Porter Five Forces Essay
Porter Five Forces
What is Porter’s 5 Forces analysis? What are the main aspects of Porter’s 5 Forces analysis? How to write Good Porter’s 5 Forces analysis of a company? Where to find information for Porter’s 5 Forces analysis? Porter’s Five Forces Examples; Reports on Different Companies Introduction
There is continuing interest in the study of the forces that impact on an organisation, particularly those that can be harnessed to provide competitive advantage. The ideas and models which emerged during the period from 1979 to the mid-1980s (Porter, 1998) were based on the idea that competitive advantage came from the ability to earn a return on investment that was better than the average for the industry sector (Thurlby, 1998).
As Porter’s 5 Forces analysis deals with factors outside an industry that influence the nature of competition within it, the forces inside the industry (microenvironment) that influence the way in which firms compete, and so the industry’s likely profitability is conducted in Porter’s five forces model. A business has to understand the dynamics of its industries and markets in order to compete effectively in the marketplace. Porter (1980a) defined the forces which drive competition, contending that the competitive environment is created by the interaction of five different forces acting on a business. In addition to rivalry among existing firms and the threat of new entrants into the market, there are also the forces of supplier power, the power of the buyers, and the threat of substitute products or services. Porter suggested that the intensity of competition is determined by the relative strengths of these forces.
Main Aspects of Porter’s Five Forces Analysis
The original competitive forces model, as proposed by Porter, identified five forces which would impact on an organization’s behaviour in a competitive market.
These include the following:
The rivalry between existing sellers in the market.
The power exerted by the customers in the market.
The impact of the suppliers on the sellers.
The potential threat of new sellers entering the market.
The threat of substitute products becoming available in the market. Understanding the nature of each of these forces gives organizations the necessary insights to enable them to formulate the appropriate strategies to be successful in their market (Thurlby, 1998).
Force 1: The Degree of Rivalry
The intensity of rivalry, which is the most obvious of the five forces in an industry, helps determine the extent to which the value created by an industry will be dissipated through head-to-head competition. The most valuable contribution of Porter’s “five forces” framework in this issue may be its suggestion that rivalry, while important, is only one of several forces that determine industry attractiveness.
This force is located at the centre of the diagram;
Is most likely to be high in those industries where there is a threat of substitute products; and existing power of suppliers and buyers in the market.
Force 2: The Threat of Entry
Both potential and existing competitors influence average industry profitability. The threat of new entrants is usually based on the market entry barriers. They can take diverse forms and are used to prevent an influx of firms into an industry whenever profits, adjusted for the cost of capital, rise above zero. In contrast, entry barriers exist whenever it is difficult or not economically feasible for an outsider to replicate the incumbents’ position (Porter, 1980b; Sanderson, 1998) The most common forms of entry barriers, except intrinsic physical or legal obstacles, are as follows:
Economies of scale: for example, benefits associated with bulk purchasing; Cost of entry: for example, investment into technology; Distribution channels: for example, ease of access for competitors; Cost advantages not related to the size of the company: for example, contacts and expertise; Government legislations: for example, introduction of new laws might weaken company’s competitive position; Differentiation: for example, a certain brand that cannot be copied (The Champagne)
Force 3: The Threat of Substitutes
The threat that substitute products pose to an industry’s profitability depends on the relative price-to-performance ratios of the different types of products or services to which customers can turn to satisfy the same basic need. The threat of substitution is also affected by switching costs – that is, the costs in areas such as retraining, retooling and redesigning that are incurred when a customer switches to a different type of product or service. It also involves:
Product-for-product substitution (email for mail, fax); is based on the substitution of need; Generic substitution (Video suppliers compete with travel companies); Substitution that relates to something that people can do without (cigarettes, alcohol).
Force 4: Buyer Power
Buyer power is one of the two horizontal forces that influence the appropriation of the value created by an industry (refer to the diagram). The most important determinants of buyer power are the size and the concentration of customers. Other factors are the extent to which the buyers are informed and the concentration or differentiation of the competitors. Kippenberger (1998) states that it is often useful to distinguish potential buyer power from the buyer’s willingness or incentive to use that power, willingness that derives mainly from the “risk of failure” associated with a product’s use.
This force is relatively high where there a few, large players in the market, as it is the case with retailers an grocery stores; Present where there is a large number of undifferentiated, small suppliers, such as small farming businesses supplying large grocery companies; Low cost of switching between suppliers, such as from one fleet supplier of trucks to another.
