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PORTER’S FIVE FORCES

August 3, 2016December 5, 2020 Lars de Bruin 23 Comments Bargaining Power of
Buyers, Bargaining Power of Suppliers, Barriers to Entry, Competition,
Competitiveness, Concentration Rate, Industry Analysis, Porter's Five Forces,
Rivalry, Threat of New Entry, Threat of Substitute Products or Services

Porter’s Five Forces analysis is a framework that helps analyzing the level of
competition within a certain industry. It is especially useful when starting a
new business or when entering a new industry sector. According to this
framework, competitiveness does not only come from competitors. Rather, the
state of competition in an industry depends on five basic forces: threat of new
entrants, bargaining power of suppliers, bargaining power of buyers, threat of
substitute products or services, and existing industry rivalry. The collective
strength of these forces determines the profit potential of an industry and thus
its attractiveness. If the five forces are intense (e.g. airline industry),
almost no company in the industry earns attractive returns on investments. If
the forces are mild however (e.g. softdrink industry), there is room for higher
returns. Each force will be elaborated on below with the aid of examples from
the airline industry to illustrate the usage.



Figure 1: Five Forces Model


THREAT OF NEW ENTRANTS

New entrants in an industry bring new capacity and the desire to gain market
share. The seriousness of the threat depends on the barriers to enter a certain
industry. The higher these barriers to entry, the smaller the threat for
existing players. Examples of barriers to entry are the need for economies of
scale, high customer loyalty for existing brands, large capital requirements
(e.g. large investments in marketing or R&D), the need for cumulative
experience, government policies, and limited access to distribution channels.
More barriers can be found in the table below.


EXAMPLE

The threat of new entrants in the airline industry can be considered as low
to medium. It takes quite some upfront investments to start an airline company
(e.g. purchasing aircrafts). Moreover, new entrants need licenses, insurances,
distribution channels and other qualifications that are not easy to obtain when
you are new to the industry (e.g. access to flight routes). Furthermore, it can
be expected that existing players have built up a large base of experience over
the years to cut costs and increase service levels.  A new entrant is likely to
not have this kind of expertise, therefore creating a competitive disadvantage
right from the start. However, due to the liberalization of market access and
the availability of leasing options and external finance from banks, investors,
and aircraft manufacturers, new doors are opening for potential entrants. Even
though it doesn’t sound very attractive for companies to enter the airline
industry, it is NOT impossible. Many low-cost carriers like Southwest Airlines,
RyanAir and EasyJet have successfully entered the industry over the years by
introducing innovative cost-cutting business models, thereby shaking up
original players like American Airlines, Delta Air Lines and KLM.



Porter’s Five Forces Video Tutorial


BARGAINING POWER OF SUPPLIERS

This force analyzes how much power and control a company’s supplier (also known
as the market of inputs) has over the potential to raise its prices or to reduce
the quality of purchased goods or services, which in turn would lower an
industry’s profitability potential. The concentration of suppliers and the
availability of substitute suppliers are important factors in determining
supplier power. The fewer there are, the more power they have. Businesses are in
a better position when there are a multitude of suppliers. Sources of supplier
power also include the switching costs of companies in the industry, the
presence of available substitutes, the strength of their distribution channels
and the uniqueness or level of differentiation in the product or service the
supplier is delivering.


EXAMPLE

The bargaining power of suppliers in the airline industry can be considered very
high. When looking at the major inputs that airline companies need, we see that
they are especially dependent on fuel and aircrafts. These inputs however are
very much affected by the external environment over which the airline companies
themselves have little control. The price of aviation fuel is subject to the
fluctuations in the global market for oil, which can change wildly because of
geopolitical and other factors. In terms of aircrafts for example, only two
major suppliers exist: Boeing and Airbus. Boeing and Airbus therefore have
substantial bargaining power on the prices they charge.


BARGAINING POWER OF BUYERS

The bargaining power of buyers is also described as the market of outputs. This
force analyzes to what extent the customers are able to put the company under
pressure, which also affects the customer’s sensitivity to price changes. The
customers have a lot of power when there aren’t many of them and when the
customers have many alternatives to buy from. Moreover, it should be easy for
them to switch from one company to another. Buying power is low however when
customers purchase products in small amounts, act independently and when the
seller’s product is very different from any of its competitors. The internet has
allowed customers to become more informed and therefore more empowered.
Customers can easily compare prices online, get information about a wide variety
of products and get access to offers from other companies instantly. Companies
can take measures to reduce buyer power by for example implementing loyalty
programs or by differentiating their products and services.


EXAMPLE

Bargaining power of buyers in the airline industry is high. Customers are able
to check prices of different airline companies fast through the many online
price comparisons websites such as Skyscanner and Expedia. In addition, there
aren’t any switching costs involved in the process. Customers nowadays are
likely to fly with different carriers to and from their destination if that
would lower the costs. Brand loyalty therefore doesn’t seem to be that high.
Some airline companies are trying to change this with frequent flyer programs
aimed at rewarding customers that come back to them from time to time.


THREAT OF SUBSTITUTE PRODUCTS

The existence of products outside of the realm of the common product boundaries
increases the propensity of customers to switch to alternatives. In order to
discover these alternatives one should look beyond similar products that are
branded differently by competitors. Instead, every product that serves a similar
need for customers should be taken into account. Energy drink like Redbull for
instance is usually not considered a competitor of coffee brands such as
Nespresso or Starbucks. However, since both coffee and energy drink fulfill a
similar need (i.e. staying awake/getting energy), customers might be willing to
switch from one to another if they feel that prices increase too much in either
coffee or energy drinks. This will ultimately affect an industry’s profitability
and should therefore also be taken into account when evaluating the industry’s
attractiveness.


