The Five Competitive Forces That Shape Strategy

Analyzing Industry’s structure using five forces is essential to understand the profitability and to
frame strategy.

If the five forces are dominant, the industry becomes tough to be profitable in the medium and the long
run. Industry structure also helps in identifying potential positioning opportunities. It is the strongest
competitive force that determines the profitability of the industry. The competitive forces are:

The threat of entry: If entry barriers are low (fixed costs, etc.), the threat of entry is high, compromising
profitability. New entrants put pressure on prices, costs and investment. It is the threat of entry, but not
the actual entry itself that holds down profitability. Entry barriers provide an advantage to incumbents if
Supply-side economies of scale, where companies producing larger volumes enjoy lower costs per unit.
Demand-side scale, where buyer’s willingness to pay for a company’s products increases with several
buyers, causing lower demand for new entrant’s products and thus decreasing prices. Switching costs of
the customers prevent new entry. If capital investment is high in the industry, new entrants’ threat is
decreased. Incumbency advantages will also help incumbents to deter new entrants. Unequal
distribution channel access means new entrants have to compete for limited shelf space with
incumbent’s products. Government policy can hinder or boost the threat of posing from new entrants.
Expected retaliation from incumbents may also hinder the entry of new competitors.

Power of suppliers: Powerful suppliers take away profits from the industry. Supplier group is powerful
if: Supplier has many industries for revenue — buyers facing higher switching costs for changing
suppliers. Suppliers’ products are differentiated — no substitutes for suppliers products.

Power of buyers: Price sensitive buyers pressure the industry for price reductions. Power of buyers
increase if: Buyers have huge volumes than a single vendor. Industry’s products are undifferentiated.
Buyers have fewer switching costs. Intermediate customers (distributors) can also gain buyer power if
they can influence the decision of downstream customers.

The threat of substitutes: Sometimes, thereat of substitute is indirect, such as a change in another
industry makes changes to the industry’s products. Substitute products put a cap on the prices of the
industry’s products. Substitute threat is high if:

Substitute offers attractive price-performance compared to industry’s products. Buyer’s switching costs
to substitute products is low. Change in industry structure may cause the substitutes more attractive than
they were before.

Competition Rivalry: High rivalry decreases profits depending on the intensity of rivalry and the basis
on which they compete. The intensity of rivalry is high when: Industry growth is low and rivals battle
for market share. Exit barriers are high. Based on the price competition, price competition, profits are
transferred directly from industry to the buyers. Apart from price competition, companies also compete on
factors such as brand image, delivery time, product features, etc. When all rivals try to meet the same
needs, the result is zero-sum competition. To achieve positive-sum competition, the competitors must
focus on segmentation and focus on satisfying the needs of the specific target group, thus increasing the
overall industry’s profitability.
 Industry structure helps in identifying the value retained by the companies after the value is taken
away by the substitutes, customer, suppliers and new entrants. It is also important to avoid common pitfall
of mistaking certain attributes of an industry with industry structure:

Industry growth: It attracts new entrants’ thus decreasing profitability. Technology and innovation
need not necessarily mean better profitability. Government can be good or bad for an industry.
Complementary products can raise or lower the entry barriers. The presence of complements can affect
the threat of substitutes. Complements affect profitability. To understand the significance of
complements, it is advised to look complements through the lens of five forces.

Five forces help in identifying the changes in the industry structure. The five forces reveal why an
industry is profitable. Studying five forces not only helps in understanding the industry structure, but also
helps in identifying shifts in industry structure and explore opportunities. The following strategies can be
employed with respect to five forces to improve the industry’s profitability:

Company’s positioning: Strategy is all about finding a position where industry’s forces are the weakest.
E.g. Paccar identifying a customer segment of owner-operated trucks. They have identified the customers
were less price sensitive, willing to pay more for their product than competitor products. Thus they have
found a positioning where the competitive forces were weak and acted on it.

Exploiting industry change: Sometimes, the giants inside the industry can’t cope with the industry
change. In those situations, smaller competitors act on the industry change. If not, new entrants will act on
it. For e.g., Apple acting on digital music revolution by introducing iTunes. Major recording companies
were unable to act on it. As a result, 2 out of 6 recordings were closed.

Shaping industry change: A firm can lead its industry towards a better industry structure by altering the
five forces. It can be done by using Redividing profitability or expanding overall profit pool. In
redividing profitability, the goal is to reduce the share of profits leaking away to suppliers, buyers,
substitutes and new entrants. To neutralize supplier power, make it easier to switch among suppliers. To
limit substitutes, offer better value and better features. To ward off rivalry, focus on differentiated
products. Increase the fixed costs to ward off new entrants.

Expanding the profit pool: The goal is to reduce the wastage and costs of suppliers. For e.g., making
distribution channels more competitive, helping suppliers improve their operational efficiency,
competitors focusing on different segments. This increases the overall profits.