Porter’s Five Forces
Michael Porter, a leading business analyst and professor, identified five critical external factors that affect strategy in any industry.
Apply Porter’s Five Forces to the external landscape to derive optimal strategies
- Porter’s Five Forces include: threat of new entrants (also know as barriers to entry), threat of substitutes, rivalry, bargaining power of suppliers, and bargaining power of buyers.
- Managers use the Five Forces model to help identify opportunities and threats or to evaluate decisions in the context of their organization ‘s environment.
- Attractiveness refers to the overall industry profitability. An “unattractive” industry is one in which the combination of the Five Forces drives down overall profitability.
- In analyzing these five factors, it is useful to rate each category as an external risk factor (i.e., low, medium, or high). Ideal industries have low threats from each of these forces (i.e., low buy power, low rivalry, low risk of new entrants, etc.).
- This model is a useful for the strategic derivation of managers; it allows them to narrow down their focus on specific key issues within a given industry.
- entrant: Participant.
- substitute: A replacement or stand-in for something that achieves a similar result or purpose.
Michael Porter, a leading business analyst and professor at Harvard Business School, has identified five key forces that affect the strategy of any industry. His list, Porter’s Five Forces, draws upon industrial organization (IO) economics to derive forces that determine the competitive intensity—and therefore attractiveness—of a market.
Attractiveness refers to the overall industry profitability. An “unattractive” industry is one in which the combination of the Five Forces drives down overall profitability. A very unattractive industry would be one approaching “pure competition.” In this state, available profits for all firms are driven to normal profit rates. In analyzing the following five factors, it is useful to rate each category as an external risk factor (i.e., low, medium, or high). Ideal industries will have low threats from each of these forces (i.e., low buy power, low rivalry, low risk of new entrants, etc.).
The Five Forces
Porter’s Five Forces include:
- Threat of new entrants (or barriers to entry): From the view of current incumbents, profitable markets that yield high returns will attract new firms. This results in many new competitors and eventually decreases profitability for all firms in the industry. Unless the entry of new firms can be blocked by incumbents, the abnormal profit rate will tend toward zero (also known as “perfect competition”). From the perspective of new entrants, high barriers to entry mean that the capital costs of getting into the industry make it difficult to compete with current incumbents.
- Threat of substitute products or services: The existence of products outside of the realm of the common product boundaries, which fulfill the same need, increases the propensity of customers to switch to alternatives. This should not be confused with competitors’ similar products; it is instead a different product that fills the same need. Take transportation as an example: General Motors (GM) would view city subways as a substitute to someone buying a new car.
- Rivalry: For most industries, the intensity of competitive rivalry is the major determinant of the competitiveness of the industry. This involves how many firms are in the industry and how their competitive dynamics reduce profitability. Airlines have extremely high rivalry, for example.
- Bargaining power of buyers: The bargaining power of customers is also described as the market of outputs. It is the ability of customers to put the firm under pressure, which also affects the customer’s sensitivity to price changes. Picture a supply and demand curve: if the supply greatly outstrips the demand, the buyers have more power than the suppliers.
- Bargaining power of suppliers: The bargaining power of suppliers is also described as the market of inputs. When there are few substitutes, suppliers of raw materials, components, labor, and services (such as expertise) to the firm can be a source of power over the firm. Suppliers can refuse to work with the firm or charge excessively high prices for unique resources. Similar to power of buyers, this bargaining power relies on scarcity and basic economics of supply and demand.
Managers use the Five Forces model to help identify opportunities or evaluate decisions in the context of the environment. Often, the Five Forces are mapped against a SWOT analysis to develop a corporate strategy. To complete a Five Forces analysis, it is often best to build a grid on a piece of paper and label each section. Filling in each section to develop a view of the industry can help managers determine if the industry is truly competitive, a monopoly, or an oligopoly. An important question to ask is: “What will make a company able to compete in this environment? ”
Limitations of the Five-Forces View
Like most models, Porter’s Five Forces has advantages and limitations when applied to strategic planning processes.
Employ Porter’s Five Forces in a meaningful strategic way, with a thorough understanding of the potential limitations
- Strategy consultants will use Porter’s Five Forces framework when making a qualitative evaluation of a firm’s strategic position; however, it is only one tool of many and is not infallible.
