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Strategy Skills > Building an Evidence Base

Analysing data - Market analysis

> in practice

Market analysis aims to provide:

• Insights into and understanding of industry and departmental positions
• Knowledge of the likely impact of various policy actions on departments and industry structure
• Understanding of likely international reactions and reactions of private and voluntary sector to changes.

There are a number of different frameworks that can be used for market or industry analysis:

• Structure, Conduct, Performance
• Forces at Work
• Cost Structure Analysis

Structure, Conduct, Performance

This can be used to analyse different components (e.g. demand or supply chain economics) of industry structure and their impact on the conduct of private and public sector players in the sector.

It is mainly used for strategy studies where it is important to understand the industry dynamics and how government and the private sector interact. The analysis needs to consider a number of different elements when analysing structure, conduct and performance.

The key steps to conducting an industry analysis are determining what to look, the collection of data, and the interpretation of data:

Forces at Work

This model presents an alternative for structuring industry assessments based on the suppliers, new entrants, buyers, substitutes and industry competitors:

The forces at work model provides a comprehensive checklist for analysing the structure of industries and sectors. The framework should not be used just to give a snapshot in time. It is important not just to describe the forces, but also to understand their future impact.

The five forces are not independent of each other. Pressures from one direction can trigger changes in another. For example, potential new entrants finding themselves blocked may find new routes to market by bypassing traditional distribution channels and selling directly to consumers.

The Five Forces Framework can be used to gain insights into the forces at work in the industry or environment, which need particular attention in the development of strategy. It is important to use the framework for more than simply listing the forces. The following questions help focus on the implications of these forces:

• What are the key forces at work in the environment? These will differ by type of industry.
• What are the underlying forces in the macro-environment that are driving these forces? For example, lower labour costs for software and service operators in India are both an opportunity and a threat to European and US companies.
• Is it likely that the forces will change, and if so, how?
• How do particular industries/departments stand in relation to these competitive forces? What are their strengths and weaknesses in relation to the key forces at work?
• What can we do to influence forces?

Cost Structure Analysis

Cost structure analysis can help provide answers to questions such as:

• Is the good/service inherently expensive to supply, or might market conditions (excess demand and/or lack of competition) be pushing cost higher?
• How do costs behave as a supplier scales upwards? For example, are (dis)economies of scale experienced, are there stepped costs (e.g. in the case of telecoms networks as significant additional investment is needed to push capacity past certain thresholds)?
• Is the supply of the good/service dominated by fixed or variable costs?
• What sunk costs are incurred in setting up supply? Will these sunk costs limit new entrants and/or form the basis for games by incumbents?

Crucially, an understanding of such issues will provide insight as to how suppliers behave in the market, and how they might react to changes in government involvement - e.g. via subsidies and regulation. As such, cost analysis can suggest policy responses and help to predict the outcome of different policies.

Cost structure analysis forms one half of business modelling and profitability analysis. Such an approach enables a full break-out of cost and revenue drivers and allows an analysis of profitability by customer, type of good/service or division. In policy making terms, for example, this might mean the ability to estimate profitability by different types of Post Office customer, or the likely sustainability of childcare provision in different areas.

Steps to take:

Defining cost buckets

Costs can be broken out according to a number of different splits. For example, a childcare provider's costs might be broken out according to age of child, or function, such as staff, child costs (food and consumables), property costs, administrative overheads etc. It is important to find a mutually exclusive split - where each cost can be placed in only one of the categories. A logic tree may help in this process.

Gathering evidence

In some cases, detailed management accounts from existing suppliers might be available. In other cases, estimates might need to be pulled together from a range of different sources. Be aware that you are attempting to analyse costs for one example supplier - it cannot and will not reflect everyone in the market. Thus the need to run sensitivities and sense checks later in the process.

Constructing a spreadsheet model

Theoretically, you could stop after the precious step and still gain insights into the likely operation of the market. However, by pulling the estimates of costs in different categories together into a spreadsheet, further analysis can be conducted on the sensitivity of costs and supply on particular elements. This, in turn, allows one to predict likely reactions to policy options or new regulations. The spreadsheet itself should be as adjustable as possible to allow sensitivities and scenarios to be run easily. Refer to the modelling section for advice on the construction of spreadsheet models.

Investigating sensitivities

The spreadsheet model will allow adjustment of the cost variables to investigate the overall effect on the cost of supply or the profitability of a supplier (if the revenue side has been added). In many cases, there will be numerous variables that can be changed. It is important to alter one at a time, in a methodological fashion, in order to derive the results from changes in one variable at a time. A second approach is to run specific scenarios on the model - changing all the variables at once according to one view of the world.

Sense checking

The cost structure analysis conducted will have been based on a series of assumptions. However well these assumptions have been grounded in hard evidence, it is crucial to check that the results of the assumptions acting altogether make sense. Results can be checked with experts in the field, existing suppliers and other business plans that are available. This triangulation of results in important to ensure confidence in the messages being drawn from the analysis. This also brings up a limitation to the analysis conducted: however sophisticated the modelling, it can only be based on a series of assumptions. It does not reflect an actual outcome. It can therefore give insights into key drivers and likely reactions, but is not "the answer".

Strengths

• The structure, conduct, performance model provides an overarching framework for assessing the industries being studied. It provides a useful insight into the context within which a department or industry has been operating.
• The forces at work model provides a comprehensive checklist for analysing the structure of industries and sectors. It can be used to identify what further analysis is required.
• Cost structure analysis is potential very powerful since it can feed into a better understanding of market functioning and likely reactions to changes in policy.
• In areas where evidence has tended to be based on anecdote, cost structure analysis and modelling can bring significant new insight to the debate.

Weaknesses

• A model of costs or profitability can only give a simplified indication of the way the world works. It must not be viewed by the team (or stakeholders) as "the answer". Key messages can be drawn from running sensitivities or scenarios on the model, but should be carefully sense checked.
• Attempts to allocate overhead (shared) costs - such as administration - between different products, people or plants are fraught with difficulty and should be approached with caution. Each stakeholder will have an opinion on how such costs ought to be allocated.
• Cost structure analysis and profitability analysis will involve many variables and the team may wish to run sensitivities on most if not all inputs. This makes it crucial that key messages are drawn out for communication to stakeholders, without getting bogged down in technical details. The right insights need to be communicated in an effective way. This may mean significant lengths of time spent interpreting results within the team prior to communication to stakeholders.

References

Structure, Conduct, Performance
Industrial Market Structure and Economic Performance, Ross 1990

Forces at Work
Techniques for analysing industries and competitors, Porter 1980

Cost Structure Analysis
Katz and Rosen, "Microeconomics", 3^rd edition, 1998, McGraw Hill - provides an overview of microeconomic costs and cost structures (see chapter 9).

Begg, Fischer and Dornbusch, any edition, McGraw Hill - again, gives an overview of microeconomic costs. In the 4^th edition, this is found in chapter 8. Pages 20-24 also give a brief introduction to the principles of economic modelling.

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