Overcoming fragmentation can be a very significant strategic opportunity. The payoff to consolidating a fragmented industry can be high because the costs of entry into it are by definition low, and there tend to be small and relatively weak competitors who offer lit–tle threat of retaliation.
I have stressed earlier in this book that an industry must be viewed as an interrelated system, and this fact applies to fragmented industries as well. An industry can be fragmented because of only one of the factors listed in the previous section. If this fundamental block to consolidation can be somehow overcome, this often triggers a process by which the entire structure of the industry changes.
The beef cattle industry provides a good example of how a frag-mented industry can change in structure. The industry has historical–ly been characterized by a large number of small ranchers grazing cattle on rangelands and transporting them to a meat-packer for processing. Raising cattle has traditionally involved few economies of scale; if anything, there could well be diseconomies of control-ling a very large herd and moving it from area to area. However, technological developments have led to the wider use of the feedlot as an alternative process for fattening cattle. Under carefully con-trolled conditions, the feedlot has proven to be a far cheaper way to put weight on animals. Constructing feedlots requires large capital outlays, though, and there appear to be significant economies of scale in their operation. As a result, some large beef growers, such as Iowa Beef and Monfort, are emerging and the industry is concentrating. These large growers are beginning to be large enough to backward integrate into processing of feeds and to forward integrate into meat processing and distribution. The latter has led to the development of brand names. In this industry the fundamental cause of fragmenta-tion was the production technology utilized for fattening cattle. Once this impediment to consolidation was removed, a process of structural change was triggered which has encompassed many ele-ments of industry structure going far beyond feedlots alone.
1. COMMON APPROACHES TO CONSOLIDATION
Overcoming fragmentation is predicated on changes that unlock the fundamental economic factors leading to the fragmented struc-ture. Some common approaches to overcoming fragmentation are as follows:
Create Economies of Scale or Experience Curve. As in the beef cattle industry, if technological change leads to economies of scale or a significant experience curve, then consolidation can occur. Economies of scale created in one part of the business can sometimes outweigh diseconomies in another.
In manufacturing, innovations leading to mechanization and greater capital intensity have led to consolidation in the industry supplying laboratory animals for medical research and in the mush-room farming industry mentioned earlier in this chapter. In labora-tory animals, Charles River Breeding Laboratories has pioneered the use of large, costly breeding facilities where sanitary conditions and all aspects of the animals’ environment and diet are carefully con-trolled. Such facilities yield a superior animal for research and also unlock the fundamental cause of fragmentation in the industry. In mushroom farming, a few large companies have entered the industry and pioneered sophisticated processes for controlled mushroom growth by using conveyors, climate controls, and other devices that reduce labor costs and boost yields. These processes involve signifi-cant economies of scale, capital outlays, and technological sophisti-cation and have provided a basis for consolidation to occur in the in-dustry.
Innovations that create economies of scale in marketing can also lead to industry consolidation. For example, the widespread adoption of network television as the primary means of marketing toys has been accompanied by significant industry consolidation. The emergence of the exclusive, full-line dealer offering financing and service has brought about consolidation among earthmoving equipment manufacturers, with Caterpillar Tractor the major bene-ficiary.
The same basic arguments apply to creating scale economies in other functions, such as in distribution, service, and elsewhere.
Standardize Diverse Market Needs. Product or marketing in-novations can standardize heretofore diverse market needs. For ex–ample, the creation of a new product might coalesce buyers’ tastes; a design change might dramatically lower the cost of a standardized variety, leading buyers to judge the standardized product a better value than the expensive, custom variety. Modularizing a product might allow components to be produced in large volumes and there-by reap economies of scale or experience cost declines while main-taining the heterogeneity of final products. The potential for such innovations is clearly limited by the underlying economic character-istics of the industry, but in many industries the limiting factor to consolidation has seemed to be ingenuity and creativity in finding ways to deal with the causes of fragmentation.
Neutralize or Split Off Aspects Most Responsible for Fragmen-tation. Sometimes the causes of industry fragmentation are cen-tered in one or two areas, such as diseconomies of scale in production or fragmented buyer tastes. One strategy for overcoming fragmenta-tion is to somehow separate those aspects from the rest of the busi-ness. Two striking examples of this are campgrounds and fast food. Both these businesses rely on the need for tight local control and maintaining good service. They must also intrinsically consist of small individual locations, because any potential economies of scale in campground or fast-food facilities are offset by the need to locate near customers, or near the many major highways and vacation spots. Both the campground and fast-food industries have been his-torically fragmented, with thousands and thousands of small, owner-managed operations. Yet there are significant economies of scale in marketing and purchasing in both these businesses, particu-larly if national saturation can be achieved which allows the use of national advertising media. In both industries, fragmentation was overcome by franchising the individual locations to owner-manag-ers, who operated under the mantle of a national organization which marketed the brand name and provided central purchasing and other services. Close control and maintenance of service are in-sured, as well as the benefits of economies of scale. This concept has spawned such giants as KOA in campgrounds and McDonald’s, Piz-za Hut, and many others in fast food. Another industry in which franchising is unlocking fragmentation today is real estate broker-age. Century 21 is rapidly expanding share in this highly fragmented industry by franchising local firms, allowing them to operate auton-omously with their local names but doing so under the umbrella of the nationally advertised Century 21 name.
