An industry is a market in which similar or closely related products are sold to buyers, as shown schematically in Figure 7-1.2 In some industries a single product variety is sold to all buyers. More typically, however, there are many existing or potential items in an industry’s product line, distinguished by such characteristics as size, performance, and functions. Ancillary services (repair, installation, applications engineering) are also in fact distinct products that can be and often are provided separately from physical products.
In some industries there is a single buyer (e.g., in some defense and space industries). More typically, though, there are many existing or potential buyers. These buyers are usually not all alike, but vary according to demographics, the characteristics of the industry in which they compete, location, and in other ways. Firms provide the link between products and buyers. Firms produce, sell, and deliver products through value chains (Chapters 2-4) in competition with each other. In some industries, there are independent distribution channels be- tween firms and buyers involved in all or part of industry sales.
The boundaries of an industry are frequently in flux. Product lines are rarely static. Firms can create new product varieties that perform new functions, combine functions in new ways, or split off particular functions into separate products. Similarly, new buyers can become part of an industry, existing buyers can drop out, or buyers may alter their purchasing behavior. The current array of products and buyers reflects the products that firms have chosen to introduce and the buyers that have chosen to buy them, and not the products and buyers that an industry could potentially encompass.
Figure 7-1. An Industry as an Array of Products and Buyers
1. Structural Bases for Segmentation
The reason that industries must be segmented for competitive strategy formulation is that the products, buyers, or both within an industry are dissimilar in ways that affect their intrinsic attractiveness or the way in which a firm gains competitive advantage in supplying them. Differences in structural attractiveness and in requirements for competitive advantage among an industry’s products and buyers create industry segments.4 Segments grow out of both differences in buyer behavior as well as differences in the economics of supplying different products or buyers. Product and buyer differences that do not affect structure or competitive advantage (e.g., differences in the color of an otherwise identical product variety) may be important for production or marketing, but responding to them is not essential to competitive strategy.
Structural Differences and Segmentation. Differences in products or buyers create industry segments if they alter one or more of the five competitive forces. Chapter 1 showed how the five competitive forces determine overall industry attractiveness. Structural analysis can also be applied to industry segments; the same five forces are at work. Economies of scale or supplier power, for example, can vary among product varieties even if they are sold to the same buyer. A given buyer may also possess differing propensities to substitute for different product varieties. Similarly, the power of buyers or the threat of substitution for the same product variety can differ from buyer to buyer. Figure 7-2 represents schematically how the five forces can vary by segment.5
Figure 7-2. Differences in the Five Forces Among Segments
The television set industry provides an example of how the five forces can differ by product variety independently of who the buyer is. TV sets can be segmented by configuration (portables, table models, consoles and combination units). Small screen portables have become largely a commodity, while console TVs offer more opportunities for differentiation through styling, furniture, finish, and features. Moreover, console set production employs a different production process and different suppliers than the production of portables, and is less sensitive to economies of scale. These differences affect mobility barri- ers, supplier power, buyer power, and rivalry pressures. Similar differences which affect the five forces exist for other TV product varieties.
Large turbine generators illustrate how differences among buyers may also often have structural implications, independent of the product variety they purchase. Investor-owned electric utilities can be distinguished from municipally-owned utilities from a structural viewpoint. Investor-owned utilities tend to be more technologically sophisticated and purchase through a negotiation process, while municipal utilities are less sophisticated and purchase through public bidding. This creates differences in price sensitivity and in the ability of a firm to create mobility barriers in selling to the two types of utilities such as brand identity, switching costs, and proprietary product differences.
Both product varieties and buyers in an industry can potentially differ in all five of the competitive forces. In TV sets, for example, the distinction between console and portable sets has implications for mobility barriers, supplier power, and rivalry. In the turbine generator industry, investor-owned utilities and municipal utilities differ in their bargaining power, the rivalry among firms in serving them, and the opportunity to erect mobility barriers. Even supplier power can vary for the same product variety depending on the end buyer’s identity. In bicycles, for example, a bicycle enthusiast is much more aware of the brand name of key components such as hubs and dérailleurs. This gives parts suppliers greater bargaining power in selling to firms targeting enthusiasts. They have far less power in selling to firms that sell bicycles to casual bicycle purchasers.