- According to Porter, the Five Forces model should be used at the broader level of an entire industry; it is not designed to be used at a smaller group or market level.
- Another limitation, which Porter’s model shares with most competitive frameworks, is that of chronological thinking. Porters model is inherently static, representing only aspects of the present day.
- The purpose of the model is brainstorming: a thinking exercise to demonstrate the subjective attractiveness of a given industry landscape. It is not designed to decide optimal industries with certainty.
- Porter’s Five Forces Model: A business tool to qualitatively measure business framework.
- framework: A basic conceptual structure.
Strategy consultants will use Porter’s Five Forces framework when making a qualitative evaluation of a firm’s strategic position; however, it is only one tool of many and is not infallible. The framework is only a starting point or checklist. Like most models, Porter’s Five Forces has advantages and limitations when applied to strategic planning processes; one must understand how it is designed to be used and recognize its limitations.
Single Industry vs. Multiple Industry Operation
According to Porter, the Five Forces model is best used at the broader level of an entire industry. Assessing at the smaller levels of sectors, competitive groups, or general markets will not yield strategically relevant information. Porter’s factors are specifically determined based on the industry level. Large organizations analyzing markets that are too broad and smaller organizations focusing on specific sectors need to keep this limitation in mind when using this framework.
Some firms operate in only one industry, while others operate in multiple industries. A firm that competes in a single industry will realistically only need to assess the industry it is in (and perhaps other supporting industries depending upon the situation). For diversified companies, however, the first fundamental issue in corporate strategy is the selection of industries (lines of business) in which the company should focus. Following this, each line of business should develop its own industry-specific Five Forces analysis. The average Global 1,000 company competes in approximately 52 industries (lines of business). These large firms require a diversified series of analyses.
Adaptability and Evolution
Another limitation—which Porter’s model shares with most competitive frameworks—is that of chronological thinking. Porters model is inherently static, representing only aspects of the present day (and perhaps those that are easily predicted within the short term). As strategic planning involves long-term objectives and the pursuit of adaptability, Porter’s model is too static to be relied upon outside of short- to medium-term objectives.
It has been noted that conclusions from the Five Forces model are highly debatable. This is deliberate, as models are designed to spark discussion and underline key concerns. However, false conclusions can be reached when models are taken as certain. The purpose of the model is brainstorming: a thinking exercise to demonstrate the subjective attractiveness of a given industry landscape. It is not designed to decide optimal industries with certainty. In short, conclusions should be taken in the context of the broader strategic discussion and not as opposed to a stand-alone recommendation.
The PESTEL and SCP Frameworks
PESTEL and SCP frameworks are models for understanding different industry and market factors that impact strategic management.
Apply PESTEL and SCP frameworks to industries in which incumbents operate
- A PESTEL analysis looks at the six most common macro-environmental factors (political, economic, social, technological, environmental, and legal) in order to understand their interaction with the organization.
- A PESTEL analysis is a part of the external strategic analysis when conducting market research; it gives an overview of the different macro-environmental factors that the company has to take into consideration.
- According to the structure- conduct – performance (SCP) approach, an industry’s performance depends on the conduct of its firm, which is dependent on its structure.
- Components that make up the SCP model for industrial organization include: basic conditions, structure, conduct, performance, and government policy.
- While the PESTEL and SCP models share many similarities, it is useful for managers to view the industry from both frameworks as they decide upon optimal operating strategies.
- environmental scanning: The study and interpretation of the political, economic, social, and technological events and trends that influence a business, an industry, or even a total market
A PESTEL analysis looks at the six most common macro-environmental factors to understand their interactions. The acronym stands for political, economic, social, technological changes, ecology , and legislation. A PESTEL analysis is a useful strategic tool for understanding market growth or decline, business position, potential, and direction for operations. The basic premise behind this framework, from a strategy perspective, is to identify opportunities and threats in the market.
- Political factors include how, and to what degree, a government intervenes in the economy. Specifically, political factors include areas such as tariffs, political instability, and other policy-based obstacles that businesses encounter in a given region.
- Economic factors include economic growth, interest rates, exchange rates, and the rate of inflation. Economic factors are by far the easiest to quantify, and they provide a basic framework for capital exchange and consumer purchasing ability.
