Porter's five forces analysis
Porter's Five Forces Framework is a tool 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 of it) 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.
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. Porter's five-forces framework is based on the structure–conduct–performance paradigm in industrial organizational economics. It has been applied to try to address a diverse range of problems, from helping businesses become more profitable to helping governments stabilize industries. Other Porter strategy tools include the value chain and generic competitive strategies.
Threat of new entrants
Profitable industries that yield high returns will attract new firms. 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
- Capital requirements
- Absolute cost
- Cost disadvantages independent of size
- Economies of scale
- Product differentiation
- Brand equity
- Switching costs
- Expected retaliation
- Access to distribution channels
- Customer loyalty to established brands
- Industry profitability (the more profitable the industry, the more attractive it will be to new competitors)
- Network effect
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.
- Buyer propensity to substitute
- Relative price performance of substitute
- Buyer's switching costs
- Perceived level of product differentiation
- Number of substitute products available in the market
- Ease of substitution
- Availability of close substitute
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.
- 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
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.
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. They might use value chain or another type of analysis in conjunction. Like all general frameworks, an analysis that uses it to the exclusion of specifics about a particular situation is considered naive.
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 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 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 (lines of business).
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.
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. 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 5 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.
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) that this theory be combined with the Resource-Based View (RBV) in order for the firm to develop a sounder framework.
- National Diamond
- Value chain
- Porter's four corners model
- Industry classification
- Nonmarket forces
- Economics of Strategy
- Michael E. Porter, "How Competitive Forces Shape Strategy," May 1979 (Vol. 59, 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
- Michael Simkovic, Competition and Crisis in Mortgage Securitization
- Tang, David (21 October 2014). "Introduction to Strategy Development and Strategy Execution". Flevy. Retrieved 2 November 2014.
- Kevin P. Coyne and Somu Subramaniam, "Bringing Discipline to Strategy, The 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
|Wikimedia Commons has media related to Porter's Five Forces Model.|
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