Porter five forces analysis

The five Forces

[edit]The threat of the entry of new competitors

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 profit rate will fall towards zero (perfect competition).

 The existence of barriers to entry (patents[1], 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
 Access to distribution
 Customer loyalty to established brands
 Absolute cost advantages
 Learning curve advantages
 Expected retaliation by incumbents
 Government policies
 Industry profitability; the more profitable the industry the more attractive it will be to new
competitors
[edit]The 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; click-and-mortar -v- slags on a bridge[citation
needed]

 Level of advertising expense
 Powerful competitive strategy
 The visibility of proprietary items on the Web[1]

[2] used by a company which can intensify competitive pressures on their rivals. How will competition
react to a certain behavior by another firm? Competitive rivalry is likely to be based on dimensions such
as price, quality, and innovation. Technological advances protect companies from competition. This
applies to products and services. Companies that are successful with introducing new technology, are
able to charge higher prices and achieve higher profits, until competitors imitate them. Examples of recent
technology advantage in have been mp3 players and mobile telephones.Vertical integration is a strategy
to reduce a business' own cost and thereby intensify pressure on its rival.

[edit]The 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:

 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
[edit]The 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.

 Buyer concentration to firm concentration ratio

 Degree of dependency upon existing channels of distribution
 Bargaining leverage, particularly in industries with high fixed costs
 Buyer volume
 Buyer switching costs relative to firm switching costs
 Buyer information availability
 Ability to backward integrate
 Availability of existing substitute products
 Buyer price sensitivity
 Differential advantage (uniqueness) of industry products
 RFM Analysis
[edit]The 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
 Supplier concentration to firm concentration ratio
 Employee solidarity (e.g. labor unions)
 Supplier competition - ability to forward vertically integrate and cut out the buyer

Ex. If you are making cookies and there is only one person who sells flour, you have no alternative but to
buy it from him.

Porter's Five Forces

Assessing the Balance of Power in a Business Situation

The Porter's 5 Forces tool is a simple but powerful tool for understanding where power lies in a business
situation. This is useful, because it helps you understand both the strength of your current competitive
position, and the strength of a position you're considering moving into.

With a clear understanding of where power lies, you can take fair advantage of a situation of strength,
improve a situation of weakness, and avoid taking wrong steps. This makes it an important part of your
planning toolkit.

Conventionally, the tool is used to identify whether new products, services or businesses have the
potential to be profitable. However it can be very illuminating when used to understand the balance of
power in other situations too.
Understanding the Tool:

Five Forces Analysis assumes that there are five important forces that determine competitive power in a
business situation. These are:

1. Supplier Power: Here you assess how easy it is for suppliers to drive up prices. This is driven by
the number of suppliers of each key input, the uniqueness of their product or service, their
strength and control over you, the cost of switching from one to another, and so on. The fewer the
supplier choices you have, and the more you need suppliers' help, the more powerful your
suppliers are.
2. Buyer Power: Here you ask yourself how easy it is for buyers to drive prices down. Again, this is
driven by the number of buyers, the importance of each individual buyer to your business, the
cost to them of switching from your products and services to those of someone else, and so on. If
you deal with few, powerful buyers, then they are often able to dictate terms to you.
3. Competitive Rivalry: What is important here is the number and capability of your competitors. If
you have many competitors, and they offer equally attractive products and services, then you'll
most likely have little power in the situation, because suppliers and buyers will go elsewhere if
they don't get a good deal from you. On the other hand, if no-one else can do what you do, then
you can often have tremendous strength.
4. Threat of Substitution: This is affected by the ability of your customers to find a different way of
doing what you do – for example, if you supply a unique software product that automates an
important process, people may substitute by doing the process manually or by outsourcing it. If
substitution is easy and substitution is viable, then this weakens your power.
5. Threat of New Entry: Power is also affected by the ability of people to enter your market. If it
costs little in time or money to enter your market and compete effectively, if there are few
economies of scale in place, or if you have little protection for your key technologies, then new
competitors can quickly enter your market and weaken your position. If you have strong and
durable barriers to entry, then you can preserve a favorable position and take fair advantage of it.

These forces can be neatly brought together in a diagram like the one below:
Using the Tool:

To use the tool to understand your situation, look at each of these forces one-by-one and write your
observations on our free worksheet which you can download here.

Brainstorm the relevant factors for your market or situation, and then check against the factors listed for
the force in the diagram above.

Then, mark the key factors on the diagram, and summarize the size and scale of the force on the
diagram. An easy way of doing this is to use, for example, a single "+" sign for a force moderately in your
favor, or "--" for a force strongly against you (you can see this in the example below).

