5-Forces Industry Analysis

2005 Volume 8 Issue 4

Did you ever wonder why the NBA is wildly successful, or why some teams are much more successful than others?

In honor of the 25th anniversary of Michael Porter’s contibution to strategic management, we apply 5-Forces Industry Analysis to the “industry of professional basketball” to draw conclusions about the main success factors for “firms” (teams) in the NBA industry.








Photo: Dyana








A seminal analytic tool in strategic management is the 5-Forces Industry Analysis first introduced by Harvard Business School professor Michael Porter[1] a quarter-century ago. This tool examines the buyers, suppliers, substitute products, rivalry among existing firms, and potential new entrants in a firm’s industry or product market.

Industry Analysis can be an esoteric tool if all that’s done with it is to determine how strong a supplier is, or how much rivalry exists among firms. However, it is a valuable framework if the analysis is undertaken to answer two important questions: 1) What is valued by the customer? and 2) What are the key success factors in a given industry? If the answers to these questions are then applied to firms in a particular industry, Industry Analysis can provide insights regarding why some firms are high-performing in their industry, while others are relatively low-performing.

Industry Rivalry

According to Porter, the main factors increasing rivalry among firms in an industry are market maturity, equally-balanced competitors, high fixed costs and high exit barriers. All of these factors are present in teams in the National Basketball Association (NBA).

  • First, market growth, as measured by attendance at NBA games, has leveled recently (Figure 1), thereby increasing competition among teams for a static number of fans.
  • Second, the industry is structured by the NBA to have 30 equally balanced competitors because the distribution of ability across teams must be relatively equal in order to maintain game suspense and thus to attract fans. The NBA promotes competitive balance with measures such as salary caps, reverse-order draft choices, revenue sharing, and maintaining authority over league expansion.
  • Third, the main fixed costs for teams, such as labor contracts and physical assets, are very high, which creates pressure to fill capacity.
  • Finally, the NBA prohibits firms from exiting the industry at will.

The combination of these four factors creates high rivalry among teams chasing fans, sponsors, and licensees for a static pool of revenue with which to cover high and often growing costs.

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Figure 1: NBA League Attendance 1952-2005

Nonetheless, one factor that often reduces rivalry is the ability of firms in an industry to differentiate. Firms in the NBA are highly differentiated. Indeed, statistics reveal that despite the cartel-like management of the industry by the NBA, large revenue disparities exist between teams. Two factors drive differentiation of firms in the NBA: star players and NBA championship wins. The teams that are most successful in attracting and maintaining star players are willing to pay the fines mandated by the league for exceeding the salary caps.

A comparison study of the five teams that have won the most NBA Championships in the past quarter-century with the bottom five teams in terms of team valuation reveals two things:

  1. Teams that have recently won the championship are significantly more profitable than are those in the bottom tier of the league.
  2. A correlation exists between the revenues and market size of a team’s home region (Figure 2).

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Figure 2: Comparison of the Top and Bottom Firms in the NBA, 2003-04 Season Data

Customer Power

According to Porter, customers are powerful relative to firms in an industry when it is easy for them to switch to another supplier, when they are concentrated and when the product is commodity-like. There are three customers for NBA teams: fans, media outlets, and corporations, each of which has somewhat different degrees of power.

Fans

First, 35 percent of the average NBA team’s revenues are derived from gate receipts, thereby making fans the most important customer.[2] Fans are the local residents who frequent games, watch or listen to the games, and buy season tickets and team paraphernalia. Teams that have particularly strong brand value due to superstar players or a long winning streak, such as the Chicago Bulls of the ’90s additionally benefit from a national and international following. Although fans are not concentrated and thus cannot exert much pricing pressure on teams, fans do reward successfully differentiated teams with repeat business.

Moreover, basketball fans are more attractive to advertisers than are fans of other sports because they are younger and more racially diverse than baseball and football fans (Figure 3), which appeals to many advertisers’ increasing efforts to target multiple ethnic consumer audiences. Additionally, 27 percent of NBA customers consider themselves “die-hard” fans of the team, compared to 14 percent of attendees at National Football league (NFL) games.[3] Die-hard fans, unlike more casual, “entertainment-seeking” fans, have enormously high switching costs.[4]

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Figure 3: Demographics of Average NBA Fan (Customer)

A strong correlation exists between a team’s success on the court and tickets sold; fan morale increases and the interest of non-fans is piqued when a team accumulates wins. The longer a winning team can hold on to its dynasty, the better the chance it has of creating a sustainable competitive advantage.

