Porter’s Five Forces Model

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Porter’s Five Forces

The Five Forces model of Harvard professor Michael E. Porter is an effective tool used to analyze the attractiveness and value of an industry structure.

He advocates that a structural analysis of industries be made so that a firm is in a better position to identify its strengths and weaknesses.

In comparison with the PESTLE analysis - which deals with factors outside the industry (the macro environment) - the Five Forces model focuses on factors inside the industry (the microenvironment).

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The Role of the Macro and Micro environment

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The purpose of Five-Forces Analysis The five forces are environmental forces that

impact on a company’s ability to compete in a given market.

The purpose of five-forces analysis is to diagnose the principal competitive pressures in a market and assess how strong and important each one is.

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Porter’s Five Forces Model

Threat of Substitute Products

Threat of Substitute Products

Rivalry Among Competing Firms

in Industry

Rivalry Among Competing Firms

in Industry

Bargaining Power of Buyers

Bargaining Power of Buyers

Bargaining Power of Suppliers

Bargaining Power of Suppliers

Threat of Threat of New New

EntrantsEntrants

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1. The Threat of the entry of new Entrants Profitable markets that yield high returns will draw firms.

This results in many new entrants, which will effectively decrease profitability. Unless the entry of new firms can be blocked by incumbents, the profit rate will fall towards a competitive level

New entrants into an industry threaten incumbent companies – They have to share the growing market pie with the competitors or part with some of their own market share.

The threat of new entrants will depend on 2 factors – the entry barriers to the industry and the expected retaliation from the existing firms

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Threat of New Entrants - Entry barriers reduce the threat of new competition.

Expected Retaliation from incumbent firms – the existing firm may lower its price or alter the base of competition

Government Policy (licensing)

Economies of Scale (example FMCG companies)

Product Differentiation (example Mobile phones)

Capital Requirements (automobile sector)

Switching Costs (CNG)

Access to Distribution Channels (Soft drinks)

Cost Disadvantages Independent of Scale (favorable location, proprietary products, access to raw material etc)

Barriers to Entry

Barriers to Entry

The Threat of new entrants Despite the formidable hurdles posed by existing

firms, new firms do enter industries if they find them to be promising.

The popular strategy for doing this to find market niches not served by existing firms and to gradually build up their presence in the industry

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Threat of Substitute Products The existence of close substitute

products increases the propensity of customers to switch to alternatives in response to price increases.

Example Tea and coffee can be considered as close substitutes for the market of stimulant drinks.

Firms with products which have no close substitutes can charge a higher price and earn more profits

Products with similar function limit the prices firms can charge

Products with similar function limit the prices firms can charge

Bargaining power of Suppliers Any industry requires raw materials –

components, labor and other supplies. Suppliers too have a level of bargaining power.

Suppliers if powerful can exert an influence of the manufacturing industry, such as selling the raw materials at a higher price which eats into the profits of the firms

Powerful suppliers are a entry barrier to new firms.

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Bargaining Power of SuppliersSupplier industry is dominated by a few firms (drugs suppliers and Hospitals as in case of Tamiflu by Roche)

Suppliers’ products have few substitutes – (Microprocessors) Buyer is not an important customer to supplier (Kirana shops to FMCG companies)

Supplier’s product is an important input to buyers’ product (Steel to cars)

Suppliers’ products are differentiated (Apple products to retailer)

Suppliers’ products have high switching costs (Microsoft to computers)

Suppliers can vertically integrate forward to compete with buyers and buyers can’t integrate backward to supply their own needs (Movie producing companies have integrated forward to acquire theatres)

Suppliers exert power in the industry by:Suppliers exert power in the industry by:

* Threatening to raise* Threatening to raiseprices or to reduce qualityprices or to reduce quality

Powerful suppliers can squeeze industry profitability if firms are unable to recover cost increases

Powerful suppliers can squeeze industry profitability if firms are unable to recover cost increases

Bargaining power of Buyers The bargaining power of Buyers constitute the

ability of the buyers, individually or collectively to force reduction of prices of products, demand a higher quality or seek more value for their purchases.

A higher buyer bargaining power constitutes a negative feature for the existing firms and the new entrants

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The Bargaining Power of Buyers Buyers are most powerful when:

Buyers are few in number. Buyers purchase in large quantities. A single buyer is a large customer to a firm. Buyers can switch suppliers at low cost. Buyers purchase from multiple sellers at once. When the purchased product constitutes a high

percentage of the buyers cost. Buyers can easily vertically integrate to compete

with suppliers (private labels in retail industry)

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Rivalry Among Established Companies

The intensity of competitive rivalry in an industry arises from: Industry’s competitive structure.

1. Fragmented – low entry barriers

2. Consolidated structure – Oligopolistic or monopolistic. The intensity of competition may vary from guarded tolerance to fierce rivalry.

Demand (growth or decline) conditions in industry.

1. High demand – moderate competition

2. Stagnant demand – competitive strategies to snatch others business

Height of industry exit barriers (Economic, Strategic or emotional).

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Competitive Structure

Continuum ofContinuum of Industry Structures Industry Structures

FragmentedFragmentedMany small Many small

firms,firms,no dominantno dominant

firmfirm

Few firms,Few firms,shared dominanceshared dominance

(oligopoly)(oligopoly)

Consolidated Consolidated One firm or oneOne firm or onedominant firmdominant firm

(monopoly)(monopoly)

Changing industry structures Amazon, who spotted an opportunity to surpass brick & mortar stores,

by becoming a distributor with a web-based store-front. Traditionally, the book-industry was organised as follows. A book gets printed, it then gets distributed, it then lands in a store, and then the customer buys it.

Amazon integrated three of these functions: distribution, store, and customers (four, if you include ebooks into the formula). The end-result was that the customer became empowered: he could review books, even sell books second-hand. Which disempowered other stores where this was not possible, and publishers, who were before able to simply push out best-sellers downstream. Publishers are still powerful of course, essentially acting as a gatekeeper to writers, but this will change as soon as online publishing can be consumed comfortably.