Porter's five forces analysis

Porter's Five Forces Framework is a method for analyzing competition of a business. It draws from industrial organization (IO) economics to derive five forces that determine the competitive intensity and, therefore, the attractiveness (or lack thereof) of an industry in terms of its profitability. An "unattractive" industry is one in which the effect of these five forces reduces overall profitability. The most unattractive industry would be one approaching "pure competition", in which available profits for all firms are driven to normal profit levels. The five-forces perspective is associated with its originator, Michael E. Porter of Harvard University. This framework was first published in Harvard Business Review in 1979.[1]

A graphical representation of Porter's five forces

Porter refers to these forces as the microenvironment, to contrast it with the more general term macroenvironment. They consist of those forces close to a company that affect its ability to serve its customers and make a profit. A change in any of the forces normally requires a business unit to re-assess the marketplace given the overall change in industry information. The overall industry attractiveness does not imply that every firm in the industry will return the same profitability. Firms are able to apply their core competencies, business model or network to achieve a profit above the industry average. A clear example of this is the airline industry. As an industry, profitability is low because the industry's underlying structure of high fixed costs and low variable costs afford enormous latitude in the price of airline travel. Airlines tend to compete on cost, and that drives down the profitability of individual carriers as well as the industry itself because it simplifies the decision by a customer to buy or not buy a ticket. A few carriers – Richard Branson's Virgin Atlantic is one – have tried, with limited success, to use sources of differentiation in order to increase profitability.

Porter's five forces include three forces from 'horizontal' competition – the threat of substitute products or services, the threat of established rivals, and the threat of new entrants – and two others from 'vertical' competition – the bargaining power of suppliers and the bargaining power of customers.

Porter developed his five forces framework in reaction to the then-popular SWOT analysis, which he found both lacking in rigor and ad hoc.[2] Porter's five-forces framework is based on the structure–conduct–performance paradigm in industrial organizational economics. Other Porter strategy tools include the value chain and generic competitive strategies.

Five Forces

1* Threat of new entrants

Profitable industries that yield high returns will attract new entities. New entrants eventually will decrease profitability for other firms in the industry. Unless the entry of new firms can be made more difficult by incumbents, abnormal profitability will fall towards zero (perfect competition), which is the minimum level of profitability required to keep an industry in business.

The following factors can have an effect on how much of a threat new entrants may pose:

The existence of barriers to entry (patents, rights, etc.). The most attractive segment is one in which entry barriers are high and exit barriers are low. It's worth noting, however, that high barriers to entry almost always make exit more difficult.
Government policy such as sanctioned monopolies, legal franchise requirements, or regulatory requirements.
Capital requirements – clearly the Internet has influenced this factor dramatically. Web sites and apps can be launched cheaply and easily as opposed to the brick and mortar industries of the past.
Absolute cost
Cost advantage independent of size
Economies of scale
Product differentiation
Brand equity
Switching costs are well illustrated by structural market characteristics such as supply chain integration but also can be created by firms. Airline frequent flyer programs are an example.
Expected retaliation – For example, a specific characteristics of oligopoly markets is that prices generally settle at an equilibrium because any price rises or cuts are easily matched by the competition.
Access to distribution channels
Customer loyalty to established brands. This can be accompanied by large brand advertising expenditures or similar mechanisms of maintained brand equity.
Industry profitability (the more profitable the industry, the more attractive it will be to new competitors)

2* Threat of substitutes

A substitute product uses a different technology to try to solve the same economic need. Examples of substitutes are meat, poultry, and fish; landlines and cellular telephones; airlines, automobiles, trains, and ships; beer and wine; and so on. For example, tap water is a substitute for Coke, but Pepsi is a product that uses the same technology (albeit different ingredients) to compete head-to-head with Coke, so it is not a substitute. Increased marketing for drinking tap water might "shrink the pie" for both Coke and Pepsi, whereas increased Pepsi advertising would likely "grow the pie" (increase consumption of all soft drinks), while giving Pepsi a larger market share at Coke's expense.

Potential factors:

Buyer propensity to substitute. This aspect incorporated both tangible and intangible factors. Brand loyalty can be very important as in the Coke and Pepsi example above; however contractual and legal barriers are also effective.
Relative price performance of substitute
Buyer's switching costs. This factor is well illustrated by the mobility industry. Uber and its many competitors took advantage of the incumbent taxi industry's dependence on legal barriers to entry and when those fell away, it was trivial for customers to switch. There were no costs as every transaction was atomic, with no incentive for customers not to try another product.
Perceived level of product differentiation which is classic Michael Porter in the sense that there are only two basic mechanisms for competition – lowest price or differentiation. Developing multiple products for niche markets is one way to mitigate this factor.
Number of substitute products available in the market
Ease of substitution
Availability of close substitute

3* Bargaining power of customers

The bargaining power of customers is also described as the market of outputs: the ability of customers to put the firm under pressure, which also affects the customer's sensitivity to price changes. Firms can take measures to reduce buyer power, such as implementing a loyalty program. Buyers' power is high if buyers have many alternatives. It is low if they have few choices.

Potential factors:

Buyer concentration to firm concentration ratio
Degree of dependency upon existing channels of distribution
Bargaining leverage, particularly in industries with high fixed costs
Buyer switching costs
Buyer information availability
Availability of existing substitute products
Buyer price sensitivity
Differential advantage (uniqueness) of industry products
RFM (customer value) Analysis

4* Bargaining power of suppliers

The bargaining power of suppliers is also described as the market of inputs. Suppliers of raw materials, components, labor, and services (such as expertise) to the firm can be a source of power over the firm when there are few substitutes. If you are making biscuits and there is only one person who sells flour, you have no alternative but to buy it from them. Suppliers may refuse to work with the firm or charge excessively high prices for unique resources.