In gauging the extent of power that fans wield, the most obvious conclusion is that without fans a team has no business at all. However, each individual fan has relatively little power. Although, the financial switching costs incurred in leaving one basketball team for another, or in defecting to another sport entirely (i.e., switching to purchase a different “product” than a basketball game) are not particularly high. On the other hand, die-hard fans derive a strong sense of personal identity from being a fan of a particular team. Finally, teams are hugely differentiated as manifested by the personality and talent of their rosters of players, the strategy of play advocated by each team’s coaching staff and management, the team’s regional affiliation, and the team history and legacy all elements which enable a team to increase the switching costs for fans.

Media Outlets

A second customer group consists of media outlets who bid for the rights to broadcast games. The price for such rights has grown, as can be seen in Figure 4, with the average team currently collecting about 35 percent of its total annual revenues from broadcast fees. Although there are a limited number of buyers in the market for national broadcast rights, due to the increased interest in our culture in sports over the last several decades, the NBA has been able to ask for and receive increasingly higher fees a clear sign of the NBA’s monopoly power in this segment of their market.

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Figure 4: NBA Broadcast Rights Fees, 1982 – 2008

Corporations

Corporations are the third customer of NBA teams. They buy season tickets and skybox seats, participate in multi-million dollar sponsorships, and buy naming rights for a stadium such as Staples did with the Staples Center in the Los Angeles area at a cost of $100 million over 20 years. Approximately 15 percent of the average NBA team’s annual revenue comes from corporate-related venue fees.[5] In determining how much power an individual corporation has in relation to a team, location matters most. A team in a large market, such as the New York Knicks, has to attract many potential corporate sponsors, even in a non-winning season, compared to the corporate customer base available to smaller market teams such as the Cleveland Cavaliers.

Supplier Power

Players are the chief suppliers to teams, and the extent of a player’s power depends on factors such as other teams’ interest in the player as well as the player’s performance, free agent status, and star power. Despite official salary limits, a team has several loopholes for signing talent, and a player making a salary that is almost equivalent to the payroll of an entire team is not unheard of.[6] However, the general rule is that most suppliers (players) hold relatively low power, with the exception of a few superstars.

Substitute Products

Substitute products strongly impact the dynamics of the professional basketball industry because 70 percent of NBA fans are casual entertainment seekers, rather than die-hard fans. In other words, [casual] basketball fans have very low switching costs compared to fans of other sports such as football, baseball, or hockey. Moreover, of the other professional sports, only football has a higher average ticket price than basketball (Figure 5). It is thus not only easy, but also cost-effective for the casual basketball fan to switch to another sport.

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Figure 5: Comparing Substitute Products – the NBA vs. the National Hockey League (NHL), National Football League (NFL), and Major League Baseball (MLB)

Other Competitive Switching Options

Moreover, there are countless other entertainment options competing for the fans’ leisure time and discretionary income, including 1,500 television channels, movies, college and amateur sports, eating out, and videogames. As the cost of attending a basketball game continues to increase (having risen by approximately 75 percent in the past decade), teams need to offer incentives to fans, such as family and season ticket packages, to make game attendance attractive for entertainment seekers.

New Entrants

New entrants into this industry are rare since NBA League approval and a steep franchise fee stand in the way of prospective new team owners. Moreover, attempting to circumvent the NBA would put the following obstacles into an entrepreneur’s path: 1) massive capital costs, 2) lack of brand reputation, 3) lack of TV revenue, and 4) steep competition for talent. Expansion teams occasionally do get approval, such as the Charlotte Bobcats founded in 2004. However, the competition that so many other industries face from new entrants is virtually non-existent in professional basketball.

Key Success Factors for Teams in the NBA

So what? Who cares if customers are moderately powerful, suppliers are generally weak, rivalry is fierce, and revenue lost to substitutes is high in the industry of professional basketball? Again, the problem with most applications of Porter’s 5-Forces Analysis is that the critical implications of the analysis are not delineated. What does the Industry Analysis tell us about the key success factors for firms in the industry?