Value Chain Differences and Segmentation. Differences in products and buyers also create segments if they affect the requirements for competitive advantage. The value chain can be used to diagnose this. Differences in product varieties or buyers lead to segments if:
- they affect the drivers of cost or uniqueness in the firm’s value chain
- they change the required configuration of the firm’s value chain
- they imply differences in the buyer’s value chain
An example of a product difference that affects the value chain is the difference between standard and premium bicycles. Standard bikes are built with an automated manufacturing process, while premium bikes are frequently handcrafted. Many other value activities differ for the two as well, and the drivers of cost and uniqueness of value activities differ accordingly. Thus the sources of competitive advantage for standard and premium bikes are quite different, making them different segments. Another good example of how different product varieties can affect the value chain is draft beer compared to canned beer. While the beer is the same, many other value activities are not.
An example of how differences in buyers can affect the firm’s value chain is building insulation. Since many costs in the insulation industry are driven by regional scale and by the location of buyers in relation to plants, buyers located in different geographic regions constitute important segments. This example shows not only how buyers can differ in purchasing behavior, but also how the behavior of cost in serving buyers can be quite different, even with the identical product.
Value chains also differ among buyers. The way a hotel chain uses a TV set is different from how a household uses it, with strong implications for use criteria and signals of value (Chapter 4). Differences in use criteria and signals of value among buyers define segments, because they affect the requirement for competitive advantage. It is also important to recognize that the way different product varieties fit into the same buyer’s value chain can differ—for example, a new part versus a replacement part. Product differences that affect the buyer’s use and signaling criteria define segments.
The Array of Industry Segments. In theory, every individual buyer or product variety in an industry could be a segment, because the five forces or the value chain were somehow different for each. In TV sets, for example, every screen size or feature might potentially constitute a different segment. Similarly, in turbine generators, every utility has a somewhat different value chain. In practice, however, product varieties and buyers should be grouped into categories that reflect their important differences. Deciding how to group products and buyers to capture the most important differences is a key to good segmentation and a subject to which I will return later.
An industry segment is always a combination of a product variety (or varieties) and some group of buyers who purchase it. In some cases, buyers do not have important structural differences and segments are defined by product varieties, and vice versa. Usually, however, structural differences in both product varieties and buyers are present in industries, leading to segments consisting of a subset of products sold to a subset of buyers. Note that product varieties are often associated with particular types of buyers that purchase them, as was true in both the TV set and turbine generator industries.
Industry segments must also be defined independently of the scope of activities chosen by existing competitors. Segments stem from structural differences within an industry that competitors may or may not have perceived. A segment may be important even though no competitor is yet focusing on it. Industry segmentation should include potential product varieties and buyer groups as well as those that already exist. The tendency in segmentation is to focus on observed differences in product varieties and buyers. Yet there are typically product varieties that are feasible but not yet produced, and potential buyer groups that are not currently being served. Unobserved or potential segments can be the most important to identify because they offer opportunities for preemptive moves that create competitive advantage.
2. Segmentation Variables
To segment an industry, each discrete product variety (and potential variety) in an industry should be identified and examined for structural or value chain differences from others. Product varieties can be used directly as segmentation variables. Buyer segments can be identified in a similar fashion, by examining all the buyers in the industry and probing for structural or value chain differences among them. Since buyers vary in a multiplicity of ways, experience has shown that a good starting point in identifying buyer segments is to look for buyer differences along three broad and observable dimensions: buyer type, buyer geographic location, and distribution channel employed. Buyer type encompasses such things as the buyer’s size, industry, strategy, or demographics.
While these three dimensions of buyers are often related, each has an independent effect. Location can significantly affect purchasing behavior and the value chain required to serve a buyer even if all other buyer characteristics are equal. Similarly, in many industries the same buyer is reached through different channels, though the channel employed is often related to buyer type (and also to product variety). For example, buyers of electronic components purchase small, rush orders of chips from distributors and purchase larger orders directly from manufacturers.
