Michael Porter’s Five Forces Analysis

Michael Porter’s five forces is a model used to explore the environment in which a product or company operates.

Five forces analysis looks at five key areas mainly the threat of entry, the power of buyers, the power of suppliers, the threat of substitutes, and competitive rivalry.

Introduction to Porter’s 5 forces

The model of the Five Competitive Forces was developed by Michael E. Porter in his book „Competitive Strategy: Techniques for Analyzing Industries and Competitors“ in 1980. Since that time the ‘five forces tool’ has become an important method for analyzing an organizations industry structure in strategic processes.

Porters model is based on the insight that a corporate strategy should meet the opportunities and threats in the organizations external environment. Especially, competitive strategy should based on an understanding of industry structures and the way they change.
Porter has identified five competitive forces that shape every industry and every market. These forces determine the intensity of competition and hence the profitability and attractiveness of an industry. The objective of corporate strategy should be to modify these competitive forces in a way that improves the position of the organization. Porters model supports analysis of the driving forces in an industry. Based on the information derived from the Five Forces Analysis, management can decide how to influence or to exploit particular characteristics of their industry scan.

Overview

The Original Porter’s Five Factors:

Threat of New Entrants –

The easier it is for new companies to enter the industry, the more cut-throat competition there will be. Factors that can limit the threat of new entrants are known as barriers to entry. Some examples include:

• Existing loyalty to major brands
• Incentives for using a particular buyer (such as frequent shopper programs)
• High fixed costs
• Scarcity of resources
• Government restrictions or legislation
• Entry protection (patents, rights, etc.)
• Economies of product differences
• Brand equity
• Switching costs or sunk costs
• Capital requirements
• Access to distribution
• Absolute cost advantages
• Learning curve advantages
• Expected retaliation by incumbents

Power of Suppliers

This is how much pressure suppliers can place on a business. If one supplier has a large enough impact to affect a company’s margins and volumes, then they hold substantial power. Here are a few reasons that suppliers might have power:

• There are very few suppliers of a particular product
• There are no substitutes
• The product is extremely important to the buyer, they cannot do without it
• The supplying industry has a higher profitability than the buying industry
• Supplier switching costs relative to firm switching costs
• Degree of differentiation of inputs
• Presence of substitute inputs
• Supplier concentration to firm concentration ratio
• Threat of forward integration by suppliers relative to the threat of backward integration by firms
• Cost of inputs relative to selling price of the product

Power of Buyers/ Customers

This is how much pressure customers can place on a business. If one customer has a large enough impact to affect a company’s margins and volumes, then they hold substantial power. Here are a few reasons that customers might have power

• Small number of buyers
• Purchases of large volumes
• Switching to another (competitive) product is simple
• The product is not extremely important to the buyer, they can do without it for a period of time.
• Customers are price sensitive
• Buyer concentration to firm concentration ratio
• Bargaining leverage
• Buyer volume
• Buyer switching costs relative to firm switching costs
• Buyer information availability
• Ability to backward integrate
• Availability of existing substitute products
• Buyer price sensitivity
• Price of total purchase

Availability of Substitutes

What is the likelihood that someone will switch to a competitive product or service? If the cost of switching is low, then this poses to be a serious threat. Here are a few factors that can affect the threat of substitutes:

• Buyer propensity to substitute
• Relative price performance of substitutes
• Buyer switching costs
• Perceived level of product differentiation
• Fad and fashion
• Technology change and product innovation

The main issue is the similarity of substitutes. For example, if the price of coffee rises substantially, a coffee drinker is likely to switch over to a beverage like tea because the products are so similar.

• If substitutes are similar, then it can be viewed in the same light as a new entrant.
• Consider technology substitutes (who would have thought that MP3 technology would replace tape & CD’s?)

Competitive Rivalry

And last but not least, this describes the intensity of competition between existing firms in an industry. Highly competitive industries generally earn low returns because the cost of competition is high. A highly competitive market might result from:

• Many players of about the same size, no dominant firm.
• Little differentiation between competitors products and services.
• A mature industry with very little growth.
• Companies can only grow by stealing customers away from competitors.

For many industries, this is the major determinant of the competitiveness of the industry. Sometimes rivals compete aggressively and sometimes rivals compete in non-price dimensions such as innovation, marketing, etc.

• Number of competitors
• Rate of industry growth
• Intermittent industry overcapacity
• Exit barriers
• Diversity of competitors
• Informational complexity and asymmetry
• Fixed cost allocation per value added
• Level of advertising expense

Use of the Information form Five Forces Analysis:
Porter’s Five Forces Analysis can provide valuable information for three aspects of corporate planning:

• Statistical Analysis:
  The Five Forces Analysis allows determining the attractiveness of an industry. It provides insights on profitability. Thus, it supports decisions about entry to or exit from and industry or a market segment. Moreover, the model can be used to compare the impact of competitive forces on the own organization with their impact on competitors. Competitors may have different options to react to changes in competitive forces from their different resources and competence’s. This may influence the structure of the whole industry.

