Understanding Market Shares & Business Models

We briefly described the competitive landscape of a company in the section on ‘How Industries Work’.
In this section we look at how market competition shapes up a company’s strategy, what is a business model and the role a strong model plays in a company’s success.

Understanding market shares: Why competition matters

Market share is described as the proportion of the overall industry sale in rupee terms that a company accounts for. It is a direct function of the extent to which a company is able to satisfy the needs of its customers. This is because there are a lot of companies in the market that produce similar products and earn their revenue from the same customer community. The one who is able to satisfy customer needs the best ends up with the largest market share.

Customers look for value maximization when they buy a product. In other words, they choose a product depending upon what it offers them in addition to other similar products produced by other companies. The revenues of a company therefore, depend on the incremental value it can offer its customers over other companies. Value may be offered in the form of lower prices, better features, faster delivery, more variants of the product and so on. Companies compete constantly for one-upmanship along these parameters.

Some of the tactics they use to increase market share are

  • Discounts and free gifts
  • Additional features or better quality for the same price
  • Better delivery terms
  • New variants
  • Increase in the quantity offered
  • Better after sales service
  • Increased warranty
The competition for market share can prove to be highly depleting for companies. It leads to a shrinking of their profit margins as they are forced to cut prices and offer more privileges to customers. They are also compelled to spend extensively on advertising, research and operational improvements. Competition is at its worst when companies choose to compete over prices, according to Michael Porter, a renowned marketing expert. This is because lowering prices directly transfers money from the company to its customers.

How intense the struggle for market share is is also defined by the nature of competition in the industry. Higher the number of competitors, more intense will the struggle be. Competition is the most grueling under perfect competition. Here, there is a multiplicity of firms that offer the same product. This makes the customer indifferent between buying it from different customers.

Following are some of the characteristics that help determine the intensity of competition in a market:

Factors Determining the Intensity of Market Competition

  • Nature of product :

    When competitors offer products that can be used interchangeably, the struggle for market share is the highest. In such cases, customers don’t have many reasons to pick one product over the other and it is the minutest of differences in price and characteristics that shape their choices.

  • Market size :

    Market competition is more intense when there are very few customers in the market and the revenue earned from each of them is high. This generally happens in case of industrial goods (i.e. goods produced for other companies and not final consumers). Such goods, like machinery, are worth a lot of money and have few potential customers. Companies who sell such products try aggressively to acquire these customers because they are hard to come by.

  • Barriers to entry :

    Entry barriers refer to the restrictions on new companies from entering the industry. These restrictions may be in the form of high investment requirements, stringent government regulations and economies of scale (i.e. the requirement to maintain a very high level of production to reduce per unit production cost) etc. New companies bring innovation. Restricting their entry blocks this innovation. This limits market competition to only companies that have existed for a long time. Thus, low entry barriers result in higher market competition and vice versa.

  • Switchover cost :

    Switchover cost is defined as the cost of shifting from one company’s product to another’s. It can be in the form of installation cost, training cost, cost of purchasing new accessories etc. The higher this cost, lower is the incentive for customers to shift from one product to another. This increases market competition because companies know that once they acquire a customer, the switchover cost will make it hard for him to shift to another company.

  • Industry growth potential :

    When industries reach a point where there is little opportunity for an increase in customer base or unit sales, companies can only increase revenue by poaching each other’s customers. This leads to aggressive competition.

Companies may boost market share in the short run by aggressive marketing tactics. However, achieving a sustainable increase in market share, over the long run is much more difficult and expensive. For the purpose of equity analysis, you should try to discover companies that are adept at doing so. This can only be done by companies with a high quality management and a strong business model. Such companies tend to spend heavily on research and new product development. Companies with deep pockets will normally excel at this.

What is a business model and why it matters

Put simply, a business model describes how a business will make money. Companies come into existence with lofty ideas and a wide range of resources and capabilities at their disposal. However, unless they can leverage these in a way that will produce profits for them, they cannot succeed. A model describes the strategy to be used for leveraging these resources in order to make profits. It is not as descriptive as a business plan, which may even include projected financial figures. It only describes the basic revenue-generation mechanism that a company seeks to employ. A good model will typically provide answers to the following.

