The Tobacco Industry – a Porters 5 forces analysis

The twelve year return-on-equity data for the Tobacco Industry of 27.9% is substantially above the all-industry average of 14.1% given in the Business Week data. Examining Porters five forces reveals the keys to the Tobacco industries superior profit performance.

The price customers are willing to pay for a product depends, in part, on the availability of substitutes. The absence of close substitutes in the case of cigarettes means that consumers are comparatively insensitive to price increases. This makes price demand for tobacco inelastic with respect to price. The buyer’s propensity to substitute cigarettes for another product is largely dependent on their price-performance characteristics. The needs being filled by cigarettes are very complex and the performance differences are very difficult to discern, leading to a low substitution propensity on the basis of price differences.

If an industry is profitable, other firms will inevitably attempt to enter the market. However, if the capital costs of getting established in an industry is large, many would be competitors will be discouraged. The tobacco industry enjoys high capital requirements in land, equipment, and manufacturing that make it difficult for small competitors to enter. Additionally, tobacco firms are large companies capable of larger-scale operations which enable them to benefit from economies of scale. If competitors are to enter, they either enter on a small scale and accept high unit costs or enter on a large scale and risk the underutilization that would result while sales volume is built up. Tobacco firms have high product differentiation that is established through advertising and demonstrated by high brand loyalty. Additionally, new firms are not likely to enter this industry because of the government and legal pressures that the industry as a whole is facing concerning serious health issues caused by smoking. Lastly, the established players in the tobacco industry can easily retaliate against new competitors with aggressive pricing and increased advertising, which would affect the new entrant more significantly.

The relative bargaining power of suppliers to the tobacco industry is largely small due to the low switching costs cigarette manufactures face and the buyer’s ability to backward integrate if necessary. These smaller suppliers lack the size and strength of their large buyers and can not effectively negotiate higher prices for their goods. Additionally there is a high degree of competition among the supplier of the tobacco industry.

The tobacco industry is highly competitive, with huge amounts of revenue determined by the smallest changes in market share. The tobacco industry is dominated by a few large firms; price competition may also be restrained, either by outright collusion, or more commonly through “parallelism” of pricing decisions. The intense advertising efforts of the tobacco industry lead to strong brand awareness and subsequently to a highly differentiated product that can demand a higher price than would be the case if the products were indistinguishable. Additionally the tobacco industry’s revenues are highly consistent and stable, generally unaffected from booms or busts in the economy. Furthermore, the high fixed cost structure of starting a cigarette company (factories, marketing, and machines) enables them to compete on price if necessary to ward of competition.

Another factor of the Tobacco industry’s superior performance has been the price sensitivity, or lack there of, of buyers. The tobacco industry has the luxury of switching suppliers based on price because the products they purchase (tobacco, cardboard boxes, paper) and not highly differentiated. Buyers regard their cigarettes with high importants and are not willing to do without or switch to a new brand. This low bargaining power on behalf of the buyers strengthens the tobacco industry pricing position.

The tobacco industry also enjoys a strong bargaining position, due to, in part, the relative small number of companies in the industry. The smaller the number of buyers and the bigger their purchases, the greater the cost of losing one is to the supplier. The tobacco industry purchases large quantities from its various suppliers, and is able to bargain effectively with them on the basis of price and service. Lastly, the tobacco industry’s size and strength enables them to backward integrate. If it becomes more convenient and profitable to do so, they may purchase their own tobacco farm or card board box company and produce it all in house. This credible threat of backward integration has also added to the tobacco industry’s strong bargaining power and subsequent superior profit performance.