1. Brand value is the most important asset a team can develop. A team’s appeal to its fans is a function of several factors. Most obvious is the team’s winning record. Sports games are after all a matter of competition, and a team’s ability to win is a result of securing and developing effective talent as well as good strategic management. The few teams that have enjoyed the rare period of super-success becoming a dynasty have generally not only had excellent talent, but also talent that fell within the difficult to quantify “superstar” category. One does not need to be a basketball fan to know that Larry Bird was with the Boston Celtics, and Michael Jordan was with the Chicago Bulls. Developing this kind of talent with instant name and team identification takes time and money. A team must not only be able to afford the high signing fees of free agents, but also must be able to pay the league penalty for the team’s violation of the salary cap.

Despite the investment expenditures required in this strategy, the financial payoff can be huge. The Lakers, for example, have historically used high-profile and very high-cost star players to ensure competitiveness a costly but wildly successful strategy as reflected by the Lakers’ dominance in most measures of performance in the past quarter century (Figure 6). The Lakers’ strategy focuses on driving the top revenue line by leveraging the drawing power of these stars. Their success is demonstrated by the number of tickets sold for their home games, an average of 18,967 of the 20,000 seats available per game, or 95 percent[7] in comparison to just 88.6 percent league-wide in 2004.[8]

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Figure 6: Competitive Performance of Los Angeles Lakers, 1980-2005

Ironically, profitability is intertwined with costly investments in building brand. Thus, once a team is able to pay the high payroll of superstars, it has a tendency to broaden the gap between it and the other teams. For example, the Lakers have famously gone over the pay cap to secure superstar players (Figure 7) and were able to charge an average price of $77.36 per ticket in 2004, well above the NBA league average of $45.28. In contrast, the Los Angeles Clippers, whose strategy is to contain costs and who thus stay within the salary cap, charged $43.40 per average ticket.[9]

The Lakers do not focus on containing costs, but rather focus on growing their brand, thus incurring extra expenses (which they pass on to consumers). That investment in brand fuels profitability, as seen in Figure 2. On the other hand, the Clippers are a cost-driven organization. While this strategy ensures that the Clippers also remain profitable, keeping such a close eye on costs also creates a ceiling on that team’s revenues and profits (Figure 2) that teams making greater investments in brand do not face. However, teams that can afford to underprice other substitute sporting events have an easier time maintaining or growing their game attendance.[10]

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Figure 7: Comparing Player Salaries of the Lakers and Clippers, 1990 – 2003

2. Home market size is also important to the financial success of a team. Despite a non-winning history, the Knicks can count on a large fan base and numerous corporate sponsors to generate the revenue the team needs in order to manage a massive payroll a calculated risk to ensure that the team can promise fans at least an entertaining experience, if not a competitively satisfying one. It also stands to reason that since the home market is a relatively captive one, the larger the population, the better the financial implications.

3. Effectively targeting the casual fan is critically important to enable a team to develop strong community ties and to improve its odds against the myriad entertainment substitutes. For instance, despite being located in a small market, the Sacramento Kings benefit from famously loud fans. Such fan loyalty is evidenced by the team’s fourth place ranking in the 2005 Brand Keys Sports Loyalty Index of NBA teams (following in order, the San Antonio Spurs, the Detroit Pistons, and the Los Angeles Lakers).[11]

Short of winning over die-hard fans, a team must develop an overall experience that appeals to casual fans. The importance of doing so is apparent in the expansion of services at new arenas. For example, Dallas Mavericks’ fans are pampered at American Airlines Arena with the NBA’s most technologically advanced sports venue. The arena boasts a sea of plasma HDTV monitors, state-of-the-art digital LED’s and scoreboards, and seats with Internet connections.[12] These additional services will add to the total package that a Mavericks game will provide, thus enticing casual fans who factor such benefits into their purchase decision, unlike the die-hard fan who would cheer his or her team on, even in a barn lacking running water.

Summary

In short, success in the industry of professional basketball hinges on three key factors. The first is really a matter of luck. Teams located in large metropolitan areas are given a tremendous opportunity to exploit fans in such large populations, whereas teams located in smaller markets are faced with a potential threat to overcome and must work harder to cultivate a dedicated fan base. Second, brand is of critical importance. Customers reward highly differentiated teams with higher royalty fees, larger corporate sponsorships and higher ticket prices. Third, the trick to gaining market share is to capture the casual fan who has many substitute entertainment options. The teams that cannot accomplish this on brand strength need to do so by increasing levels of service mostly in the form of new arenas. Finally, as in all industries excelling at operational efficiency, cost containment never hurts, as the Bulls’ high levels of operating revenues demonstrate (Figure 2).