 Components of a Business Model by Kotak Securities

Components of a Business Model

  • What is the product? :

    The idea for a new product is what usually brings a company into existence. It is the source from which it expects to generate its revenue. Thus, a product is central to a business model. The product may be a new tangible item, a service, an improvement over an existing product or an outright replacement of it.

  • What are the major sources of revenue?

    While in most cases it is obvious that the revenue will come from those who buy the product, in some cases it is different. In case of TV channels and websites, customers pay nothing and all the revenues are generated from advertisements. Additionally, even when revenue comes from customers, the revenue models can vary. A revenue model can be chose out of the subscription, commission, lease, brokerage, rent or barter model. Each of these has unique dynamics and must be matched with the product they are intended for.

  • What are the principal marketing channels?

    Once there is clarity as to the characteristics of the product and the costs associated with it, the next question of consequence is the channels through which it will be delivered to the customer. Companies may choose out of the traditional brick and mortar model (establishing physical stores), direct selling (physical or online) or selling through intermediaries such as wholesalers, retailers and commission agents. Choice of channel is principally based on the nature of product, associated costs and extent of oversight required.

  • What are the key obstacles?

    Running a business successfully is a challenging task as a lot of resources and people have to be brought together and relationships created among them. Doing this places a lot of obstacles in the path of the management. These may be in the form of things not coming together as originally planned or unexpected happenings that completely change the ambience in which the business is to be conducted. Although not all of these are foreseeable, the more prominent ones must be identified beforehand. An analysis of ‘what might go wrong?’ is not enough. Its expected impact on future revenues and possible remedies must also be discovered in advance.

  • Who are the target customers?

    A product may be revolutionary but it will not generate revenue if there are no buyers for it. Companies decide the target customers before they even conceive a product. This helps them decide its design and marketing strategy. Over time, new uses of a product may emerge. This may lead to the target customer class changing completely. A model must be farsighted enough to spot potential new customers and adapting the product accordingly.

  • What will the major costs be?

    Businesses incur a variety of costs. Some of them are fixed, irrespective of the number of units sold, while others vary with it. Some are incurred for once upfront, whereas others recur periodically. An analysis of cost is important in a business model because the profitability of a business can only be judged upon the estimation of costs. If a business is not profitable after subtracting expected costs from expected revenues, it is not a viable business and must be scrapped.

  • Who are the competitors?

    Business ideas are lucrative only when they have longevity. If an idea can be easily copied or bettered by others, the business will not last long. Thus, when evaluating a model, it is important to see how it will generate a stream of revenue over multiple periods, without attracting many competitors. Models that erect high entry barriers tend to display this quality. Entry barriers may be in the form of high start-up costs, highly technical nature of the product, patents and copyrights and so on.

  • How flexible is the model?

    The business environment is ever-changing. New competitors, customer categories, regulatory requirements etc. emerge in the blink of an eye. In order to be successful, a model must be able to accommodate enough flexibility. Flexibility must be displayed by ways of increasing/decreasing the scale of operations, tweaking product specifications, changing the channels of distribution, opening up new markets/sources of revenue etc.

Importance of a business model

As seen above, a model provides a blueprint for future revenue generation. As an investor, you would like to understand whether a company will continue making money in future and how clear its future vision is. A model caters to both these requirements. It provides clarity on the future objectives of the company as well as its strategy for future revenue generation. This puts you in a convenient position to decide whether or not to invest in the company.

It may be noted, however, that a business model is different from a business plan. It only lays down the broad contours of how a business will work. A business plan, in contrast, is a much more detailed roadmap for a business, with specific details regarding nature of products, production processes, suppliers, marketing strategy and revenue projections.

What next?

We are now through with our discussion about the structure and working of industries and the specific companies that form it. In the next section, we look at the rights of various stakeholders, who are indispensable to these companies. click here.

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