Porter's Five Forces Explained & Analysis PDF

Porter's Five Forces Explained and How to Use the Model The fundamentals you need to analyze an industry's weaknesses and strengths What Are Porter's Five Forces? Michael Porter's five-force strategic analysis model, introduced in a 1979 article published in the Harvard Business Review, r...

Porter's Five Forces Explained and How to Use the Model The fundamentals you need to analyze an industry's weaknesses and strengths What Are Porter's Five Forces? Michael Porter's five-force strategic analysis model, introduced in a 1979 article published in the Harvard Business Review, remains a fundamental tool for strategic analysts plotting the competitive landscape of an industry.1 In a bid to mirror the complexity real strategists would face while keeping their strategic analysis manageable, Porter set out five forces at play in a given industry: internal competition, the potential for new entrants, the negotiating power of suppliers, the negotiating power of customers, and the ability of customers to find substitutes. Below, we take you through each of Porter's five forces, detail the significant critiques of his approach, and show how to apply the model to specific markets. KEY TAKEAWAYS  Porter's five forces are used to identify and analyze an industry's competitive forces.  The five forces are competition, the threat of new entrants to the industry, supplier bargaining power, customer bargaining power, and the ability of customers to find substitutes for the sector's products.  The model guides businesses in determining the intensity of competition and potential profitability within their market, helping them better understand where power lies in their sector.  Porter's model was meant to critique "perfectly competitive" business models, unlike real-world markets where competitors aren't just rivals and firms in specific industries tend to rise and fall together.  Criticisms mounted against the model include that it's too static, doesn't speak to the advantages or problems of specific companies, doesn't account enough for collaborative business models, and doesn't apply as well to quick-changing markets. Understanding Porter's Five Forces Strategic analysis at the time of Porter's article tended not only to love acronyms (SWOT, PEST, PESTEL, BCG Matrix, ETPS, etc.) but also models focused on the internal dynamics of individual companies. While it would be unfair to suggest they ignored the competitive environment companies face, they were typically vague while doing so; e.g., the "opportunities" and "threats" of SWOT analysis were too "macro" for many dealing with the challenges of specific industries. Porter's 1979 article was also a broadside against the theoretical models found in the curriculums of the major business schools, where future strategists dealt with a "perfectly competitive" market characterized by equilibrium and no specific firm influencing prices—a model they were unlikely to find in the real world. The first sentence of Porter's 1979 article could hardly be less controversial: "The essence of strategy formulation is coping with competition." Page No. 1 It's the following sentence that, in its understated way, would prove far more consequential: "Yet it is easy to view competition too narrowly and too pessimistically."1 Rather than viewing competition narrowly as rivalry among existing competitors, which is his first force, Porter expanded the concept to include four others: the bargaining power of suppliers and buyers, the threat of new entrants, and the threat of substitute products or services. Let's take these in turn. Subscribe to "Term of the Day" and learn a new financial term every day. Stay informed and make smart financial decisions. Sign up now. Porter's Five Forces 1. Competitive Rivals Porter's first force is what we usually mean when discussing business competition. We think of Pepsi and Coca-Cola for soft drinks, Apple and Samsung for smartphones, Nike and Adidas for sneakers, and Ford and General Motors for autos. Indeed, some of these rivalries are so influential that consumers split almost culturally among those who have an iPhone, drive a Ford, or prefer Netflix to Hulu. Thus, it's no accident that we also consider business competition chiefly a war among rivals. Such rivalries can lead to price wars, high-priced marketing battles, and races for slight advances that could mean a competitive advantage. These tactics can stimulate companies to make ever better products but also erode profits and market stability.3 Several factors contribute to the intensity of competitive rivalry in an industry:  The number of competitors: The more competitors in an industry, the more fierce the rivalry, each fighting for scraps of market share.  Industry growth: In an expanding industry, competition is usually less dramatic because the market is growing so fast that competitors have little need to fight for customers—think of the automobile industry of the early 20th century and the dot- com boom of the late 1990s. However, in a stagnant or declining industry, competition can be ferocious as firms fight for a larger piece of a shrinking pie, such as in the global coal mining or print media industries of today.  Similarities in what's offered: When the products or services in a market are awfully similar (think of the lower page of results in any Amazon product search), competition tends to be intense because customers can easily switch. However, if a company offers a unique product or service or has earned brand loyalty, this can reduce competitive rivalry. Apple, Inc. (AAPL) comes to mind in tech goods, just as Rao's Italian sauces or King Arthur flour do in your supermarket aisles, each charging a higher price given its style, taste, or whatever makes it unique.  