was rather inelastic, or insensitive to price fluctuations. This presented an environment in which price wars would not be prevalent. Furthermore, the budding state of the specialty coffee industry meant competition was limited and small in scale.

The last environmental factor affecting the nature of industry competition during the era of Starbucks’ founding was the market growth rate, which for retail specialty coffee was 6% in North America in 1987. (Specialty Coffee Association of America, 1988) Potential for new entrants The second force in Porter's model, which will be applied to the analysis of the industry environment in which Starbucks was incubated, is the potential for new entrants. The primary deterrents to new entrants into any industry

are the barriers to entry.

The higher the barriers to entry are within any given industry the smaller the threat of new entrants to that industry. (Porter, 1998, p. 7) The specialty coffee industry does not put a high premium on economies of scale. Although, companies with national distribution in the coffee industry at large experienced some discounts through bulk purchases and superior infrastructures, their advantages were small. This alone would imply low 11 barriers to entry in the specialty coffee industry. However, to make a thorough analysis, the other factors determining the total scale of all the barriers to entry combined must be considered.

Products within the industry were greatly differentiated, with varying degrees of quality, convenience, customer service, and differences in the atmosphere and ambience of the retail stores. The high differentiation within the specialty coffee industry made it possible to establish brands that could act as barriers to entry. Since most capital requirements within the specialty coffee retail industry were fixed costs, including the leasing of property, construction of roasting plants, and specialized equipment, the switching costs imposed on competitors within the industry were quite high.

The basic coffee industry had created a barrier to entry by limiting the access to distribution channels through the use of exclusive contracting with grocery stores but this was not the case in the specialty coffee industry, where distribution was done primarily through retail outlets owned by the specialty coffee producers. These more transparent barriers to entry suggest neither high nor low barriers to entry in the specialty coffee industry and force us to examine the less transparent barriers to entry.

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cost advantages can be independent of scale and may be gained by establishing one's position in an industry early. These can be referred to as first mover advantage. Some of these advantages come from proprietary product technology, favorable access to raw materials, favorable locations and a learning or experience curve. (Grant, 2008, p. 9) Those firms which established themselves early within the specialty coffee industry obtained access to the highest quality Arabica coffee beans, built in the most favorable locations and learned quickly the delicate balance between quality and 12 customer convenience.

Since, there was no established retail specialty coffee organization within the United States, the potential for a retaliatory act against a new entrant was insignificant. Cumulatively, the barriers to entry seem high in the specialty coffee industry in the late 1980s due to high product differentiation, high specialized capital requirements, high switching costs and disadvantages to new entrants in the form of limited access to premium Arabica coffee, limited choice of locations and a moderately steep learning curve.

However, all of these barriers to entry required other firms to be established within the specialty coffee industry, which was not the case in the late 1980s, leaving the industry vulnerable to new entrants despite the potentially high barriers to entry. Substitute Products Another force which acts upon an organization and is included in Porter's five forces model is the threat of substitute products. The primary substitute products posing a potential threat to specialty coffee were the caffeinated soft drinks produced by Pepsi and Coca-Cola.

Competitors like Pepsi and Coca-Cola offered beverages, which had the caffeine inherent in specialty coffee, at significantly

lower prices. (Quelch, 2006) However, there existed large differences in taste and the demographic makeup of consumers between the two products; thus, consumers were unlikely to directly substitute coffee for caffeinated soft drinks or vice versa. The only true direct substitute for specialty coffee available was basic coffee; however, basic coffee was considered to be of 13 significantly lower quality than specialty coffee.

As a result, it actually presented the industry with little threat of substitution. Bargaining Power of Buyers The bargaining power of buyers also plays an important role in determining the desirability from an investor’s standpoint of the environment in which the specialty coffee industry existed at inception. The force of the buyer’s bargaining power is proportional to the ability of buyers to force down prices, bargain for higher-quality products or more services, and pit rival organizations against one another. (Porter, 1998, p. 4) In the specialty coffee industry, individual consumers constituted the majority fraction of all buyers; therefore, they didn’t typically buy in large volumes and did not act in concert. Both of these factors reduced the relative bargaining power of buyers in this industry. In addition, the cost of buying a cup of specialty coffee did not represent a significant fraction of any individual buyer’s cost of living, reducing the tendency for price shopping and increasing the emphasis on quality and customer service.

