PORTER’S FIVE FORCES MODEL FOR INDUSTRY ANALYSIS

PORTER’S FIVE FORCES MODEL FOR INDUSTRY ANALYSIS

Michael Porter, an authority on competitive strategy, contends that a corporation is most concerned with the intensity of competition within its industry. The level of this intensity is determined by basic competitive forces, as depicted in given figure. “The collective strength of these forces,” he contends, “determines the ultimate profit potential in the industry, where profit potential is measured in terms of long-run return on invested capital.” In carefully scanning its industry, a corporation must assess the importance to its success of each of five forces: threat of new entrants, rivalry among existing firms, threat of substitute products or services, bargaining power of buyers and bargaining power of suppliers. Also relative power of other stakeholders exists as the sixth force.

Source: Wheelen, T. L. & Hunger J. D. (2012). Strategic Management and Business Policy: Toward Global Sustainability. New Jersey: PearsonEducation, Inc.

The stronger each of these forces, the more limited companies are in their ability to raise prices and earn greater profits. Although Porter mentions only five forces, a sixth—other stakeholders—is added here to reflect the power that governments, local communities, and other groups from the task environment wield over industry activities. Using the model in given figure, a high force can be regarded as a threat because it is likely to reduce profits. A low force, in contrast, can be viewed as an opportunity because it may allow the company to earn greater profits. In the short run, these forces act as constraints on a company’s activities. In the long run, however, it may be possible for a company, through its choice of strategy, to change the strength of one or more of the forces to the company’s advantage. For example, Dell’s early use of the Internet to market its computers was an effective way to negate the bargaining power of distributors in the PC industry.

A strategist can analyze any industry by rating each competitive force as high, medium, or low in strength. For example, the global athletic shoe industry could be rated as follows: rivalry is high (Nike, Reebok, New Balance, Converse, and Adidas are strong competitors worldwide), threat of potential entrants is low (the industry has reached maturity/sales growth rate has slowed), threat of substitutes is low (other shoes don’t provide support for sports activities), bargaining power of suppliers is medium but rising (suppliers in Asian countries are increasing in size and ability), bargaining power of buyers is medium but increasing (prices are falling as the low-priced shoe market has grown to be half of the U.S. branded athletic shoe market), and threat of other stakeholders is medium to high (government regulations and human rights concerns are growing). Based on current trends in each of these competitive forces, the industry’s level of competitive intensity will continue to be high—meaning that sales increases and profit margins should continue to be modest for the industry as a whole.

Threat of New Entrants

New entrants to an industry typically bring to it new capacity, a desire to gain market share, and substantial resources. They are, therefore, threats to an established corporation. The threat of entry depends on the presence of entry barriers and the reaction that can be expected from existing competitors. An entry barrier is an obstruction that makes it difficult for a company to enter an industry. For example, no new domestic automobile companies have been successfully established in the United States since the 1930s because of the high capital requirements to build production facilities and to develop a dealer distribution network. Some of the possible barriers to entry are:

_ Economies of scale: Scale economies in the production and sale of microprocessors, for example, gave Intel a significant cost advantage over any new rival.

_ Product differentiation: Corporations such as Procter & Gamble and General Mills, which manufacture products such as Tide and Cheerios, create high entry barriers through their high levels of advertising and promotion.

_ Capital requirements: The need to invest huge financial resources in manufacturing facilities in order to produce large commercial airplanes creates a significant barrier to entry to any competitor for Boeing and Airbus.

_ Switching costs: Once a software program such as Excel or Word becomes established in an office, office managers are very reluctant to switch to a new program because of the high training costs.

_ Access to distribution channels: Small entrepreneurs often have difficulty obtaining supermarket shelf space for their goods because large retailers charge for space on their shelves and give priority to the established firms who can pay for the advertising needed to generate high customer demand.

_ Cost disadvantages independent of size: Once a new product earns sufficient market share to be accepted as the standard for that type of product, the maker has a key advantage. Microsoft’s development of the first widely adopted operating system (MSDOS) for the IBM-type personal computer gave it a significant competitive advantage over potential competitors. Its introduction of Windows helped to cement that advantage so that the Microsoft operating system is now on more than 90% of personal computers worldwide.

_ Government policy: Governments can limit entry into an industry through licensing requirements by restricting access to rawmaterials, such as oil-drilling sites in protected areas.

Rivalry among Existing Firms

In most industries, corporations are mutually dependent. A competitive move by one firm can be expected to have a noticeable effect on its competitors and thus may cause retaliation. For example, the entry by mail order companies such as Dell and Gateway into a PC industry previously dominated by IBM, Apple, and Compaq increased the level of competitive activity to such an extent that any price reduction or new product introduction was quickly followed by similar moves from other PC makers. The same is true of prices in the United States airline industry. According to Porter, intense rivalry is related to the presence of several factors, including:

_ Number of competitors: When competitors are few and roughly equal in size, such as in the auto and major home appliance industries, they watch each other carefully to make sure that they match any move by another firm with an equal countermove.

_ Rate of industry growth: Any slowing in passenger traffic tends to set off price wars in the airline industry because the only path to growth is to take sales away from a competitor.

