In 1979, Harvard Professor, Michael E. Porter first proposed the Five Forces Framework in his HBR article, titled “How Competitive Forces Shape Strategy”. The model explores five factors that influence the dynamics of an industry that ultimately impact the profitability of the operating firms. In combination with PEST and SWOT analyses, Porter’s Five Forces completes the strategic landscape for effective decision-making for organizations of all sizes, including small businesses and startups. This article applies to all types of offerings – goods, services, hybrid – and company structures.
What is the Porter’s Five Forces analysis about?
If you want to know what operating in a particular market will be like, you will need to understand the external elements that shape it up. Armed with this knowledge, you can stay ahead in the game. Porter’s model identifies five interdependent forces (or threats) that you must consider.
Bargaining Power of the Buyers
Bulk buyers, usually corporates and government agencies, usually enjoy a stronger position in deal negotiation. The balance of the agreements is often tipped in their favor. For firms of any size, customer concentration (>10%) is not a favorable position to have. This is more so if there are other companies providing similar commodities or services as yours. For less technical offerings, the potential for substitution also increases greatly.
If the product is not critical to the performance of the services or goods the buyer provides, they might become more price sensitive. Similarly, corporate consumers operating on thin margins or retail consumers in medium or lower income groups look out for better bargains.
Large institutional customers that have the capability of integrating backward in the value chain can pose a serious competition. An example would be an apparel manufacturer (seller), who provides finished inventory to a fashion store chain (customer). The chain, in turn, puts its own branding for retail sale. In time, the store starts eyeing better margins and since it has the resources, it acquires a clothing manufacturer. Now, the seller will lose either partial or entire revenue from this buyer. On the other hand, this backward integration will leave the store chain with a more profitable line of goods.
Bargaining Power of the Suppliers
A limited number of vendors or those providing some specialized input can exert an influence on prices, quality, and supply. For instance, if you are an online retailer you might have to depend upon one or two reliable shipping partners, who could be more expensive.
Vendors’ position may also be strengthened if their goods/services have consumers across sectors. Continuing with our previous example, courier companies and postal departments have a large retail and corporate consumer base. Therefore, they have a lower dependency on individual segments or units, except those giving very large shipping orders.
Threat of New Entrants
Industries with low barriers to entry encourage a deluge of startup enterprises until excess fragmentation begins to put substantial pressure on margins. Lower profitability, then, discourages newer entrants and marginal entities either close down or get acquired. This process is called consolidation. Barriers here imply the difficulty in setting up a new concern, the sources of which are:
- Economies of Scale – the size of operations affecting profitability
- Product Differentiation – the uniqueness of new offerings that beat existing brand loyalties
- Capital Costs – high capital requirements acting as a deterrent
- Cost Drawbacks – lack of certain advantages as compared to established players, e.g. experience, vendor relationships, proprietary technology
- Distribution Channels – lack prolific distribution channels compared to existing firms
- Government Regulation – policies to protect a sector from overcrowding
Threat of Substitutes
Products that may be dissimilar but with same or superior attributes can sometimes pose a tangible challenge for an industry. They might offer a price advantage or better functionality. There have been numerous examples – cord phones losing out to mobiles, high street travel agencies to online travel websites, traditional mobile calling to VoIP/Skype and the list goes on.
Now let us suppose, you are a manufacturer of soft drinks that have been customers’ favorite for a long time. However, there is a growing health consciousness among the consumers and another vendor, with a powerful distribution network, rolls out a new line of cold press fruit juices. These juices are a little more expensive than your drinks but find great favor due to their health benefits. Most likely, by the time you adjust to the changed course, your opponent would have captured a large chunk of the market.
Substitutes tend to become a bigger hazard if the switching costs for the customers is low. Another scenario is where the companies are unable to anticipate the change or have been too slow in responding.
The trick is to employ proactive strategies that help you make most of the industry headwinds and harness your core strengths. It does not matter whether you are a startup, small or medium enterprise. To get actionable plans and boost your profits, contact us here.
The tools entities often use against their rivals are price wars, advertising, and product differentiation. The intensity of rivalry depends upon the number of competitors, overall market size, growth rate, consumers’ price sensitivity, exist costs, and the risk of obsolescence.
Is there a practical use?
Once a situational analysis is done, the next step is to find out ways to manage each adverse component, while building upon the low-risk areas. Porter’s Five Forces have interdependencies in such a way that they can be made to work in tandem. You can address a challenging force by utilizing your stronger position in another area.
For instance, buyers’ power increases with the availability of potent substitutes. You can answer this by increasing the switching costs for the customers if segment rivalry is not particularly intense. In addition, you can fully or partially replicate the substitutes, tweak some features in the existing products, realign your pricing strategy, or even acquire the manufacturers of close replacements. In this case, supply side elements will have an impact on the overall response.
Porter’s Five Forces analysis is a valuable and almost indispensable business planning tool when put together with PEST and SWOT frameworks. These instruments together form a system that can help create winning strategies and alternatives. Join hands with our teams to devise the most appropriate tactics for you. If you are based in the U.S, UK, Europe or India, write to us at firstname.lastname@example.org. You can also send a WhatsApp message at +919654421064.