Whether you are starting a new business or looking for more insight into your existing company's prospects, you probably have questions about the competition. One way to answer those questions is by using Porter's Five Forces model.
Originally developed by Harvard Business School's Michael E. Porter in 1979, the five forces model looks at five specific factors that help determine whether or not a business can be profitable, based on other businesses in the industry.
"Understanding the competitive forces, and their underlying causes, reveals the roots of an industry's current profitability while providing a framework for anticipating and influencing competition (and profitability) over time," Porter wrote in a Harvard Business Review article. "A healthy industry structure should be as much a competitive concern to strategists as their company’s own position."
According to Porter, the origin of profitability is identical regardless of industry. In that light, industry structure is what ultimately drives competition and profitability —not whether an industry produces a product or service, is emerging or mature, high-tech or low-tech, regulated or unregulated.
"If the forces are intense, as they are in such industries as airlines, textiles, and hotels, almost no company earns attractive returns on investment," Porter wrote. "If the forces are benign, as they are in industries such as software, soft drinks, and toiletries, many companies are profitable."
Understanding the Five Forces
Porter regarded understanding both the competitive forces and the overall industry structure as crucial for effective strategic decision-making. In Porter's model, the five forces that shape industry competition are:
Competitive rivalry. This force examines how intense the competition currently is in the marketplace, which is determined by the number of existing competitors and what each is capable of doing. Rivalry competition is high when there are just a few businesses equally selling a product or service, when the industry is growing and when consumers can easily switch to a competitors offering for little cost. When rivalry competition is high, advertising and price wars can ensue, which can hurt a business's bottom line. Rivalry is quantitatively measured by the Concentration Ratio (CR), which is the percentage of market share owned by the four largest firms in an industry.
Bargaining power of suppliers. This force analyzes how much power a business's supplier has and how much control it has over the potential to raise its prices, which, in turn, would lower a business's profitability. In addition, it looks at the number of suppliers available: 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 firms in the industry, the presence of available substitutes, and the supply purchase cost relative to substitutes.
Bargaining power of customers. This force looks at the power of the consumer to affect pricing and quality. Consumers have power when there aren't many of them, but lots of sellers, as well as when it is easy to switch from one business's products or services to another. Buying power is low when consumers purchase products in small amounts and the seller's product is very different from any of its competitors.
Threat of new entrants. This force examines how easy or difficult it is for competitors to join the marketplace in the industry being examined. The easier it is for a competitor to join the marketplace, the greater the risk of a business's market share being depleted. Barriers to entry include absolute cost advantages, access to inputs, economies of scale and well-recognized brands.
Threat of substitute products or services. This force studies how easy it is for consumers to switch from a business's product or service to that of a competitor. It looks at how many competitors there are, how their prices and quality compare to the business being examined and how much of a profit those competitors are earning, which would determine if they have the ability to lower their costs even more. The threat of substitutes are informed by switching costs, both immediate and long-term, as well as a buyer's inclination to change.
Example of Porter's Five Forces
There are several examples of how Porter's Five Forces can be applied to various industries online. As an example, stock analysis firm Trefis looked at how Under Armour fits into the athletic footwear and apparel industry.
- Under Armour faces intense competition from Nike, Adidasand newer players.
- Nike and Adidas, which have considerably larger resources at their disposal, are making a play within the performance apparel market to gain market share in this up-and-coming product category.
- Under Armour does not hold any fabric or process patents, and hence its product portfolio could be copied in the future.
Bargaining power of suppliers
- A diverse supplier base limits bargaining power.
- In 2012, Under Armour's products were produced by 27 manufacturers located across 14 countries. Of these, the top 10 accounted for 49 percent of the products manufactured.
Bargaining power of customers
- Under Armour'scustomers include both wholesale customers as well as end customers.
- Wholesale customers, like Dick's Sporting Goods and the Sports Authority, hold a certain degree of bargaining leverage, as they could substitute Under Armour's products with other competitors' to gain higher margins.
- Bargaining power of end customers is lower as Under Armour enjoys strong brand recognition.
Threat of new entrants
- Large capital costs are required for branding, advertising and creating product demand, and hence this limits the entry of newer players in the sports apparel market.
- However, existing companies in the sports apparel industry could enter the performance apparel market in the future.
Threat of substitute products
- The demand for performance apparel, sports footwear and accessories is expected to continue, and hence we think this force does not threaten Under Armour in the foreseeable future.
Strategies for success
Once your analysis is complete, it is time to implement a strategy to expand your competitive advantage. To that end, Porter identified three "generic strategies"that can be implemented in any industry, and in companies of any size:
Cost leadership: In this strategy, your goal is to increase profits by reducing costs while charging industry-standard prices, or to increase market share by reducing the sales price while retaining profits.
Differentiation: This strategy aims to make the company's products significantly different from the competition, improving their competitiveness and value to the public. This strategy requires both good research and development and effective sales and marketing teams.
Focus: In the focus strategy, businesses select niche markets in which to sell their goods. This strategy requires intense understanding of the marketplace, its sellers, buyers and competitors. The use of this strategy frequently requires the companies to also implement a cost leadership or differentiation position.
Porter said the new strategy should be executed at the corporate, business unit and departmental levels. Of these, Porter considered the business unit most significant.
More information about the generic strategies is available in Porter's 1985 book, Competitive Advantage (Free Press).
Alternatives and addendums
While Porter's Five Forces is an effective and time-tested model, it has been criticized for failing to explain strategic alliances. In the 1990s, Yale School of Management professors Adam Brandenbuger and Bare Nalebuff created the idea of a sixth force, "complementors," using the tools of game theory. In their model, complementors sell products and services that are best used in conjunction with a product or service from a competitor. Intel, which manufactures processors, and computer manufacturer Apple could be considered complementors in this model. More information can be found at Strategic CFO.
Regardless of whether the complement force is potent in your company's industry, additional modeling tools are likely to help you round out your understanding of your business and its potential. A value chain analysis aims to help companies understand where they have the best productive advantage, while the BCG matrix helps companies identify which products are likely to benefit the most from increased investment.
Templates and more information
To learn more about Porter's Five Forces and find templates to complete your own Five Forces analysis, visit the following websites:
Additional reporting by Chad Brooks, Business News Daily senior writer.
Originally published on Nov. 12, 2013. Updated Feb. 18, 2015.