Then look at the situation you find using this analysis and think through how it affects you. Bear in mind
that few situations are perfect; however looking at things in this way helps you think through what you
could change to increase your power with respect to each force. What’s more, if you find yourself in a
structurally weak position, this tool helps you think about what you can do to move into a stronger one.

This tool was created by Harvard Business School professor, Michael

Porter, to analyze the attractiveness and likely-profitability of an industry.
Since publication, it has become one of the most important business
strategy tools. The classic article which introduces it is "How Competitive
Forces Shape Strategy" in Harvard Business Review 57, March - April
1979, pages 86-93.

Example:

Martin Johnson is deciding whether to switch career and become a farmer - he's always loved the
countryside, and wants to switch to a career where he's his own boss. He creates the following Five
Forces Analysis as he thinks the situation through:

This worries him:

 The threat of new entry is quite high: if anyone looks as if they’re making a sustained profit, new
competitors can come into the industry easily, reducing profits.
 Competitive rivalry is extremely high: if someone raises prices, they’ll be quickly undercut.
Intense competition puts strong downward pressure on prices.
 Buyer Power is strong, again implying strong downward pressure on prices.
 There is some threat of substitution.

Unless he is able to find some way of changing this situation, this looks like a very tough industry to
survive in. Maybe he'll need to specialize in a sector of the market that's protected from some of these
forces, or find a related business that's in a stronger position.
Key points:

Porter's Five Forces Analysis is an important tool for assessing the potential for profitability in an industry.
With a little adaptation, it is also useful as a way of assessing the balance of power in more general
situations.

It works by looking at the strength of five important forces that affect competition:

 Supplier Power: The power of suppliers to drive up the prices of your inputs.

 Buyer Power: The power of your customers to drive down your prices.
 Competitive Rivalry: The strength of competition in the industry.
 The Threat of Substitution: The extent to which different products and services can be used in
place of your own.
 The Threat of New Entry: The ease with which new competitors can enter the market if they see
that you are making good profits (and then drive your prices down).

By thinking about how each force affects you, and by identifying the strength and direction of each force,
you can quickly assess the strength of your position and your ability to make a sustained profit in the
industry.

You can then look at how you can affect each of the forces to move the balance of power more in your
favor.

For more information on five forces analysis, and on Michael Porter's approaches to competitive analysis,
read  Competitive Strategy: Techniques for Analyzing Industries and Competitors  by Michael E. Porter.

The next article in this section looks at Core Competence Analysis - a key technique for understanding
your competitive strengths. To read this, click "Next Article" below.
Industry Handbook: Porter's 5 Forces Analysis
1. Threat of New Entrants - The easier it is for new companies to enter the industry, the more cutthroat
competition there will be. Factors that can limit the threat of new entrants are known as barriers to
entry. Some examples include:

o Existing loyalty to major brands

o Incentives for using a particular buyer (such as frequent shopper
programs)
o High fixed costs
o Scarcity of resources
o High costs of switching companies
o Government restrictions or legislation

 Power of Suppliers - This is how much pressure suppliers can place on a business. If one
supplier has a large enough impact to affect a company's margins and volumes, then it holds
substantial power. Here are a few reasons that suppliers might have power:

o There are very few suppliers of a particular product

o There are no substitutes
o Switching to another (competitive) product is very costly
o The product is extremely important to buyers - can't do without it
o The supplying industry has a higher profitability than the buying industry
 Power of Buyers - This is how much pressure customers can place on a business. If one
customer has a large enough impact to affect a company's margins and volumes, then the
customer hold substantial power. Here are a few reasons that customers might have power:

o Small number of buyers

o Purchases large volumes
o Switching to another (competitive) product is simple
o The product is not extremely important to buyers; they can do without the
product for a period of time
o Customers are price sensitive

 Availability of Substitutes - What is the likelihood that someone will switch to a competitive
product or service? If the cost of switching is low, then this poses a serious threat. Here are a
few factors that can affect the threat of substitutes:

o The main issue is the similarity of substitutes. For example, if the price of
coffee rises substantially, a coffee drinker may switch over to a beverage like tea.
o If substitutes are similar, it can be viewed in the same light as a new
entrant.

 Competitive Rivalry - This describes the intensity of competition between existing firms in an
industry. Highly competitive industries generally earn low returns because the cost of
competition is high. A highly competitive market might result from:

o Many players of about the same size; there is no dominant firm
o Little differentiation between competitors products and services
o A mature industry with very little growth; companies can only grow by
stealing customers away from competitors