To segment an industry, then, four observable classes of segmentation variables are used either individually or in combination to capture differences among producers and buyers. In any given industry, any or all of these variables can define strategically relevant segments:
- Product variety. The discrete product varieties that are, or could be, produced.
- Buyer The types of end buyers that purchase, or could purchase, the industry’s products.
- Channel (immediate buyer). The alternative distribution channels employed or potentially employed to reach end buyers.
- Geographic buyer location. The geographic location of buyers, defined by locality, region, country, or group of countries.
Identifying segmentation variables is perhaps the most creative part of segmenting an industry, because it involves conceiving of dimensions along which products and buyers differ that carry important structural or value chain implications. This requires a clear understanding of industry structure as well as the firm’s and the buyer’s value chain.
To identify product segments, all the physically distinct product types produced or potentially produced by an industry should be isolated, including ancillary services that could feasibly be offered separately from the product. Replacement parts are also a distinct product variety. Groups or bundles of products that can be sold together as a single package should also be identified as a product variety, in addition to the items currently sold separately.7 In the hospital management industry, for example, some firms sell a complete management package at a single price, while others sell individual services such as physician recruiting. The package should be viewed as a separate product variety for purposes of segmentation. Similarly, in industries where the product requires service, there are often three product varieties—the product sold separately, service sold separately, and the product and service sold together. In many industries, the list of product varieties that results from going through such a process is quite long.
Product varieties in an industry can differ in many ways that translate into structural or value chain differences and hence segments. Some of the most typical product differences that are good proxies for structural or value chain differences that define segments are as follows, along with some illustrative examples of why they reflect segments:
Physical size. Size is often a proxy for technological complexity or how a product is used, both of which affect the possibilities for differentiation. For example, different sized forklifts are typically used for different applications. Size may also imply differences in the value chain required to produce different varieties. Different sized varieties must often be manufactured on different machines, and require different components. For example, a miniature camera requires a different manufacturing process and higher precision components than a standard camera.
Price level. The price level of product varieties is often associated with buyer price sensitivity. Price also serves as a good proxy in some industries for the design and nature of manufacturing or selling value activities.
Features. Product varieties with different features may be associated with different levels of technological sophistication, different production processes, and different suppliers.
Technology or design. Differences in technology (e.g., analog versus digital watches) or design (front opening versus side opening valves) among product varieties can involve different levels of technological complexity, different production processes, and other factors.
Inputs employed. Sometimes product varieties differ significantly in their use of raw materials or other inputs (e.g., plastic versus metal parts). Such differences often have implications for the manufacturing process or supplier bargaining power.
Packaging. Varieties may differ in the way they are packaged and subsequently delivered, such as in bulk versus bagged sugar or draft versus canned beer. This translates into value chain differences in both the firm and buyers.
Performance. Performance differences such as pressure rating, fuel economy, and accuracy are related to the technology and design of product varieties, and often reflect differences in R&D, manufacturing sophistication, and testing.
New versus aftermarket or replacement. Replacement products often go through entirely different downstream value chains than identical new products, and may be different in other ways such as buyer price sensitivity, switching costs, and required delivery time.
Product versus ancillary services or equipment. The distinction between a product and ancillary products or services is often a key indicator of price sensitivity, differentiability, switching costs, and the value chain required to provide them.
Bundled versus unbundled. Selling various products as a package (bundle) versus selling individual items (unbundle) can have implications for mobility barriers, the ability to differentiate, and the value chain required (see Chapter 12).
The product differences that are most meaningful for industry segmentation are those that reflect the most important structural differences. There are often a number of different product descriptors that are related. Price level, technology, and performance may all be correlated, for example, and reflect the same basic differences among products. If each descriptor is measuring the same difference, the measure that most closely measures or proxies the structural or value chain differences should be chosen.
