There are five general market or competitive forces that affect every business to some degree. These are often called Porter’s Five Forces because they were popularized in Michael E. Porter’s book, Competitive Strategy, published in 1980. The five forces result from industry structure and have an effect on the performance of a business and the attractiveness of a market. They describe the pressure on the industry participants and the impact on profitability performance of a company. The five forces are as follows:
- Bargaining Power of Buyers
- Bargaining Power of Suppliers
- Threat of New Entrants
- Threat of Substitution
- Intensity of Rivalry among Existing Competitors
The strength and effect of each of the forces varies depending upon the industry structure. Most businesses will be strongly affected by at least one of these forces. Very few businesses are affected by all five. While the strength of the forces is largely a function of the industry structure, industry participants can often take some action to mitigate the effect of the forces. Understanding the industry structure and resultant competitive forces is an important part of the strategic analysis and planning process. In industries where the combination of these forces are high, the pressure limits the achievable profitability and returns, making the industry and the industry participants less attractive or making the business more challenging for existing participants.
The bargaining power of buyers is mainly dependent upon the size and strength of the buyers. Large and strong buyers that are able to easily switch suppliers or backward integrate have strong leverage in dictating price and terms. This is especially true when the product or service is more of a commodity rather than a differentiated product.
An obvious example of this situation is the automotive industry where the OEM’s have great strength, especially relative to some of the smaller suppliers of common products. They are often able to dictate pricing and drive margins down. When possible, the best defense in situations of high buyer leverage is to create differentiation in some way that provides more power to the seller or drive up switching costs. In some cases the strategic selection of customers can keep a supplier out of the worst scenarios of buyer leverage.
The bargaining power of suppliers is strong when they have unique materials, technology, or other means to control the industry participants that rely upon them. Situations where there are few qualified suppliers or where there is strong differentiation of the supplier or high switching cost and where the industry participant is small relative to the supplier are often instances where the supplier has high leverage.
Intel would be a good example where technology and brand power gives them a strong position relative to computer manufacturers. For many years Gore-Tex controlled the best material for water-proof active wear and could control the market. Another less obvious example is the position of a labor though a union such as the UAW. Examples of how companies position themselves by location decisions or design decisions to move away from high-leverage suppliers are common.
The threat of new entrants is largely a function of not having factors such as economy of scale, product differentiation or the ability to develop proprietary technology, switching costs, or strong brands. In industries that are largely commodities and where it is easy to start up a new participant, the continual flow or even the threat of new entrants drives down pricing and profits. Buyers use this leverage in price negotiations or sourcing decisions.
The restaurant business is an example where local businesses come and go every day. Commodity businesses like sand, stone, etc. and manufacturing businesses like machine shops or plastic injection molding are pressured by the ease of new entrants. One obvious solution is to build differentiation or switching costs by developing or adding technology or unique capabilities.
The threat of substitution is an often overlooked potential pressure because substitution can come from left field. Where threat of entry is new participants coming into an existing industry, the threat of substitution can partially or completely replace an existing industry. This is best demonstrated with some examples, such as high-fructose corn syrup replacing sugar refiners, fractional aircraft ownership replacing aircraft charters, electronic music files replacing the record and CD business, etc. Substitution can also include instances where a downstream product or industry is re-engineered to eliminate the need for certain products or services, with the example of video stores. The defense here is more a matter of being aware of the world outside of one’s particular products and industry. If the railroad industry had thought of themselves as being in the transportation business rather than the railroad business they might have retained their value by adapting rather than being replaced by substitute means of transport.
The intensity of rivalry among existing competitors is the area with which most industry participants are familiar. Competitive rivalry is a result of numerous competitors, slow industry growth, lack of differentiation, excess industry capacity, high strategic stakes, or high exit barriers. Most of the causes of competitive rivalry are out of the control of an individual industry participant. The one defense is differentiation either through technology or through unique capabilities or relationships. Apple is an example of a company that generally stays out of the competitive fray by continually differentiating itself and its products.
Analyzing the industry structure is a necessary step in understanding the value and profit potential of a business. This analysis can identify threats and opportunities. It sets the context for strategy decisions. Profitability and return on investment can be optimized by identifying market or industry opportunities that face lower competitive forces.
What are the pressures facing your industry and business? How can you mitigate the risks and develop opportunities?