June 14, 2021
Porter’s 5 forces model helps analyze an industry by understanding the attractiveness, profitability and intensity of competition in the industry.
WHAT IT IS
While every industry is different, the underlying drivers of profit are the same. The industry structure and the company’s relative position within the industry are two key drivers of company profitability.
First described by Michael Porter in his 1979 Harvard Business Review article, Porter’s five forces is a strategic planning framework for understanding the competitive forces at work in an industry and how they drive the way economic value is divided among industry players.
According to Porter’s five forces model, an industry’s competitiveness does not only come from the competitors. Porter’s five forces template is a tool for analyzing a company’s competitive environment, including the number and power of a company’s competitive rivals, potential new market entrants, suppliers, customers, and substitute products that influence a company’s profitability.
WHY DO IT
The structure of an industry is not static. Over time, buyers or suppliers within an industry can become more powerful or less powerful. Innovations in an industry can make new entry or substitution more likely or less likely. Regulatory changes can impact competitive intensity or affect barriers to entry. New pricing or distribution approaches taken by competitors can also affect the path of industry competition.
Porter’s five forces model serves as a competitive strategy that helps companies anticipate shifts in competition, shape how industry structure evolves, and find better strategic positions. Thus, companies can make informed decisions about which industries they should compete in and how to position themselves for success within those industries.
HOW TO DO IT
Step 1: Preparation for the analysis
Porter’s five forces analysis requires detailed knowledge of the external environment. It should be done by a cross-functional team of experts from operations, product development, sales and marketing, customer service and finance. Before starting the process, you should be ready with answers to most, if not all, of the questions pertaining to each section of the five forces.
Step 2: Threat of New entry
The threat of new entry maps out the degree of difficulty for a new player to enter the market and make a profit. The less time and resources it would take for a competitor to enter your market, the easier it is for your company’s position to weaken. An industry with a strong barrier to entry is ideal for an existing company since it would charge higher prices and negotiate better terms. The airline industry is an example of an industry with a strong barrier to entry.
Step 3: Threat of substitution
This refers to the potential for your product or service being replaced by an entirely new product or service, like electric-powered vehicles to internal combustion engines. Companies that sell goods or services with no close substitutes will have more power to increase prices and lock in favourable terms. Currently, electric vehicles (EVs) are posing a threat of substitution to Autogas vehicles.
Step 4: Supplier power
This factor addresses how easily suppliers can drive up the cost of inputs. It is affected by the number of suppliers of core inputs, the uniqueness of these inputs, and the switching cost to another supplier. The fewer suppliers in an industry, the more power they would have to charge more or push other advantages. An industry with high bargaining power of suppliers is computer hardware manufacturers who need specific microchips from their suppliers.
Step 5: Buyer power
This factor determines how much power customers have to drive prices lower. It is affected by how many customers a company has, its significance, and the cost of acquiring new customers. The smaller the customer base, the more power customers have to negotiate for lower prices and better deals. An example of an industry with low bargaining power of buyers is the pharmaceutical industry.
Step 6: Competitive rivalry
The larger the number of competitors and their offering, the lesser the power a company has. In a highly competitive category, both suppliers and customers can shop around, which puts downward pressure on prices and profits. Hair shampoo production is a highly competitive industry with several players in the market.
|Threat of New Entry||Threat of substitution||Buyer power||Competitive rivalry|
|Economies of scale||Number of substitute products available||Buyer volume (number of customers)||Number of competitors|
|Product differentiation||Buyer's propensity to substitute||Size of each buyer's order||Diversity of competitors|
|Brand identity/loyalty||Relative price performance of substitutes||Buyer concentration||Industry concentration and balance|
|Access to distribution channels||Perceived level of product differentiation||Buyer's ability to substitute||Industry growth|
|Capital requirements||Switching costs||Buyer's switching costs||Industry life cycle
|Access to the latest technology||Substitute producer's profitability & aggressiveness||Buyer's information availability||Quality differences|
|Access to necessary inputs||Buyer's threat of backward integration||Product differentiation|
|Absolute cost advantages||Industry threat of forward integration||Brand identity/loyalty|
|Experience and learning effects||Price sensitivity||Switching costs|
|Government policies||Intermittent overcapacity|
|Switching costs||Informational complexity|
|Expected retaliation from existing players||Barriers to exit|
Step 7: Decision making
Now analyze each of the factors for the industry of your choice and rate them as high, low or medium. Look out for any quick wins, flag internally any concerns, and consider what it teaches you about your future direction. You can then make a decision about how you are going to position yourselves to take advantage of the market, equipped with porter’s five forces framework.
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