Industry Handbook: Porter's 5 Forces Analysis

Filed Under Fundamental Analysis, Statistics Fundamental Analysis, Statistics If you are not familiar with the five competitive forces model, here is a brief background on who developed it, and why it is useful. The model originated from Michael E. Porter's 1980 book "Competitive Strategy: Techniques for Analyzing Industries and Competitors." Since then, it has become a frequently used tool for analyzing a company's industry structure and its corporate strategy. In his book, Porter identified five competitive forces that shape every single industry and market. These forces help us to analyze everything from the intensity of competition to the profitability and attractiveness of an industry. Figure 1 shows the relationship between the different competitive forces.

Figure 1: Porter\'s five competitive forces

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 o

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

o o o o

2. 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 o

There are no substitutes Switching to another (competitive) product is very costly The product is extremely important to buyers - can\'t do without it The supplying industry has a higher profitability than the buying industry

3. 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 o o o

Small number of buyers Purchases large volumes Switching to another (competitive) product is simple The product is not extremely important to buyers;

they can do without the product for a period of time

o

Customers are price sensitive

4. 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:
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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. If substitutes are similar, it can be viewed in the same light as a new entrant.

5. 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:

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

Porters Generic Competitive Strategies

A firm's relative position within its industry determines whether a firm's profitability is above or below the industry average. The fundamental basis of above average profitability in the long run is sustainable competitive advantage. There are two basic types of competitive advantage a firm can possess: low cost or differentiation. The two basic types of competitive advantage combined with the scope of activities for which a firm seeks to achieve them, lead to three generic strategies for achieving above average performance in an industry: cost leadership, differentiation, and focus. The focus strategy has two variants, cost focus and differentiation focus.

1. Cost Leadership
In cost leadership, a firm sets out to become the low cost producer in its industry. The sources of cost advantage are varied and depend on the structure of the industry. They may include the pursuit of economies of scale, proprietary technology, preferential access to raw materials and other factors. A low cost producer must find and exploit all sources of cost advantage. if a firm can achieve and sustain overall cost leadership, then it will be an above average performer in its industry, provided it can command prices at or near the industry average.

2. Differentiation
In a differentiation strategy a firm seeks to be unique in its industry along some dimensions that are widely valued by buyers. It selects one or more attributes that many buyers in an industry perceive as important, and uniquely positions itself to meet those needs. It is rewarded for its uniqueness with a premium price.

3. Focus
The generic strategy of focus rests on the choice of a narrow competitive scope within an industry. The focuser selects a segment or group of segments in the industry and tailors its strategy to serving them to the exclusion of others.

Porters Five Forces Model of Competition

inShare5 Michael Porter (Harvard Business School Management Researcher) designed various vital frameworks for developing an organizations strategy. One of the most renowned among managers making strategic decisions is the five competitive forces model that determines industry structure. According to Porter, the nature of competition in any industry is personified in the following five forces: i. Threat of new potential entrants ii. iii. iv. v. Threat of substitute product/services Bargaining power of suppliers Bargaining power of buyers Rivalry among current competitors

FIGURE: Porters Five Forces model The five forces mentioned above are very significant from point of view of strategy formulation. The potential of these forces differs from industry to industry. These forces jointly determine the profitability of industry because they shape the prices which can be charged, the costs which can be borne, and the investment required to compete in the industry. Before making strategic decisions, the managers should use the five forces framework to determine the competitive structure of industry. Lets discuss the five factors of Porters model in detail:

1.

Risk of entry by potential competitors: Potential competitors refer to the firms which are not currently competing in the industry but have the potential to do so if given a choice. Entry of new players increases the industry capacity, begins a competition for market share and lowers the current costs. The threat of entry by potential competitors is partially a function of extent of barriers to entry. The various barriers to entry are

Economies of scale Brand loyalty Government Regulation Customer Switching Costs Absolute Cost Advantage Ease in distribution Strong Capital base

2.

Rivalry among current competitors: Rivalry refers to the competitive struggle for market share between firms in an industry. Extreme rivalry among established firms poses a strong threat to profitability. The strength of rivalry among established firms within an industry is a function of following factors:

Extent of exit barriers Amount of fixed cost

Competitive structure of industry Presence of global customers Absence of switching costs Growth Rate of industry Demand conditions

3. Bargaining Power of Buyers: Buyers refer to the customers who finally consume the product or the firms who distribute the industrys product to the final consumers. Bargaining power of buyers refer to the potential of buyers to bargain down the prices charged by the firms in the industry or to increase the firms cost in the industry by demanding better quality and service of product. Strong buyers can extract profits out of an industry by lowering the prices and increasing the costs. They purchase in large quantities. They have full information about the product and the market. They emphasize upon quality products. They pose credible threat of backward integration. In this way, they are regarded as a threat. 4. Bargaining Power of Suppliers: Suppliers refer to the firms that provide inputs to the industry. Bargaining power of the suppliers refer to the potential of the suppliers to increase the prices of inputs( labour, raw materials, services, etc) or the costs of industry in other ways. Strong suppliers can extract profits out of an industry by increasing costs of firms in the industry. Suppliers products have a few substitutes. Strong suppliers products are unique. They have high switching cost. Their product is

an important input to buyers product. They pose credible threat of forward integration. Buyers are not significant to strong suppliers. In this way, they are regarded as a threat.
5.