When the causes of fragmentation center around the production or service delivery process, as in the examples above, overcoming fragmentation requires decoupling production from the rest of the business. If buyer segments are numerous or where extreme product differentiation leads to preferences for exclusivity, it may be possi-ble—through the use of multiple, scrupulously disassociated brand names and styles of packaging—to overcome the constraints placed on market share. Another case is that in which an artist or other cus-tomer or supplier wants to deal with a smaller, more personalized or-ganization with a particular image or reputation. In the record in-dustry, this desire has been dealt with by the use of multiple in-house labels and contracts with associated labels, all of which use the same record pressing, marketing, promotion, and distribution organiza-tion. Each label is set up independently and strives to create the per-sonal touch for its artists. Yet the overall market share of the parent company can be significant, as in the case of CBS and Warner Brothers, each with about 20 percent of the market.
This basic approach to overcoming fragmentation recognizes that the root cause of the fragmentation cannot be altered. Rather, the strategy is to neutralize the parts of the business subject to frag-mentation to allow advantages of share in other aspects to come into play.
Make Acquisitions for a Critical Mass. In some industries there may ultimately be some advantages to holding a significant share, but it is extremely difficult to build share incrementally be-cause of the causes of fragmentation. For example, if local contacts are important in selling, it is difficult to invade the territory of other firms in order to expand. But if the firm can develop a threshold share, it can begin to reap any significant advantages of scale. In cases such as this, a strategy of making many acquisitions of local companies can be successful, provided the acquisitions can be inte-grated and managed.
Recognize Industry Trends Early. Sometimes industries con-solidate naturally as they mature, particularly if the primary source of fragmentation was the newness of the industry; or exogenous in-dustry trends can lead to consolidation by altering the causes of frag-mentation. For example, computer service bureaus are facing in-creasing competition from minicomputers and microcomputers. This new technology means that even the small– and medium-sized firm can afford to have its own computer. Thus, service bureaus in-creasingly have had to service the large, multilocation company to continue their growth and/or to offer sophisticated programming and other services in addition to just computer time. This develop-ment has increased the economies of scale in the service bureau in-dustry and is leading to consolidation.
In the service bureau example, the threat of substitute products triggered consolidation by shifting buyers’ needs, and thereby stimu–lating changes in service that were increasingly subject to economies of scale. In other industries, changes in buyers’ tastes, changes in the structure of distribution channels, and innumerable other industry trends may operate, directly or indirectly, on the causes of fragmen-tation. Government or regulatory changes can force consolidation by raising standards in the product or manufacturing process be-yond the reach of small firms through the creation of economies of scale. Recognizing the ultimate effect of such trends, and positioning the company to take advantage of them, can be an important way of overcoming fragmentation.
2. INDUSTRIES THAT ARE “STUCK”
So far I have concentrated on industries whose fragmentation is rooted in industry economics and on ways of overcoming fragmen-tation that address these root causes. Yet a critical point to recognize for purposes of strategy is that many industries are fragmented, not for fundamental economic reasons, but because they are “stuck” in a fragmented state. Industries become stuck for a number of reasons.
Existing Firms Lack Resources or Skills. Sometimes the steps required to overcome fragmentation are evident, but existing firms lack the resources to make the necessary strategic investments. For example, there may be potential economies of scale in production, but firms lack the capital or expertise to construct large-scale facili–ties or to make required investments in vertical integration. Firms may also lack the resources or skills to develop in-house distribution channels, in-house service organizations, specialized logistical facili-ties, or consumer brand franchises that would promote industry con-solidation.
Existing Firms Are Myopic or Complacent. Even though firms have the resources to promote industry consolidation, they may be emotionally tied to traditional industry practices that support the fragmented structure or otherwise unable to perceive opportunities for change. This fact, possibly combined with the lack of resources, may partly explain the historical fragmentation of the U.S. wine in-dustry. Producers had long been production-oriented and had made apparently little effort to develop national distribution or consumer brand recognition. A number of large consumer goods and liquor companies bought their way into the industry in the mid-1960s and reversed this orientation.
Lack of Attention by Outside Firms. If the previous two con-ditions are present, some industries remain fragmented for long peri-ods of time, despite presenting ripe targets for consolidation, be-cause of lack of attention by outside firms. No outsiders perceive the opportunity to infuse resources and a fresh perspective into the in-dustry to promote consolidation. Industries that escape attention (and offer ripe prospects for entry) tend to be those off the beaten track (manufacture of labels, mushroom farming) or those lacking glamour or any apparent excitement (manufacture of air filters and grease filters). They may also be too new or too small to be of inter-est to major established firms which have the resources to overcome fragmentation.
If a firm can spot an industry in which the fragmented structure does not reflect the underlying economics of competition, this can provide a most significant strategic opportunity. A company can en-ter such an industry cheaply because of its initial structure. Since there are no underlying economic causes of fragmentation, none of the investment costs or risks of innovations to change underlying economic structure need be borne.
Source: Porter Michael E. (1998), Competitive Strategy_ Techniques for Analyzing Industries and Competitors, Free Press; Illustrated edition.