Porter five forces analysis
|This article relies on references to primary sources. (October 2009)|
Porter five forces analysis is a framework for industry analysis and business strategy development. It draws upon industrial organization (IO) economics to derive five forces that determine the competitive intensity and therefore attractiveness of a market. Attractiveness in this context refers to the overall industry profitability. An "unattractive" industry is one in which the combination of these five forces acts to drive down overall profitability. A very unattractive industry would be one approaching "pure competition", in which available profits for all firms are driven to normal profit.
Three of Porter's five forces refer to competition from external sources. The remainder are internal threats.
Porter referred to these forces as the micro environment, to contrast it with the more general term macro environment. 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 and yet individual companies, by applying unique business models, have been able to make a return in excess of the industry average.
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 forces from 'vertical' competition: the bargaining power of suppliers and the bargaining power of customers.
Porter developed his Five Forces analysis in reaction to the then-popular SWOT analysis, which he found unrigorous and ad hoc. Porter's five forces is based on the Structure-Conduct-Performance paradigm in industrial organizational economics. It has been applied to a diverse range of problems, from helping businesses become more profitable to helping governments stabilize industries.
Threat of new entrants
Profitable markets that yield high returns will attract new firms. This results in many new entrants, which eventually will decrease profitability for all firms in the industry. Unless the entry of new firms can be blocked by incumbents, the abnormal profit rate will trend towards zero (perfect competition).
- 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. Few new firms can enter and non-performing firms can exit easily.
- Economies of product differences
- Brand equity
- Switching costs or sunk costs
- Capital requirements
- Expected retaliation
- Access to distribution
- Customer loyalty to established brands
- Absolute cost
- Industry profitability; the more profitable the industry the more attractive it will be to new competitors.
Threat of new entrants, sources. 1)Economies of scale, 2)Product differentiation, 3)Cost disadvantages independent of size, 4)Access to distribution channels, 5)Government Policy.
Threat of substitute products or services
The existence of products outside of the realm of the common product boundaries increases the propensity of customers to switch to alternatives. For example, tap water might be considered a substitute for Coke, whereas Pepsi is a competitor's similar product. 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), albeit while giving Pepsi a larger slice at Coke's expense. Another example is the substitute of traditional phone with VoIP phone.
- Buyer propensity to substitute
- Relative price performance of substitute
- Buyer switching costs
- Perceived level of product differentiation
- Number of substitute products available in the market
- Ease of substitution. Information-based products are more prone to substitution, as online product can easily replace material product.
- Substandard product
- Quality depreciation
Bargaining power of customers (buyers)
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. e.g. firm can implement loyalty program to reduce the buyer power.
- 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 relative to firm switching costs
- Buyer information availability
- Force down prices
- Availability of existing substitute products
- Buyer price sensitivity
- Differential advantage (uniqueness) of industry products
- RFM (customer value) Analysis
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. Suppliers may refuse to work with the firm, or, e.g., charge excessively high prices for unique resources.
- Supplier switching costs relative to firm switching costs
- Degree of differentiation of inputs
- Impact of inputs on cost or differentiation
- Presence of substitute inputs
- Strength of distribution channel
- Supplier concentration to firm concentration ratio
- Employee solidarity (e.g. labor unions)
- Supplier competition - ability to forward vertically integrate and cut out the BUYER
E.g. if you are making biscuits and there is only one person who sells flour, you have no alternative but to buy it from them.
Intensity of competitive rivalry
For most industries, the intensity of competitive rivalry is the major determinant of the competitiveness of the industry.
- Sustainable competitive advantage through innovation
- Competition between online and offline companies
- Level of advertising expense
- Powerful competitive strategy
- Firm concentration ratio
- Degree of transparency
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 or "checklist." They might use "Value Chain" afterward. Like all general frameworks, an analysis that uses it to the exclusion of specifics about a particular situation is considered naїve.
According to Porter, the five forces model 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 that 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 first fundamental issue in corporate strategy is the selection of industries (lines of business) in which the company should compete; and each line of business should develop its own, industry-specific, five forces analysis. The average Global 1,000 company competes in approximately 52 industries (lines of business).
Porter's framework has been challenged by other academics and strategists such as Stewart Neill. Similarly, the likes of ABC, Kevin P. Coyne  and Somu Subramaniam have stated 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 competitive behavior.
An important extension to Porter was found in the work of 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"), helping to explain the reasoning behind strategic alliances. The idea that complementors are the sixth force has often been credited to Andrew Grove, former CEO of Intel Corporation. According to most references, the sixth force is government or the public. Martyn Richard Jones, whilst consulting at Groupe Bull, developed an augmented 5 forces model in Scotland in 1993. It is based on Porter's model 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.
It is also perhaps not feasible to evaluate the attractiveness of an industry independent of the resources a firm brings to that industry. It is thus argued (Werner 1984) that this theory be coupled with the Resource-Based View (RBV) in order for the firm to develop a much more sound strategy. It provides a simple perspective for accessing and analyzing the competitive strength and position of a corporation, business or organization.
- Michael Porter, Nicholas Argyres, Anita M. McGahan, "An Interview with Michael Porter", The Academy of Management Executive 16:2:44 at JSTOR
- Michael Simkovic, Competition and Crisis in Mortgage Securitization
- Kevin P. Coyne and Somu Subramaniam, "Bringing discipline to strategy", The McKinsey Quarterly, 1996, Number 4, pp. 14-25
- Michael E. Porter. "The Five Competitive Forces that Shape Strategy", Harvard Business Review, January 2008, p.86-104. PDF
- Werner Felt, B. (1984), A resource-based view of the firm, Strategic Management Journal, Vol. 5, (April-June): pp. 171-180
- Coyne, K.P. and Sujit Balakrishnan (1996),Bringing discipline to strategy, The McKinsey Quarterly, No.4.
- Porter, M.E. (March/April 1979). "How Competitive Forces Shape Strategy". Harvard Business Review.
- Porter, M.E. (1980) Competitive Strategy, Free Press, New York, 1980.
- Porter, M.E. (2008) The Five Competitive Forces That Shape Strategy, Harvard business Review, January 2008.
- Ireland, Hoskisson, Understanding Business Strategy. SOUTH WESTERN.
- Rainer and Turban, Introduction to Information Systems (2nd edition), Wiley, 2009, pp 36–41.
- Kotler Philip, Marketing Management, Prentice-Hall, Inc. 1997
- Mintzberg, Ahlstrand and Lampel,Strategy Safari 1998.
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