More than one product dimension may define relevant segments, and all product differences that affect structure should be identified. The best method for segmenting an industry in which there are multiple segmentation variables will be discussed below. It is also important in product segmentation to include product varieties that are feasible though not currently being produced, such as service sold independently of the product or a product variety with a new mix of features. Good examples are cordless telephones and the “no name” food items now sold in grocery stores.
To identify buyer segments, all the different types of end buyers to which an industry sells must be examined for important structural or value chain differences. In most industries, there are several ways in which buyers can be classified. In consumer goods, for example, some key factors include age, income, household size, and decision maker. In industrial, commercial, or institutional products, buyer size, technological sophistication, and nature of use for the product are among the factors that distinguish buyers.
There is an active debate among marketers about the best means of segmenting buyers.59 In fact, no one variable can ever capture all the buyer differences that might determine segments, particularly since differences that affect the cost of serving buyers (and the value chain for doing so) are often just as important for segmentation as differences in their purchasing behavior. Buyer segmentation should reflect the underlying structural and value chain differences among buyers rather than any single classification scheme, because the goal of segmentation is to expose all these differences.
Industrial and Commercial Buyers
Common factors which serve as proxies for structural or value chain differences that distinguish buyer segments among industrial and commercial buyers are as follows, along with some illustrative examples of how they reflect segments:
BUYER INDUSTRY. The buyer’s industry is often a proxy for how a product is used in the buyer’s value chain and what fraction of total purchases it represents. For example, candy bar manufacturers buy and use chocolate much differently than dairy product firms, who use less chocolate and have less need for product quality. Differences such as these can affect factors such as buyer price sensitivity, susceptibility to substitution, and the cost of supplying the buyer.
BUYER’S STRATEGY (E.G., DIFFERENTIATION VERSUS COST LEADERSHIP). A buyer’s competitive strategy is often an important indicator of how a product is used and of price sensitivity, among other things. Strategy shapes the buyer’s value chain and the role a product plays in it. For example, a differentiated high- margin food processor is more concerned with ingredient quality and consistency than a private label food manufacturer that competes on cost.
TECHNOLOGICAL SOPHISTICATION. A buyer’s technological sophistication can be an important indicator of its susceptibility to differentiation and resulting price sensitivity. Major oil companies tend to be more sophisticated buyers of oil field services and equipment than independents, for example.
OEM VERSUS USER. Original equipment manufacturers (OEMs) that incorporate a product into their product and sell it to other firms often have differing levels of price sensitivity and sophistication than firms that use the product themselves.
VERTICAL INTEGRATION. Whether a buyer is partially integrated into the product or into ancillary or related products (e.g., in-house service) can greatly affect the buyer’s bargaining power and a firm’s ability to differentiate itself.
DECISION-MAKING UNIT OR PURCHASING PROCESS. The particular individuals involved in the decision-making process can have a major impact on the sophistication of the purchase decision, the desired product attributes, and price sensitivity. Many industrial products are purchased in complex processes involving many individuals (see Chapter 4), and the procedures often vary markedly even among buyers in the same industry. Some users of electronic components purchase through trained and dedicated purchasing agents, for example, and are much more price- sensitive than other component buyers that employ engineers in purchasing or use purchasing agents also responsible for purchasing other items.
SIZE. A buyer’s size can indicate its bargaining power, how it uses a product, the purchasing procedures employed, and the value chain with which it is best supplied. Sometimes order size is the relevant measure of size, while in other industries it may be total annual purchases. In still other cases company size may be the best determinant of bargaining power and purchasing procedures.
OWNERSHIP. The ownership structure of a buyer firm may have a major impact on its motivations. Private companies may value different product characteristics than public companies, for example, while a division of a diversified firm may be guided by purchasing practices determined by the parent.
FINANCIAL STRENGTH. A buyer’s profitability and financial re- sources can determine such things as its price sensitivity, need for credit, and frequency of purchase.
ORDER PATTERN. Buyers can differ in their ordering pattern in ways that affect buyer bargaining power or the value chain required to supply them. Buyers that place regular and predictable orders, for example, may be much less costly to serve than those whose orders come at erratic intervals. Some buyers also typically have more seasonal or cyclical purchasing patterns than others, affecting a firm’s pattern of capacity utilization.