Force 5: Supplier Power
Supplier power is a mirror image of the buyer power. As a result, the analysis of supplier power typically focuses first on the relative size and concentration of suppliers relative to industry participants and second on the degree of differentiation in the inputs supplied. The ability to charge customers different prices in line with differences in the value created for each of those buyers usually indicates that the market is characterized by high supplier power and at the same time by low buyer power (Porter, 1998).
Bargaining power of suppliers exists in the following situations:
Where the switching costs are high (switching from one Internet provider to another); High power of brands (McDonalds, British Airways, Tesco); Possibility of forward integration of suppliers (Brewers buying bars); Fragmentation of customers (not in clusters) with a limited bargaining power (Gas/Petrol stations in remote places). The nature of competition in an industry is strongly affected by the suggested five forces. The stronger the power of buyers and suppliers, and the stronger the threats of entry and substitution, the more intense competition is likely to be within the industry. However, these five factors are not the only ones that determine how firms in an industry will compete – the structure of the industry itself may play an important role.
Indeed, the whole five-forces framework is based on an economic theory know as the “Structure-Conduct-Performance” (SCP) model: the structure of an industry determines organizations’ competitive behaviour (conduct), which in turn determines their profitability (performance). In concentrated industries, according to this model, organizations would be expected to compete less fiercely, and make higher profits, than in fragmented ones. However, as Haberberg and Rieple (2001) state, the histories and cultures of the firms in the industry also play a very important role in shaping competitive behaviour, and the predictions of the SCP model need to be modified accordingly.
How to write a Good Porter’s 5 Forces analysis
The Porter’s Five Forces model is a simple tool that supports strategic understanding where power lies in a business situation. It also helps to understand both the strength of a firm’s current competitive position, and the strength of a position a company is looking to move into. Despite the fact that the Five Force framework focuses on business concerns rather than public policy, it also emphasizes extended competition for value rather than just competition among existing rivals, and the simplicity of its application inspired numerous companies as well as business schools to adopt its use (Wheelen and Hunger, 1998).
With a clear understanding of where power lies, it will enable a company to take fair advantage of its strengths, improve weaknesses, and avoid taking wrong steps. Therefore, to apply this planning tool effectively, it is important to understand the situation and to look at each of the forces individually.
In conducting an analysis of Porter’s Five Forces, it is required to brainstorm all relevant factors for the company’s market situation, and then check against the factors presented for each force in the diagram above. The next step is to highlight the key factors on a diagram, and summarize the size and the scale of the force on the diagram. It is suggested to use relevant signs, for instance, “+” and “-” to represent the forces moderately in company’s favour, or for a force strongly against.
After identifying favourable and unfavourable forces for the company’s performance and industry’s attractiveness, it is important to analyse the situation and examine the impacts of the forces. One of the critical comments made of the Five Forces framework is its static nature, whereas the competitive environment is changing turbulently. Are the five forces able to foresee industry expansion? Is it the corporate strategist’s goal to find a position in the industry where his or her company can best defend itself against these forces or can influence them in its favour, or is the goal to become part of the ongoing commerce with the intention to produce innovative ideas that will expand the size of the industry? Is it true that the environment poses a threat to the organisation, leading to the consideration of suppliers and buyers as threats that need to be tackled, or does it offer the ground for a constitutive industry player co-operation?
By thinking through how each force affects a company, and by identifying the strength and direction of each force, it provides an opportunity to identify the strength of the position and the ability to make a sustained profit in the industry (Mind Tools, 2006).
Limitations of Porter’s Five Force Model
Porter’s model is a strategic tool used to identify whether new products, services or businesses have the potential to be profitable. However it can also be very illuminating when used to understand the balance of power in other situations.
Porter argues that five forces determine the profitability of an industry. At the heart of industry are rivals and their competitive strategies linked to, for example, pricing or advertising; but, he contends, it is important to look beyond one’s immediate competitors as there are other determinates of profitability. Specifically, there might be competition from substitute products or services. These alternatives may be perceived as substitutes by buyers even though they are part of a different industry. An example would be plastic bottles, glass bottles, and cans for packaging soft drinks. There may also be the potential threat of new entrants, although some competitors will see this as an opportunity to strengthen their position in the market by ensuring, as far as they can, customer loyalty.
Finally, it is important to appreciate that companies purchase from suppliers and sell to buyers. If they are powerful they are in a position to bargain profits away through reduced margins, by forcing either cost increases or price decreases. This relates to the strategic option of vertical integration, when the company acquires, or merges with, a supplier or customer and thereby gains greater control over the chain of activities which leads from basic materials through to final consumption (Luffman and et al., 1996; Wheelen and Hunger, 1998).