Threat of Substitute products: Substitute products refer to the products having ability of satisfying customers needs effectively. Substitutes pose a ceiling (upper limit) on the potential returns of an industry by putting a setting a limit on the price that firms can charge for their product in an industry. Lesser the number of close substitutes a product has, greater is the opportunity for the firms in industry to raise their product prices and earn greater profits (other things being equal).

The power of Porters five forces varies from industry to industry. Whatever be the industry, these five forces influence the profitability as they affect the prices, the costs, and the capital investment essential for survival and competition in industry. This five forces model also help in making strategic decisions as it is used by the managers to determine industrys competitive structure. Porter ignored, however, a sixth significant factor- complementaries. This term refers to the reliance that develops between the companies whose products work is in combination with each other. Strong complementors might have a strong positive effect on the industry. Also, the five forces model overlooks the role of innovation as well as the significance of individual firm differences. It presents a stagnant view of competition

Elements in Porter's Value Chain

Rather than looking at departments or accounting cost types, Porter's Value Chain focuses on systems, and how inputs are changed into the outputs purchased by consumers. Using this viewpoint, Porter described a chain of activities common to all businesses, and he divided them into primary and support activities, as shown below.

Primary Activities
Primary activities relate directly to the physical creation, sale, maintenance and support of a product or service. They consist of the following:

Inbound logistics These are all the processes related to receiving, storing, and distributing inputs internally. Your supplier relationships are a key factor in creating value here. Operations These are the transformation activities that change inputs into outputs that are sold to customers. Here, your operational systems create value. Outbound logistics These activities deliver your product or service to your customer. These are things like collection, storage, and distribution systems, and they may be internal or external to your organization. Marketing and sales These are the processes you use to persuade clients to purchase from you instead of your competitors. The benefits you offer, and how well you communicate them, are sources of value here. Service These are the activities related to maintaining the value of your product or service to your customers, once it's been purchased.

Support Activities
These activities support the primary functions above. In our diagram, the dotted lines show that each support, or secondary, activity can play a role in each

primary activity. For example, procurement supports operations with certain activities, but it also supports marketing and sales with other activities.

Procurement (purchasing) This is what the organization does to get the resources it needs to operate. This includes finding vendors and negotiating best prices. Human resource management This is how well a company recruits, hires, trains, motivates, rewards, and retains its workers. People are a significant source of value, so businesses can create a clear advantage with good HR practices. Technological development These activities relate to managing and processing information, as well as protecting a company's knowledge base. Minimizing information technology costs, staying current with technological advances, and maintaining technical excellence are sources of value creation. Infrastructure These are a company's support systems, and the functions that allow it to maintain daily operations. Accounting, legal, administrative, and general management are examples of necessary infrastructure that businesses can use to their advantage.

Companies use these primary and support activities as "building blocks" to create a valuable product or service.

Using Porter's Value Chain

To identify and understand your company's value chain, follow these steps.

Step 1 Identify subactivities for each primary activity.

For each primary activity, determine which specific subactivities create value. There are three different types of subactivities:

Direct activities create value by themselves. For example, in a book publisher's marketing and sales activity, direct subactivities include making sales calls to bookstores, advertising, and selling online. Indirect activities allow direct activities to run smoothly. For the book publisher's sales and marketing activity, indirect subactivities include managing the sales force and keeping customer records. Quality assurance activities ensure that direct and indirect activities meet the necessary standards. For the book publisher's sales and marketing activity, this might include proofreading and editing advertisements.

Step 2 Identify subactivities for each support activity.

For each of the Human Resource Management, Technology Development and Procurement support activities, determine the subactivities that create value within each primary activity. For example, consider how human resource management adds value to inbound logistics, operations, outbound logistics, and so on. As in Step 1, look for direct, indirect, and quality assurance subactivities. Then identify the various value-creating subactivities in your company's infrastructure. These will generally be cross-functional in nature, rather than

specific to each primary activity. Again, look for direct, indirect, and quality assurance activities.

Step 3 Identify links.

Find the connections between all of the value activities you've identified. This will take time, but the links are key to increasing competitive advantage from the value chain framework. For example, there's a link between developing the sales force (an HR investment) and sales volumes. There's another link between order turnaround times, and service phone calls from frustrated customers waiting for deliveries.

Step 4 Look for Opportunities to Increase Value.

Review each of the subactivities and links that you've identified, and think about how you can change or enhance it to maximize the value you offer to customers (customers of support activities can internal as well as external).

Porters Five Forces of Competitive Position

New Market Entrants, eg:

entry ease/barriers geographical factors incumbents resistance new entrant strategy routes to market

Supplier Power, eg:

brand reputation geographical coverage product/service level quality relationships with customers bidding

Competitive Rivalry, eg:

number and size of firms industry size and trends fixed v variable cost bases product/service ranges differentiation, strategy

Buyer Power, eg:

buyer choice buyers size/number change cost/frequency product/service importance volumes, JIT scheduling

Product and Technology Development, eg:

alternatives price/quality market distribution changes fashion alan chapman 2005, based on Michael Porter'sand Five trends Forces of Competitive Position Model. legislative effects

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