Potential factors are:

Supplier switching costs relative to firm switching costs
Degree of differentiation of inputs
Impact of inputs on cost and differentiation
Presence of substitute inputs
Strength of distribution channel
Supplier concentration to firm concentration ratio
Employee solidarity (e.g. labor unions)
Supplier competition: the ability to forward vertically integrate and cut out the buyer.

5* Competitive rivalry

For most industries the intensity of competitive rivalry is the biggest determinant of the competitiveness of the industry. Having an understanding of industry rivals is vital to successfully marketing a product. Positioning depends on how the public perceives a product and distinguishes it from competitors‘. An organization must be aware of its competitors' marketing strategies and pricing and also be reactive to any changes made. Rivalry among competitors tends to be cutthroat and industry profitability low while having the potential factors below:

Potential factors:

Sustainable competitive advantage through innovation
Competition between online and offline organizations
Level of advertising expense
Powerful competitive strategy which could potentially be realized by adhering to Porter‘s work on low cost versus differentiation.
Firm concentration ratio

Usage

Strategy consultants occasionally use Porter's five forces framework when making a qualitative evaluation of a firm's strategic position. However, for most consultants, the framework is only a starting point and value chain analysis or another type of analysis may be used in conjunction with this model.[3] Like all general frameworks, an analysis that uses it to the exclusion of specifics about a particular situation is considered naïve .

According to Porter, the five forces framework should be used at the line-of-business industry level; it is not designed to be used at the industry group or industry sector level. An industry is defined at a lower, more basic level: a market in which similar or closely related products and/or services are sold to buyers (see industry information). A firm which competes in a single industry should develop, at a minimum, one five forces analysis for its industry. Porter makes clear that for diversified companies, the primary issue in corporate strategy is the selection of industries (lines of business) in which the company will compete. The average Fortune Global 1,000 company competes in 52 industries [4].

Criticisms

Porter's framework has been challenged by other academics and strategists. For instance, Kevin P. Coyne and Somu Subramaniam claim that three dubious assumptions underlie the five forces:

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 changes in competitive behavior.[5]

Also, the last chapter of the book: "Age of agile" attributes the bankruptcy of Porter's firm to the outdated nature of his model around competitiveness instead of creating customer value and not making the customers at the center of the universe, i.e customer centricity.

An important extension to Porter's work came from Adam Brandenburger and Barry Nalebuff of Yale School of Management in the mid-1990s. Using game theory, they added the concept of complementors (also called "the 6th force") to try to explain the reasoning behind strategic alliances. Complementors are known as the impact of related products and services already in the market.[6] The idea that complementors are the sixth force has often been credited to Andrew Grove, former CEO of Intel Corporation. Martyn Richard Jones, while consulting at Groupe Bull, developed an augmented five forces model in Scotland in 1993. It is based on Porter's Framework and includes Government (national and regional) as well as pressure groups as the notional 6th force. This model was the result of work carried out as part of Groupe Bull's Knowledge Asset Management Organisation initiative.

Porter indirectly rebutted the assertions of other forces, by referring to innovation, government, and complementary products and services as "factors" that affect the five forces.[7]

It is also perhaps not feasible to evaluate the attractiveness of an industry independently of the resources that a firm brings to that industry. It is thus argued (Wernerfelt 1984)[8] that this theory be combined with the resource-based view (RBV) in order for the firm to develop a sounder framework.

gollark: It *reduces* the trust you need, which is the problem.

gollark: Yes, but it's not a good replacement because it's unfair.

gollark: ubq has some weird complaint about it dehumanizing transactions because something something reduces necessary trust.

gollark: Proof of stake is kind of terrible though?

gollark: 0003 00440 01014 11410.

References

Michael E. Porter, "How Competitive Forces Shape Strategy", Harvard Business Review, May 1979 (Vol. 57, No. 2), pp. 137–145.
Michael Porter, Nicholas Argyres and Anita M. McGahan, "An Interview with Michael Porter", The Academy of Management Executive 16:2:44 at JSTOR
Tang, David (21 October 2014). "Introduction to Strategy Development and Strategy Execution". Flevy. Retrieved 2 November 2014.
"External Inputs to Strategy | Boundless Management". courses.lumenlearning.com. Retrieved 2017-12-06.
Kevin P. Coyne and Somu Subramaniam, "Bringing Discipline to Strategy, McKinsey Quarterly, 1996, (Vol. 33, No. 4), pp. 14–25.
Brandenburger, A. M., & Nalebuff, B. J. (1995). The Right Game: Use Game Theory to Shape Strategy. Harvard Business Review, (Vol. 73, No. 4), 57–71. PDF
Michael E. Porter. "The Five Competitive Forces that Shape Strategy", Harvard Business Review, January 2008 (Vol. 88, No. 1), pp. 78–93. PDF
Wernerfelt, B. (1984), A Resource-based View of the Firm, Strategic Management Journal, Vol. 5: pp. 171–180 PDF

Porter's five forces analysis

Five Forces

1* Threat of new entrants

2* Threat of substitutes

3* Bargaining power of customers

4* Bargaining power of suppliers

5* Competitive rivalry

Usage

Criticisms

See also

References

Further reading