One of the primary differences between the basic coffee industry and the specialty coffee industry is the amount of differentiation involved in the specialty coffee industry and the lack of differentiation in the basic coffee industry. This further dilutes the bargaining power of buyers through the

brand premium that specialty coffee retailers demanded. As stated earlier, the largest purchasers of specialty coffee are individual consumers, who face no switching costs. Specialty Coffee Association of America, 1988) This increases their bargaining power. Lastly, the buyer or consumer in the 14 specialty coffee industry does not have full information. The consumer does not know the actual demand, market prices or supplier costs which greatly reduces their bargaining power. Overall, then, the bargaining power of the buyers or customers of the specialty coffee industry, which consisted largely of individual consumers, was not substantial. Bargaining Power of Suppliers

As with any commodity suppliers, the bargaining power of suppliers to the specialty coffee industry would be exerted by either threatening to raise the price of the Arabica beans which are used in the production of dark roasted coffee, or by a threat of reduction in the quality or quantity of the coffee beans themselves. The suppliers of Arabica beans were mostly small to medium-sized family owned farms and typically sold their crops to processors through local markets. (Lee, 2007) Primarily, these farms were located in Latin America, the Pacific Rim and East Africa. Lee, 2007) These farms were numerous and unrelated to one another, with no unionization, giving them very little collective bargaining power. Although there was no direct substitute for the Arabica beans used in the production of specialty coffee, the vast array of farms which supplied the crop made it easy for buyers to avoid obligations to any particular farmer, which again eroded the bargaining power of suppliers. The farmers who produced the Arabica beans sold exclusively to specialty coffee retailers and as

such were dependent upon their sustained business.

In spite of all of the stated reasons which suggest the specialty coffee industry is one where the bargaining power of suppliers is severely hindered, the most important 15 ingredient in specialty coffee is quality Arabica beans. This allows for differentiation to occur between the numerous suppliers farms based upon the quality of beans they produce. This, in turn, should substantially increase their bargaining power as suppliers. Summary: The Five Market Forces in Specialty Coffee in 1987

Having applied Michael Porter's five forces model to the specialty coffee industry environment which confronted Starbucks Corporation in 1987, a conclusion can be logically derived in regard to the proportional effects of each of the forces on the competition within the specialty coffee industry. Namely, it can be concluded that the force created by industry rivalry resulted in an environment in which competition was grounded in strategies of differentiation and focus, while discouraging price wars.

Furthermore, the strongest of the four forces acting on the specialty coffee industry was that of potential new entrants given the existence of established firms in North America. The bargaining power of both suppliers and buyers was negligible due primarily to the small purchasing volume each individual had to offer the specialty coffee industry. The threat of substitutes was similarly insignificant given the declining sales of carbonated soft drinks as compared to coffee and, specifically, specialty coffee.

Knowing the kind of environment in which the specialty coffee industry originated, and the power each of the five forces exerted on it, an assessment of the industry attractiveness as a whole can also be

made. 16 Specialty Coffee Industry Attractiveness The most attractive industry for any profit maximizing firm within a capitalistic society would be one in which they can have a pure monopoly. In economics this refers to situations in which one established firm can be the sole provider of a product or service in a particular market segment. Grant, 2008, p. 67) Industries in which monopolies are created characteristically have a lack of economic competition for the goods or services that they provide and typically have no viable substitutes. This theory of monopoly would be one end of the industry attractiveness scale, while the other endpoint would be defined by the theory of perfect competition. (Grant, 2008, p. 68) This theory describes an economic model which uses a hypothetical market form where no one producer or consumer has any market power or ability to influence pricing.

The environments in which perfect competition materializes are characterized by a multitude of established firms with identical products and very little ability to differentiate their product. (Mankiw, 2007) It is also typical in environments where all of the forces acting upon the industry are of large magnitude. As a collective society, perfect competition is desirable given its efficiency in allocating resources and ability to maximize social welfare.