In short, Porter’s 5-Forces Industry Analysis continues to deserve a prominent place among contemporary managerial tools, if it is used thoroughly to understand the key success factors for firms in an industry or product market.


[1] Michael Porter, Competitive Strategy (New York: Free Press, 1980).

[2] http://users.pullman.com/rodfort/SportsData/BizFrame.htm. (no longer accessible)

[3] www.harrisinteractive.com/news/allnewsbydate.asp?NewsID=312

[4] Unsurprisingly, die-hards are willing to pay high ticket prices. Teams recognize the customer segmentation in the market, as is evidenced by the variation in ticket prices often ranging from $10 to over $1000 per ticket for the same game.

[5] Skybox rentals can cost upwards of $250,000 each per season (not including tickets), and corporate sponsorships may represent several million dollars per year as well.

[6] For example, in 2004, the salary cap for a team’s entire payroll was set at just below $44 million. Despite this, Shaquille O’Neal of the Lakers was paid $26.5 million, in contrast to the league-average salary of approximately $2.5 million.

[7] www.insidehoops.com/attendance. (no longer accessible)

[8] www.georgelapides.com/view.php/id/83

[9] www.sportsbusinesssims.com

[10] The Chicago Bulls are an excellent example of a highly branded team that also focuses on cost control. Chicago was the most profitable franchise in the season ending 2004 (see Figure 2) in large part due to minimizing player payroll. Although the team’s win/loss record (23-59) was the second worst in the league, it nonetheless generated $35 million in gate receipts (equal to the league average) due to the power of the Bulls’ brand (propelled largely by the star power of Michael Jordan). Additionally, the Bulls non-payroll expenses were low. For instance, Jerry Reinsdorf owns the Chicago Bulls team and half of the Bulls’ venue, the United Center, thereby allowing him to control concessions and parking costs more so than can the typical NBA team. Reinsdorf has also aggressively sought corporate sponsorships such as Verizon Wireless, Miller Brewing, Gatorade, and PepsiCo to enhance revenues.

[11] www.brandkeys.com/awards/sports05.cfm and www.sportsfansofamerica.com/About/PR/May,2004-NBA.htm. (no longer accessible)

[12] www.thesportsroadtrip.com/nbafavorites.html

About the Author(s)

Karen Schnietz, PhD, is an associate professor of strategy at the Graziadio School of Business and Management, Pepperdine University. Her research focuses on the impact of public policies on the private competitive environment and strategies of firms, and on the financial impact of corporate social responsibility, and has been published in Business and Politics, Corporate Reputation Review, International Organization, and the Journal of International Business, among other journals. Dr. Schnietz received her AB degree from Bryn Mawr College in Pennsylvania, and her MBA and PhD degrees from UC Berkeley. This article grew out of a student assignment in her Strategic Management course.

Sanjay Advani, MBA, is a category manager for Homestore.com in Westlake Village, California, and has a decade of marketing experience. Mr. Advani obtained his BA in marketing from UC Santa Barbara and an MBA from Pepperdine University.

Tim Henderson, MBA, is a strategic account manager with Digital Insight in Westlake Village, California and has almost 20 years of sales and marketing experience. Mr. Henderson obtained his BA in Political Science from UC Santa Barbara and an MBA from Pepperdine University.

Harold McIntyre, MBA, is a section manager for Verizon in Carrollton, Texas and has 25 years of experience in Information Technology and Customer Relations. Mr. McIntyre obtained his BS in Computer Math and Statistics from California State University, Northridge and an MBA from Pepperdine University.

Darrell Simms, MBA, is a program manager at Stellar Microelectronics in Valencia, California, and has over 25 years of work experience in the electronics industry. Mr. Simms received his BS in Electronic Management from Southern Illinois University and an MBA from Pepperdine University.

Sara van Valkenburg, MBA, is a contracts manager for Sage Publications in Thousand Oaks, California. Ms. van Valkenburg received her BS in Conservation and Resource Studies from UC Berkeley and an MBA from Pepperdine University.

Comments

RUNINDC

February 28, 2011 at 7:49 pm

A very thorough and accurate assessment. Thanks for applying Porters 5F to the NBA


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