Exit barriers: When it's difficult or costly for companies to leave the industry due to specialized assets, contractual obligations, or emotional attachment, they may choose to stay and compete, even if the market's prospects grow dimmer by the day. The airline industry is a classic example. Airlines have high costs for their assets, contractual obligations (leasing agreements and labor contracts), and regulatory requirements, which means that when airlines face a shrinking market—or even an unprofitable route—they can't retreat from the market quickly. Page No. 2   Fixed costs: Porter notes that if an industry has high fixed costs, companies have a "strong temptation" to cut prices rather than slow production when demand slackens. Paper and aluminum manufacturing are two good examples that Porter gives.1 2. Potential for New Entrants in an Industry Industries where new firms can enter more easily almost always have lower profit margins, and the firms involved each have less market share.1 The sector for local restaurants has relatively low entry requirements: there aren't significant investments or regulatory hurdles to surmount before opening to the public. Thus, it's also the case that your favorite restaurant may not stay open for long, given the hypercompetitive environment and constant entrance of new restaurants opening. Here are factors in measuring how much new entrants threaten an industry:  Economies of scale: Industries where large-scale production leads to lower costs face less of a threat from new entrants. New firms would need to achieve a similar size to compete on price, which might be difficult or costly.  Product differentiation: When existing firms have strong brand identities or customer loyalty, it's harder for new entrants to gain market share, reducing the threat of entry.  Capital requirements: High startup costs for equipment, facilities, etc., can deter new entrants. For example, starting a car manufacturing business requires significant investment, so until Tesla Inc.'s (TSLA) growth in the early 2010s, Americans from the 1950s could have named the major U.S. car brands of the early 2000s.  Access to distribution channels: If existing firms control the distribution channels—retail stores, online platforms, cable infrastructure, etc.—then new entrants would need to find a way to replicate that structure while competing with the established firms on price, a tricky proposition.  Regulations: Licenses, safety standards, and other regulatory standards can create barriers, making it too ungainly or costly for new firms to enter the market. Examples would include those looking to build new hotels in downtown areas or supply power to a region.  Switching costs: If it's costly or difficult for customers to switch from existing firms to new entrants, the threat of entry is lower. 3. Supplier Power Suppliers are powerful when they are the only source of something important that a firm needs, can differentiate their product, or have strong brands. When the power of suppliers in an industry is high, this raises costs or otherwise limits the resources a firm needs. Here are some factors used to measure the supplier power of an industry:  The number of suppliers: When few firms can give a company something it needs to stay in business, each has greater negotiating power. They can raise prices or reduce quality without fear of losing business.  Uniqueness: If a supplier provides a unique product or it's not easy to find a substitute, it is more dominant. Businesses can't easily switch to another supplier.  Switching costs: If it's costly or time-consuming to switch suppliers, then they have more power. Businesses are less likely to switch, even if prices increase.  Forward integration: If suppliers can move into the buyer's industry, they have more power. They already have access to the necessary supplies, making it difficult for their former buyers to compete once they decide to enter the market themselves. Page No. 3   Industry importance: Some sectors are tightly intertwined, such as automotive suppliers and the major auto companies or the semiconductor and tech industries, which can balance the power between the suppliers and those in the sector. This is because the supplier needs these buyers to do well so that it can, too. When a supplier can just as easily sell its products elsewhere, that gives it a great deal more power. 4. Customer Power When customers have more strength, they can exert pressure on businesses to provide better products or services at lower prices. This force intensifies under certain conditions:  The number of buyers: The fewer the buyers, the more they have power. In sectors like aerospace manufacturing, each major airline, the industry's customers, has significant leverage in negotiations and can demand favorable terms because the sellers depend on their business.  Purchase size: Just like you head off to the big box stores to buy in bulk for a cheaper per-unit cost on whatever now fills up your garage, major retail chains like Walmart Inc. (WMT) buy in large volumes and can negotiate better terms and discounts.  Switching costs: In industries like telecommunications, where it's easy for consumers to switch providers, companies such as Verizon Communications, Inc. (VZ) and AT&T Inc. (T) have to offer competitive terms.  Price sensitivity: In the fast-fashion industry, where customers are highly price- sensitive, brands must keep their prices low to attract cost-conscious consumers.  Informed buyers: In many sectors, the customers are savvy, know the competitive terrain well, and thus can negotiate better prices. Porter chose the metaphor of forces because they aren't static, so business must constantly adjust their strategies as forces in an industry change. 5. Threat of Substitutes When customers can find substitutes for a sector's services, that's a major threat to the companies in that industry. Here are some ways that this threat can be magnified:  Relative price performance: If the cost of a substitute is lower and its performance is comparable or better, customers are likely to switch to the substitute. For instance, streaming services like Netflix became a substitute for traditional cable TV, providing a lower price that soon threatened the cable industry.  Customer willingness to go elsewhere: The threat is high if buyers find it easy to switch to a substitute. For example, in the early 2010s, customers found switching from taxis to ride-sharing apps like Uber or Lyft cheaper and easier.  The sense that products are similar: If buyers perceive that there are few differences between your product and a substitute, even if there are, they may be more likely to switch.  