_ Product or service characteristics: A product can be very unique, with many qualities differentiating it from others of its kind or it may be a commodity, a product whose characteristics are the same, regardless of who sells it. For example, most people choose a gas station based on location and pricing because they view gasoline as a commodity.

_ Amount of fixed costs: Because airlines must fly their planes on a schedule, regardless of the number of paying passengers for any one flight, they offer cheap standby fares whenever a plane has empty seats.

_ Capacity: If the only way a manufacturer can increase capacity is in a large increment by building a new plant (as in the paper industry), it will run that new plant at full capacity to keep its unit costs as low as possible—thus producing so much that the selling price falls throughout the industry.

_ Height of exit barriers: Exit barriers keep a company from leaving an industry. The brewing industry, for example, has a low percentage of companies that voluntarily leave the industry because breweries are specialized assets with few uses except for making beer.

_ Diversity of rivals: Rivals that have very different ideas of how to compete are likely to cross paths often and unknowingly challenge each other’s position. This happens often in the retail clothing industry when a number of retailers open outlets in the same location—thus taking sales away from each other. This is also likely to happen in some countries or regions when multinational corporations compete in an increasingly global economy.

Threat of Substitute Products or Services

A substitute product is a product that appears to be different but can satisfy the same need as another product. For example, e-mail is a substitute for the fax, Nutrasweet is a substitute for sugar, the Internet is a substitute for video stores, and bottled water is a substitute for a cola.

According to Porter, “Substitutes limit the potential returns of an industry by placing a ceiling on the prices firms in the industry can profitably charge.” To the extent that switching costs are low, substitutes may have a strong effect on an industry. Tea can be considered a substitute for coffee. If the price of coffee goes up high enough, coffee drinkers will slowly begin switching to tea. The price of tea thus puts a price ceiling on the price of coffee. Sometimes a difficult task, the identification of possible substitute products or services means searching for products or services that can perform the same function, even though they have a different appearance and may not appear to be easily substitutable.

Bargaining Power of Buyers

Buyers affect an industry through their ability to force down prices, bargain for higher quality or more services, and play competitors against each other. A buyer or a group of buyers is powerful if some of the following factors hold true:

 _ A buyer purchases a large proportion of the seller’s product or service (for example, oil filters purchased by a major auto maker).

_ A buyer has the potential to integrate backward by producing the product itself (for example, a newspaper chain could make its own paper).

_ Alternative suppliers are plentiful because the product is standard or undifferentiated (for example, motorists can choose among many gas stations).

_ Changing suppliers costs very little (for example, office supplies are easy to find).

_ The purchased product represents a high percentage of a buyer’s costs, thus providing an incentive to shop around for a lower price (for example, gasoline purchased for resale by convenience stores makes up half their total costs).

_ A buyer earns low profits and is thus very sensitive to costs and service differences (for example, grocery stores have very small margins).

_ The purchased product is unimportant to the final quality or price of a buyer’s products or services and thus can be easily substituted without affecting the final product adversely (for example, electric wire bought for use in lamps).

Bargaining Power of Suppliers

Suppliers can affect an industry through their ability to raise prices or reduce the quality of purchased goods and services. A supplier or supplier group is powerful if some of the following factors apply:

_ The supplier industry is dominated by a few companies, but it sells to many (for example, the petroleum industry).

_ Its product or service is unique and/or it has built up switching costs (for example, word processing software).

_ Substitutes are not readily available (for example, electricity).

_ Suppliers are able to integrate forward and compete directly with their present customers (for example, a microprocessor producer such as Intel can make PCs).

_ A purchasing industry buys only a small portion of the supplier group’s goods and services and is thus unimportant to the supplier (for example, sales of lawn mower tires are less important to the tire industry than are sales of auto tires).

Relative Power of Other Stakeholders

A sixth force should be added to Porter’s list to include a variety of stakeholder groups from the task environment. Some of these groups are governments (if not explicitly included elsewhere), local communities, creditors (if not included with suppliers), trade associations, special-interest groups, unions (if not included with suppliers), shareholders, and complementors.

According to Andy Grove, Chairman and past CEO of Intel, a complementor is a company (e.g., Microsoft) or an industry whose product works well with a firm’s (e.g., Intel’s) product and without which the product would lose much of its value. An example of complementary industries is the tire and automobile industries. Key international stakeholders who determine many of the international trade regulations and standards are the World Trade Organization, the European Union, NAFTA, ASEAN, and Mercosur.

The importance of these stakeholders varies by industry. For example, environmental groups in Maine, Michigan, Oregon, and Iowa successfully fought to pass bills outlawing disposable bottles and cans, and thus deposits for most drink containers are now required. This effectively raised costs across the board, with the most impact on the marginal producers who could not internally absorb all these costs. The traditionally strong power of national unions in the United States’ auto and railroad industries has effectively raised costs throughout these industries but is of little importance in computer software.

SOURCE:  COMPETITIVE ADVANTAGE: Techniques for Analyzing Industries and Competitors by Michael E. Porter. Copyright © 1980, 1988 by The Free Press. (Cited in Wheelen, T. L. & Hunger J. D. (2012). Strategic Management and Business Policy: Toward Global Sustainability. New Jersey: PearsonEducation, Inc.)