Consumer Goods Buyers
Typical proxies of buyer differences that define segments among consumer goods buyers are as follows, along with illustrative examples of how they reflect segments:
DEMOGRAPHICS. Buyer demographics can be a proxy for the desired product attributes, price sensitivity, and other use and signaling criteria. For example, single persons have different needs and purchasing patterns for frozen entrees than families with children. Many aspects of demographics can be important, including family size, income, health, religion, sex, nationality, occupation, age, presence of working females, social class, etc. In banking, for example, wealth, annual income, and the education level of household members all determine what banking services are purchased and how price sensitive the buyer is.
PSYCHOGRAPHICS OR LIFESTYLE. Hard-to-measure factors such as lifestyle or self-image can be important discriminators of purchasing behavior among consumers. Jetsetters may value a product differently than equally wealthy conservatives, for example.9
LANGUAGE. Language also may define segments. In the record industry, for example, the Spanish speaking market worldwide is a relevant segment.
DECISION-MAKING UNIT OR PURCHASING PROCESS. The decision-making process within the household can be important to desired product attributes and price sensitivity. One spouse may be more interested in performance features of a car, for example, while the other opts for comfort and reliability.
PURCHASE OCCASION. Purchase occasion refers to such things as whether a product is purchased as a gift or for the buyer’s own use, and whether the product is to be part of a special event or used routinely. A buyer’s use and signaling criteria are often very different depending on the occasion, even if the buyer is the same person and the product is similar. Purchasers of pens for gifts, for example, will favor recognized brands names such as Cross that may carry less weight in purchasing for personal use.
Several buyer dimensions may be important in defining buyer segments. In oil field equipment, for example, buyer size, technological sophistication, and ownership are all relevant variables. In frozen entrees, household size, age of family members, whether both parents are working, and income are all relevant variables. Potential buyers of a product not currently purchasing may also constitute segments. Buyer segmentation variables may also be related and the task is to select the variables that best reflect structural and value chain differ- ences.
To identify segments based on channels, all existing and feasible channels through which a product can or does reach buyers should be identified. The channel employed usually has implications for how a firm configures its value chain and the vertical linkages (Chapter 2) that are present. The channel can also reflect factors which are important cost drivers such as order size, shipment size, and lead time. Large orders of electronic components are sold direct, for exam- ple, while small orders are sold through distributors (often to the same buyers). Channels can also differ greatly in bargaining power. Mass merchandisers such as Sears and K-Mart have a great deal more power than independent department stores.
Typical differences in channels that define segments include:
Direct versus distributors. Selling direct removes the need to gain access to channels and may imply a very different value chain than selling through distributors.
Direct mail versus retail (or wholesale). Direct mail eliminates the potential bargaining power of the intermediate channel. It also usually carries implications for value activities such as the logistical system.
Distributors versus brokers. Brokers typically do not hold inventory and may handle a different product line than distributors.
Types of distributors or retailers. Products may be sold through retailers or distributors of very different types, which carry different assortments and have different strategies and purchasing processes.
Exclusive versus nonexclusive outlets. Exclusivity may affect a channel’s bargaining power and also the activities performed by the channel versus those performed by the firm.
There are often several types of channels in an industry. In copiers, for example, machines are sold direct as well as through copier distributors, office products distributors, and retailers. Channel segmentation must also include any potential channel that might be feasible. For example, L’eggs resegmented the hosiery market by discovering a new channel, the direct sale of hosiery to supermarkets.
Geographic location can affect both buyer needs and the costs of serving buyers. Geographic location may be important directly as a cost driver and may also affect the value chain required to reach the buyer. Geographic location also frequently serves as a proxy for desired product attributes due to differences in weather, customs, government regulation, and the like. For example, commercial roofs in the southern United States require less insulation than in the North, while the roofing membrane is more likely to be ballasted with gravel in the North than in the South because a roof designed to take a snow load can handle the extra weight.
