Using Porter’s 5 forces the right way (explained with examples)
When I read about Michael Porter’s five forces for the first time, it seemed like a very basic and easy to understand framework, but the implications of the model are underestimated especially because the model is not used the way it is supposed to be used. The following contains a brief analysis of how Michael Porter suggests the five forces should be used to gauge a particular industry’s attractiveness.
I have also written a post explaining how to perform a Value Chain analysis of a firm. You can find it through my profile or the embedded link.
Overview:
Michael Porter’s 5 forces framework was first published in Harvard Business Review in 1979 and also published in Michael Porter’s book, “Competitive Strategy: Techniques for Analyzing Industries and Competitors” in 1980.
The five forces (also called structural forces) are a set of factors that directly affects how much competition a firm in an industry faces. In other words, it helps you assess an industry’s profit potential for an “average” firm.
Following are the five structural forces:
- Threat of new entrants
- Bargaining power of suppliers
- Bargaining power of buyers
- Threat of substitutes
- Intensity of competitive rivalry
Porter defines an industry as “a group of competitors producing products or services that compete directly with each other”. The first step before jumping into the five structural forces would be to identify the firms you think a “focal” firm is competing against.
To better understand how the five forces’ analysis work, we will consider, as an example, the retail coffee house industry with focal firms like Starbucks, Second Cup, etc. competing for profits and customers.
Now, let us discuss in detail each of the five-structural force:
1) Threat of Substitute Products: Substitute products are products with similar functions and can potentially limit the prices firms can charge. Retail Coffee-house Industry not only faces competition from basic coffee but also competes with substitute products like tea, juice, soft drinks, alcohol and other non-coffee related drinks.
Porter states that the biggest criteria to gauge if the threat of substitute products is High is to compare the price/performance relationship relative to the current industry products. The more attractive the price/performance ratio of substitute products the tighter the lid on an industry’s profits.” (Dess et al., 2013).
What this means is that in a scenario where consumers are switching to a healthier lifestyle and are more focused on reducing the added sugar from juice, soft-drinks, etc., the price-performance relationship of the substitute product compared to retail coffee will reduce, resulting in a low threat of substitute products.
2) Intensity of Rivalry: Intense rivalry can play out in various ways like Price competition, Advertising battles, R&D competition, etc. According to Porter’s framework, the intensity of competitive rivalry is HIGH if:
In the retail coffee industry, the barriers to entry are low as anyone can rent a place and get an espresso machine to sell coffee. With many mom and pop coffee stores and retail coffee shows, the number of competitors in the industry is high. In case, most of the coffee houses use beans and other ingredients to create different blends of coffee but the end customers are not able to tell the difference, the product differentiation would be low. Also, it would cost the customer nothing to switch from one brand to another resulting in low switching costs. The factors combined will result in a High Intensity of competitive rivalry in the industry.
3) Threat of New Entrants: According to Michael Porter, the threat of new entrants is low if a new firm has a lot of barriers to entry or if the new firm can only enter at a competitive disadvantage. According to the framework, the threat of new entrants is HIGH if:
For our retail coffee industry example, the product differentiation and the switching costs for the customers are low (as explained in the section above). But, these factors are offset to a certain extent by the high proprietary knowledge of the Incumbent firms regarding the industry and the Incumbent firms’ existing relationships with Distributors and suppliers providing these firms with an easier (higher) access to raw materials; bringing down the Threat of New Entrants to a Medium.
4) Bargaining Power of Suppliers: Suppliers in an industry exert power by threatening to raise the price or reduce quality. Powerful suppliers can squeeze industry profitability if firms are unable to recover cost increases. According to the framework, the bargaining power of suppliers is HIGH if:
For the retail coffee industry, in a scenario, there are many suppliers that provide the beans required by these firms and there is not a significant difference in the quality of the product from different suppliers, then the differentiation of the supplier’s product will be classified as low. Also, with many suppliers offering similar commodity-type products, the Switching Costs for the focal firms would be low. The Threat of Forward Integration from Suppliers would be low as the suppliers will not have the Incumbent’s accumulated knowledge and economies of Scale to easily open retail coffee-houses. All of these factors combined will result in low bargaining power of the Suppliers.
5) Bargaining Power of Buyers: Buyers compete with the focal industry by bargaining down prices, forcing higher quality and leading focal firms in price wars. According to the five forces model, the bargaining power of buyers is high if:
For our retail coffee industry example, buyers have low switching costs because of the several coffee options available to them through different competitors. Also as mentioned in one of the sections above, the nature of the products results in low product differentiation. These factors, however, are partially offset by a low concentration of buyers relative to the focal firms because the consumers are individuals with no collective bargaining power and a low threat of backward integration by the buyers caused by low access to high-quality coffee beans directly from the exporters resulting in medium bargaining power for Buyers.
Conclusion:
It is important to remember that the five forces analysis gives you a snapshot in time of an Industry’s profit potential and the behavior of these forces may change over time depending on external factors (like Politics, regulations, etc.)
According to Porter, you only need one highly negative structural force to make an industry unattractive. In other words, there is low potential for profit for an average firm in the industry. Why? Because each high structural force means high competition for profit in the industry.
So, in our retail coffee industry example, even though some big firms like Starbucks may be making a lot of profits but the profit potential for an average firm would be low because of high negative structural force for the Intensity of rivalry in the industry. According to the framework, the framework deems the industry unattractive with low potential for profits because of high competition for profits.
There have been a few criticisms about the framework but there is no denying the fact that Porter’s 5 forces framework can help a business assess the Industry and identify the opportunities and threats in an external environment.
P.S: For those interested, I have written a post explaining how to perform a Value Chain analysis of a firm. You can find it through my profile or the embedded link.