• Dynamical Analysis:
  In combination with a PESTLE Analysis, which reveals drivers for change in an industry, Five Forces Analysis can reveal insights about the potential future attractiveness of the industry. Expected Political, Economical, Socio-demographical, Technological, Legal and Environmental changes can influence the five competitive forces and thus have impact on industry structures.
  Useful tools to determine potential changes of competitive forces are scenarios.
• Analysis of Options:
  With the knowledge about intensity and power of competitive forces, organizations can develop options to influence them in a way that improves their own competitive position. The result could be a new strategic direction, e.g. a new positioning, differentiation for competitive products of strategic partnerships (see section 4).

Porters model of Five Competitive Forces allows a structured and systematic analysis of market structure and competitive situation. The model can be applied to particular companies, market segments, industries or regions. Therefore, it is necessary to determine the scope of the market to be analyzed in a first step. Following, all relevant forces for this market are identified and analyzed Hence, it is not necessary to analyzer all elements of all competitive forces with the same depth.

The Five Forces Model is based on microeconomics. It takes into account supply and demand, complementary products and substitutes, the relationship between volume of production and cost of production, and market structures like monopoly, oligopoly or perfect competition.

Influencing the Power of Five Forces
After the analysis of current and potential future state of the five competitive forces, managers can search for options to influence these forces in their organization’s interest. Although industry-specific business models will limit options, the own strategy can change the impact of competitive forces on the organization. The objective is to reduce the power of competitive forces.

The following figure provides some examples. They are of general nature. Hence, they have to be adjusted to each organization’s specific situation. The options of an organization are determined not only by the external market environment, but also by its own internal resources, competence’s and objectives.

Generic Strategies to help counter the Five Forces
Strategy can be formulated on three levels:

• Corporate level
• Business unit level
• Functional or departmental level.

The business unit level is the primary context of industry rivalry. Michael Porter identified three generic strategies (cost leadership, differentiation, and focus) that can be implemented at the business unit level to create a competitive advantage. The proper generic strategy will position the firm to leverage its strengths and defend against the adverse effects of the five forces.

Assumptions made about the Five Forces model:

• That buyers, competitors, and suppliers are unrelated and do not interact and collude
• That the source of value is structural advantage (creating barriers to entry)
• That uncertainty is low, allowing participants in a market to plan for and respond to competitive behavior.

Use of the Five Forces model

The Five Forces tool is a simple but powerful tool for understanding where power lies in a given business situation. This is important, as it helps you understand both the strength of your current competitive position, and the strength of a position you’re looking to move into.

With a clear understanding of where power lies, you can take fair advantage of a situation of strength, improve a situation of weakness, and avoid taking wrong steps. This makes it an important part of your business planning toolkit.

Application with other tools

Porters five forces model works well in association with  a SWOT analysis and a PESTLE analysis

About Michael Porter

American Michael Porter was born in 1947. After initially graduating in engineering, Porter achieved an economics doctorate at Harvard, where he was subsequently awarded university professorship, a position he continues to fulfill at Harvard Business School. Porter’s research group is based at the Harvard Business School, and separately he co-founded with Mark Kramer the Foundation Strategy Group, ‘a mission-driven social enterprise, dedicated to advancing the practice of philanthropy and corporate social investment, through consulting to foundations and corporations’.

After his earlier work on corporate strategy Porter extended the application of his ideas and theories to international economies and the competitive positioning of nations, as featured in his later books. In fact in 1985 Porter was appointed to President Ronald Reagan’s Commission on Industrial Competitiveness, which marked the widening of his perspective to national economies. By the 1990’s Porter had established a reputation as a strategy guru on the international speaking circuit second only to Tom Peters, and was among the world’s highest earning academics.

Porter’s first book Competitive Strategy (1980), which he wrote in his thirties, became an international best seller, and is considered by many to be a seminal and definitive work on corporate strategy. The book, which has been published in nineteen languages and re-printed approaching sixty times, changed the way business leaders thought and remains a guide of choice for strategic managers the world over.

References:

This tool was created by Harvard Business School professor, Michael Porter, to analyze the attractiveness and likely-profitability of an industry. Since publication, it has become one of the most important business strategy tools. The classic article which introduces it is “How Competitive Forces Shape Strategy” in Harvard Business Review 57, March – April 1979, pages 86-93

Michael Porter’s key books:

Competitive Strategy: Techniques for Analyzing Industries and Competitors, 1980
Competitive Advantage: Creating and Sustaining Superior Performance, 1985
Competition in Global Industries, 1986
The Competitive Advantage of Nations, 1990

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