However, this forms the opposite point on our industry attractiveness scale because it is the most undesirable position from the standpoint of a profit maximizing firm. This scale will help us to define the attractiveness of the specialty coffee industry in relation to these two extremes. The five forces analysis of the specialty coffee industry has allowed us to identify some of

the key structural characteristics of the main players in 17 the industry, such as the buyers, suppliers, potential new entrants, potential substitutes and rivals within the industry.

These key structural characteristics suggest that the forces exerted by these five players on the specialty coffee industry initially made it ideal for a situation to develop in which the industry structure was closer to the monopoly end point on the scale of attractiveness rather than the pure competition end point. The primary competition among rivals within the industry was not price oriented; the buyers of specialty coffee and the sellers of Arabica beans had little bargaining power at their disposal; and there existed no true substitutes for specialty coffee.

The strongest force acting on the industry was that of the potential new entrants, which could be mitigated by a first mover firm if it was able to establish dominant brand recognition, successfully expand aggressively and create a defendable differentiated product. Therefore, placing the specialty coffee industry at its inception in the late 1980s on the scale defined above is now possible and it appears to reside closer to the monopoly end of the scale than perfect competition, making it a very desirable industry from the standpoint of a profit maximizing firm such as Starbucks.

However, where the specialty coffee industry is placed in respect to a pure monopoly and a perfectly competitive market is not the only determinant in the absolute attractiveness of the industry. The second important factor influencing the attractiveness of an industry is the demographic makeup of the consumer base. In 1987, the average American consumed 2. 3 cups of coffee

per day, which led the world in coffee consumption. (Lee, 2007) This added to the attractiveness of the industry by providing an enormous pool of potential customers.

Specialty coffee consumption as a percentage of total coffee consumption in the United States had been growing at a rate of roughly 3% per year from 1985 to 1987. 18 (Koehn, 2005) This illustrates the beginning of what became an enormous shift in consumer preference from the basic packaged coffees to the specialty coffees. The majority of customers who purchased their coffee from one of the five Starbucks operating in 1987 had a college degree, were male and over the age of 35.

In addition, on average, the typical customer had an income over $50,000 and consumed 19 cups of coffee per week, both at and away from home combined. (Quelch, 2006) These two factors also play a significant role in determining the attractiveness of the industry because they show that the average customer of the specialty coffee industry has more financial resources, education and consumes more coffee than the typical American. This implies a consumer base that is more flexible to price fluctuations and is less likely to fuel discounting among rival competitors, or a price war.

Both Michael Porter's five forces analysis of the specialty coffee industry and the demographic makeup of the consumer base, then, suggest an extremely attractive industry with large growth potential in the late 1980s. An appropriate question at this juncture is, why a firm hadn’t established a position in the specialty coffee industry given its level of attractiveness? The answer, although simple, is that specialty coffee represented a

small fraction of total coffee consumption as compared to what it represents today, especially ready to drink specialty coffee. Koehn, 2005) Knowing why no firm had established a position in the specialty coffee industry and understanding the key structural characteristics and demographic qualities of the industry allows us to identify the ideal business strategy. The objective of any firm trying to dominate or monopolize the specialty coffee industry would be to create defendable 19 sources of competitive advantage through the use of barriers to entry and a horizontal or organic hierarchy that could outpace competition in innovation.

Results of the five forces analysis would suggest, given the unlikely prospect of a price war and the negative repercussions of one, that price superiority alone would be an ill-advised approach. As stated earlier in this analysis, the specialty coffee industry has the potential for high barriers to entry but lacks them due to the industries immature state and the presence of no established firms.

An ideal strategy would involve a firm establishing themselves in a rapid manner through an aggressive growth strategy. In addition, another barrier to entry could be created through brand recognition for high quality standards, coupled with a variety of specialty coffees. Lastly, the ideal business strategy, which would take maximum advantage of the state of the specialty coffee industry in 1987, would cater to its high income well educated consumer base.

This could be done by implementing a price premium well above the cost of the specialty coffee, thus, taking advantage of the consumer base’s price elasticity and desire for world-class quality coffee. Providing exceptional customer service would reinforce this

strategy. Understanding the characteristics of the appropriate competitive strategy for the specialty coffee industry as it existed in the 1980s, then, allows a comparison to be drawn to Starbucks’ original generic strategy.