Availability of close substitutes: Though this sounds the same as the last bullet point, you have to strategize differently around it. There are times when potential substitutes are very different from a company's products but consumers still treat them as the same. But in other cases, there are genuinely similar products in the market and the threat of substitutes is high, such as between brand-name and generic medications. Page No. 4 Competitive Measures When published, Michael Porter's framework marked a departure from the then-dominant models of business strategy, steeped in classic competition theory.4 Those models, still echoed in Economics 101 textbooks, rested on several key, if questionable, assumptions: markets as arenas for many small firms with no significant market power, homogeneous products, perfect information symmetry, and no barriers to market entry or exit. While helpful for learning basic principles, this idealized view could be taken to an extreme when strategizing with neatly constructed supply and demand curves, assuming, for instance, new market entrants would stabilize rising prices by increasing supply. Business strategists need to deal with sectors where information asymmetry, product differentiation, and significant entry and exit barriers are common. Firms do have some control over prices, contradicting classical assumptions. In short, where economists assumed most markets acted like the model, for Porter, most firms are in industries with entrenched interests and different supplier and customer relations. They need strategies for dealing with anything but perfect competition.5 Mild-to-Intense Competition Porter's five forces come together in different ways for any given sector. He labeled industry competition as ranging from "intense" to "mild," with profits harder to achieve as the intensity in a sector rises. In intensely competitive industries, all or most of the five forces have a strong influence.1 The fast food industry is Porter's own example, which still remains the case.1 In this sector, there's a fierce rivalry among established players like McDonald's and Burger King, high bargaining power for suppliers and customers, and a relentless threat of new entrants and substitutes, all of which means profits are constantly getting squeezed for anyone in the sector. Meanwhile, in "mild" industries, such as commercial aircraft manufacturing, there are weaker forces. Here, low supplier bargaining power, a minimal threat of new entrants, and a lack of direct substitutes (like commercial aircraft for long-distance travel) help form a sector more conducive to higher profits. Applying the Model Since his 1979 Harvard Business Review article, Porter has published many books on strategic analysis, including works where he has expanded on his five-force model. H e's also become very concise in providing the specific steps in performing an industry analysis: 1. Define the industry: The process begins with a clear description of the industry, helping you to focus your analysis. 2. Identify the key players: Specify and group the major actors in the sector into strategic categories based on relevant criteria. 3. Assess the strategic strengths: This means evaluating the firm and its industry to determine the better and worse strategies that can be applied. 4. Analyze the industry structure: This involves examining the overall structure of the industry, particularly the factors that influence how profitable it is. 5. Evaluating the competitive forces: Only once you've done the above does Porter advise doing a detailed analysis of the five competitive forces, assessing their positive and negative effects, and then looking forward to any changes in these forces ahead. Page No. 5  6. Identify the factors you have some control over: Here, you want to pinpoint aspects of the industry structure that could be influenced by competitors, new market entrants, or your firm. In sum, what can be changed? Critiques of the Five Forces Porter’s model helped reframe the understanding of competition. It wasn’t confined to direct rivals but extended to suppliers and customers—traditionally viewed in a transactional light. Suppliers, especially those with unique resources or enjoying a monopoly, could dictate terms, lower profits, or, in extreme cases, forward-integrate into the buyer’s industry. Customers, too, wield power, especially when buying in bulk or when they can just go elsewhere quickly or choose to bypass companies for in-house products.2 But the model has its pitfalls. For example, many have critiqued the model’s emphasis on sector affiliation. Porter concentrates on industry-wide forces, which can sideline an individual company’s unique strategies and advantages. This industry-centric view may not fully capture how distinct company characteristics can change the game, not just play within an industry’s preset rules. The model assumes clear lines among sectors, which may not be tenable given the increasingly blurred lines in today’s business world, where companies are simultaneously in several sectors. Industries are no longer isolated silos; instead, they often intersect and interact, leading to a far more complex environment than the model suggests.4 Porter’s five-force model has also been critiqued for not adequately addressing the role of partnerships and collaboration.6 While Porter certainly entertained a competitive model where rivalry wasn’t just a war to the death, the problem is that he didn’t go far enough. In an interconnected global economy, alliances and cooperative strategies are often as pivotal to success as having a competitive advantage, a factor that the model doesn’t explicitly consider. Another critique that can be filed under “going in the right direction but not far enough” is that the model is too static and fails to account for industries with rapid changes in technology and consumer preferences. While effective in stable sectors, critics say it doesn’t apply well to industries marked by fast-paced innovation and shifting demand.2 Most strikingly, Porter’s model generalizes competition, implying a seemingly uniform industry structure for every market. Page No. 6