Typical geographic segments are based on variables such as the following:
Localities, regions or countries. Geographic areas may have differences in such areas as transportation systems and regulations. Geographic buyer location also plays a key role in defining scale economies. Depending on the geographic scope of scale economies (Chapter 3), different sized geographic areas may be the relevant segments. In the residential roofing shingle industry, regions are the appropriate segments because high logistical costs limit the effective radius of a plant. In food distribution, metropolitan areas are the appropriate segments because of dense customer location and use of trucks for local delivery.
Weather zones. Climatic conditions often have a strong impact on product needs or on the value chain required to serve an area.
Country stage of development or other country groupings. Buyers located in developing countries may have very different needs than those in developed countries. In addition, packaging, logistical systems, marketing systems, and many other aspects of the value chain may differ significantly. Similarly, other groupings of countries may expose similarities that define segments.
The relevant measure of geographic location for segmentation purposes will differ from industry to industry. In most cases, the relevant location to use in segmentation is the location where a product is actually consumed or used. However, sometimes the location to which a product is shipped (e.g., the warehouse) is more relevant. In other cases, the location of the buyer’s headquarters or primary dwelling emerges as the most important geographic segmentation variable, even though the buyer uses the product somewhere else.
There can also be more than one meaningful geographic segmentation. For example, regions may be meaningful segments for determining cost position in industries where the costs of key value activities are driven by regional scale, whereas countries may be meaningful segments for determining desired product attributes and the ability to differentiate.
3. Finding New Segments
Some segmentation variables are readily apparent as a result of industry convention or competitor behavior. There are often established norms for dividing buyers or grouping geographic areas, based on historical data collected by trade associations or government agencies. In the oil industry, for example, the distinction between majors and independents is an accepted segmentation. Traditional categorization schemes for product varieties in an industry are also typical. Competitors may also define apparent segments through their choice of focus strategies.
However, segmentation must go beyond conventional wisdom and accepted classification schemes. Correct industry segmentation should reflect important differences for structure or the value chain among products, buyers, channels, or geography, whether or not they are recognized and used currently. The greatest opportunity for creating competitive advantage often comes from new ways of segmenting, because a firm can meet true buyer needs better than competitors or improve its relative cost position.
In searching for potential new product segments, the following questions can be usefully considered:
- Are there other technologies or designs to perform the required functions in the buyer’s value chain?
- Could additional functions be performed by an enhanced product?
- By reducing the number of functions the product performs (and possibly lowering the price), could the needs of some buyers be better served?
- Are there different bundles (either narrower or broader) of products and services that could be feasibly sold as a package?
Off-price retailers are an example of a new segmentation based on reducing the number of functions the product performs. Firms such as Loehmann’s eliminate costly services such as credit and returns while selling through spartan outlets without extensive dressing rooms or sales help. This stripped down value chain, without many traditional value activities, has created an entirely new segment. A similar process is occurring in the hotel/motel industry, where budget chains such as La Quinta are selling rooms without other services such as restaurants and bars, and other chains are combining services in new ways.
The possibility of employing new channels also frequently exists. Firms can sell direct where the norm has been to use agents or distributors or employ new types of distributors or retailers. Timex did this in watches, and Avon did it in cosmetics. Any feasible channel is a potential segment.
In identifying new geographic and buyer segments, creativity is often required in two areas. The first is finding important new ways that geography or buyers can be divided to reflect structural or value chain differences. As discussed earlier, Stouffer’s discovered important differences in purchase criteria for frozen entrees by isolating single households and households with two working parents. The second area for creativity in geographic or buyer segmentation is in identifying potential new buyer types or geographic areas not presently being served by the industry. Sometimes reaching a new buyer type or geographic area will require product modifications, while in other cases it just requires that a firm gain a better understanding of its buyers’ needs and potential new applications for its product. For example, Arm & Hammer baking soda found a large market in deodorizing refrigerators, and Johnson & Johnson Baby Shampoo proved popular with adults. No product change was required for reaching either new buyer group.
Source: Porter Michael E. (1998), Competitive Advantage: Creating and Sustaining Superior Performance, Free Press; Illustrated edition.