EXAMPLE

In terms of the airline industry, it can be said that the general need of its
customers is traveling. It may be clear that there are many alternatives for
traveling besides going by airplane. Depending on the urgency and distance,
customers could take the train or go by car. Especially in Asia, more and more
people make use of highspeed trains such as Bullet Trains and Maglev Trains.
Furthermore, the airline industry might get some serious future competition from
Elon Musk’s Hyperloop concept in which passengers will be traveling in capsules
through a vacuum tube reaching speed limits of 1200 km/h. Taken this altogether,
the threat of substitutes in the airline industry can be considered at least
medium to high.


RIVALRY AMONG EXISTING COMPETITORS

This last force of the Porter’s Five Forces examines how intense the current
competition is in the marketplace, which is determined by the number of existing
competitors and what each competitor is capable of doing. Rivalry is high when
there are a lot of competitors that are roughly equal in size and power, when
the industry is growing slowly and when consumers can easily switch to a
competitors offering for little cost. A good indicator of competitive rivalry is
the concentration ratio of an industry. The lower this ration, the more intense
rivalry will probably be. When rivalry is high, competitors are likely to
actively engage in advertising and price wars, which can hurt a business’s
bottom line. In addition, rivalry will be more intense when barriers to exit are
high, forcing companies to remain in the industry even though profit margins are
declining. These barriers to exit can for example be long-term loan agreements
and high fixed costs.


EXAMPLE

When looking at the airline industry in the United States, we see that the
industry is extremely competitive because of a number of reasons which include
the entry of low cost carriers, the tight regulation of the industry wherein
safety become paramount leading to high fixed costs and high barriers to exit,
and the fact that the industry is very stagnant in terms of growth at the
moment. The switching costs for customers are also very low and many players in
the industry are similar in size (see graph below) leading to extra fierce
competition between those firms. Taken altogether, it can be said that rivalry
among existing competitors in the airline industry is high.


(Source: United States Department of Transportation, 2016)

By looking at each competitive force individually, you are able to roughly map
out the focal industry and its attractiveness. Note that industries might differ
in terms of attractiveness depending on the country you are looking at.
Government policies are for example likely to be different in each country and
also the amount of suppliers and buyers might vary from nation to nation.
Porter’s Five Forces is a good starting point to evaluate an industry but should
not be used in isolation. You could for example combine it with a Value Chain
Analysis or through the VRIO Framework in order to get a better sense of where
your company’s competitive advantage is coming from and to better position your
company between the rivals. Moreover, Porter’s Five Forces is often combined
with the PESTEL analysis to give a good overview of the organization’s
environment. Lastly, it should be said that the framework also received some
criticism from several authors. Some authors have for instance argued that the
model needs a 6th force called the ‘complementors’, in order to explain the
reasoning behind strategic alliances and joint ventures. This extended model is
also known as the Value Net Model. However, even though the criticism it got,
Porter’s Five Forces is still one of the most used frameworks for strategy
development and is likely to remain that way in the near future.



Figure 2: Porter’s Five Forces Factors





FULL LIST OF PORTER’S FIVE FORCES FACTORS:

THREAT OF NEW ENTRANTS

 * Economies of scale
 * Product differentiation
 * Brand identity/loyalty
 * Access to distribution channels
 * Capital requirements
 * Access to latest technology
 * Access to necessary inputs
 * Absolute cost advantages
 * Experience and learning effects
 * Government policies
 * Switching costs
 * Expected retaliation from existing players

BARGAINING POWER OF SUPPLIERS

 * Number of suppliers
 * Size of suppliers
 * Supplier concentration
 * Availability of substitutes for the supplier’s products
 * Uniqueness of supplier’s products or services (differentiation)
 * Switching cost for supplier’s products
 * Supplier’s threat of forward integration
 * Industry threat of backward integration
 * Supplier’s contribution to quality or service of the industry products
 * Importance of volume to supplier
 * Total industry cost contributed by suppliers
 * Importance of the industry to supplier’s profit

BARGAINING POWER OF BUYERS

 * Buyer volume (number of customers)
 * Size of each buyer’s order
 * Buyer concentration
 * Buyer’s ability to substitute
 * Buyer’s switching costs
 * Buyer’s information availability
 * Buyer’s threat of backward integration
 * Industry threat of forward integration
 * Price sensitivity

THREAT OF SUBSTITUTE PRODUCTS OR SERVICES

 * Number of substitute products available
 * Buyer’s propensity to substitute
 * Relative price performance of substitutes
 * Perceived level of product differentiation
 * Switching costs
 * Substitute producer’s profitability & aggressiveness

RIVALRY AMONG EXISTING COMPETITORS

 * Number of competitors
 * Diversity of competitors
 * Industry concentration and balance
 * Industry growth
 * Industry life cycle
 * Quality differences
 * Product differentiation
 * Brand identity/loyalty
 * Switching costs
 * Intermittent overcapacity
 * Informational complexity
 * Barriers to exit

FURTHER READING:

 * Porter, M.E. (1979). How Competitive Forces Shape Strategy. Harvard Business
   Review
 * Porter, M.E. (2008). The Five Competitive Forces That Shape Strategy. Harvard
   Business Review

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23 THOUGHTS ON “PORTER’S FIVE FORCES”

 * Alex
   January 12, 2020 at 21:42
   Permalink
   
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   Permalink
   
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   Permalink
   
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   April 28, 2020 at 17:58
   Permalink
   
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   May 11, 2020 at 12:01
   Permalink
   
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