It is important to be aware that this model has further limitations in today’s market environment; as it assumes relatively static market structures. Based originally on the economic situation in the eighties with its strong competition and relatively stable market structures, it is not able to take into account new business models and the dynamism of the industries, such as technological innovations and dynamic market entrants from start-ups that will completely change business models within short times.
For instance, the computer and software industry is often considered as being highly competitive. The industry structure is constantly being revolutionized by innovation that indicates Five Forces model being of limited value since it represents no more than snapshots of a moving picture. Therefore, it is not advisable to develop a strategy solely on the basis of Porter’s models (Kippenberger, 1998; Haberberg and Rieple, 2001), but to examine it in addition to other strategic frameworks of SWOT and PEST analysis.
Nevertheless, that does not mean that Porters theories became invalid. What needs to be done is to adopt the model with the knowledge of its limitations and to use it as part of a larger framework of management tools, techniques and theories. This approach, however, is advisable for the application of every business model (Recklies, 2001).
Porter’s Six Forces model and its relationship to the standard Five Forces model Porter’s Five Forces model actually has an extension referred to as Porter’s Six Forces model. It is considerably less popular than the Five Forces model as its acceptance has been less positive than the Five Forces model. The Six Forces model though is very similar to the Five Forces model with the only difference being the addition of the sixth force in the framework. This sixth force in the model is termed as the relative power of other stakeholders, and can refer to a number of other groups or entities, depending on the factor which has the greatest influence including:
• Complementors – One school of thought looks at the sixth force to be complementors, which are businesses offering complementary products to the sector in focus and being analysed (Grove 1996). The author states that these complementary businesses, as a sixth factor, affect the industry as changes in these businesses (such as new techniques, approaches or technologies) can impact on the dynamics between the industry and the complementors.
• The government – The sixth force in the framework can also be considered to be the government, and is included in the framework if it has potential to impact on all the other five forces (Gordon, 1997). Thus, the government can have direct impact on the industry as the sixth force, but can also have indirect impact or influence by affecting the other five forces, whether favourably or unfavourably.
• The public – Yet other viewpoints look at the public as the sixth force in the model, particularly if the public has a strong influence in the dynamics of the sector resulting in changes to the other forces or in the sector as a whole.
• Shareholders – This group can also be considered potentially as the sixth force. This is more important in recent years where shareholder activity has increased significantly in the boardroom, and management of firms has been scrutinised much more and even given ‘threats’ if certain actions favoured by the shareholders were not pursued.
• Employees – Employees could also be considered as the sixth force if they wielded extraordinarily strong influence on the firm in a particular sector. The status of employees seems to follow similar rules in certain sectors, and thus could be considered a strong influence in these sectors. For example, in the automobile sector in the US, a large part of the work force are unionised, and thus could be considered the sixth force instead of the government or complementors.
While a sixth force has been added to Porter’s original Five Forces model, the acceptance of this framework has been somewhat limited. This could be for two reasons. First, is that there is no definite and specific sixth force in all sectors, as it is different for each sector. Second, while a sixth force could be defined for all sectors, the influence of this factor can also be captured in the other five forces and thus the necessity of having it in the framework is less compelling.
Where to find information for Porter’s 5 Forces analysis
In conducting the analysis it is crucial to examine the existing literature:
Periodicals, business articles on the industry performance, etc; Analyst reports and trade organisations;
Company annual reports and its publications on the main suppliers and distribution network; Anything that will give the exposure to the market situation, competitors present in the market, new emerging companies in the industry. It is important to make sure that the sources are reliable and relevant to the current condition of the industry. It has to be viable, reliable and valid, in order to conduct a good analysis of the model. For this purpose, the gathered data and information has to be checked and be applied to the current business conditions.
Further limitations could be present in the nature of market forces that reduce the applicability of the information sources to present situations; and the amount of detailed information required. This can be prohibitive to its practical use. For example, the level of competitor information required is very detailed and may not always be available.
Any company must seek to understand the nature of its competitive environment if it is to be successful in achieving its objectives and in establishing appropriate strategies. If a company fully understands the nature of the Porter’s five forces, and particularly appreciates which one is the most important, it will be in a stronger position to defend itself against any threats and to influence the forces with its strategy. The situation is fluid, and the nature and relative power of the forces will change. Consequently, the need to monitor and stay aware is continuous.