- Social factors include the cultural aspects of the environment, such as health consciousness, population growth rate, age distribution, career attitudes, and emphasis on safety. Often referred to socio-demographic factors, they largely consist of preferences and attitudes displayed by different groups of individuals within a given market. Social factors can be very difficult to measure with certainty.
- Technological factors include research and development (R&D), automation, technology incentives, and the rate of technological change. Disruptive innovations can dramatically alter an industry and change who is best poised for competition. Carefully monitoring these factors on a daily basis is crucial to a company’s success and has grown in importance over the years.
- Environmental factors include ecological and environmental aspects such as weather, climate, and climate change. Industries like tourism, farming, and insurance are especially affected by these factors. Growing awareness of the potential impacts of climate change is affecting how companies operate and the products they offer, both creating new markets and diminishing or destroying existing ones.
- Legal factors include discrimination laws, consumer laws, antitrust laws, employment laws, and health and safety laws. These factors can affect how a company operates, its costs, and the demand for its products.
According to the structure-conduct-performance (SCP) approach, an industry’s performance (or the success of an industry in producing benefits for the consumer) depends on the conduct of its firm. The conduct of the firm, in turn, is dependent on its structure (or factors that determine the competitiveness of the market).
The structure of the industry depends on basic conditions such as technology and demand for a product. This creates a linear relationship of sorts, where the structural inputs can impact the conduct and strategy of the firm, leading to better (or worse) performance.
Taken into account alongside the PESTEL framework, management should carefully consider and define the structure of a given industry. This structure will provide critical inputs for the broader industry, which in turn will impact the conduct of the organization through strategic integration. If this process is accomplished effectively—and management has integrated the external structure with the internal conduct strategically—higher performance can then be derived.
Crafting an effective strategy requires understanding the competitive dynamics of the space in which the business operates.
Identify critical competitive components that directly influence strategic development
- Competitor analysis is an assessment of the strengths and weaknesses of current and potential competitors. This analysis provides both an offensive and defensive strategic context in order to identify opportunities and threats.
- Competitor analysis requires the specific selection of key success factors within an industry; it also requires the qualitative measurement of accomplishing these for both the firm and its key competitors.
- Competitor profiling coalesces all of the relevant sources of competitor analysis into one framework to support efficient and effective strategy formulation, implementation, monitoring, and adjustment.
- By identifying key competitors and relative strengths and weaknesses, organizations can react more quickly and effectively from a strategic perspective.
- assessment: An appraisal or evaluation.
- dynamic: Changeable; active; in motion, usually as the result of an external force.
Competition in Business
Merriam-Webster defines competition in business as “the effort of two or more parties acting independently to secure the business of a third party by offering the most favorable terms.” The competition is a moving-target, ever-evolving and adapting to better capture market share and profitability; therefore competition is a critical area of analysis for strategic managers. Observing and predicting competitive movements and dynamics is a key to success and a primary responsibility of upper management.
The Dynamic Model of Competition
The dynamic model of the strategy process is a way of understanding how strategic actions occur. It recognizes that strategic planning is dynamic; that is, strategy-making involves a complex pattern of actions and reactions. It is partially planned and partially unplanned. Competitive dynamics thus looks at how competitive firms act and react.
In marketing and strategic management, competitor analysis is an assessment of the strengths and weaknesses of current and potential competitors. This analysis provides both an offensive and defensive strategic context in order to identify opportunities and threats. Competitor profiling coalesces all of the relevant sources of competitor analysis into one framework to support efficient and effective strategy formulation, implementation, monitoring, and adjustment.
Components of Competitor Analysis
Competitor analysis is an essential component of corporate strategy. It is argued that most firms do not conduct this type of analysis systematically enough. Instead, many enterprises operate on conjectures and informal impressions gathered from information received about competitors. As a result, traditional environmental scanning places many firms at risk of dangerous competitive “blind spots” due to a lack of robust competitor analysis.
Competitor analysis requires the specific selection of key success factors within an industry. It also requires the qualitative measurement of accomplishing these for both the firm and its key competitors. For example, consider that customer service, quality, and brand perception are the key success factors in retail fashion. In this case, Ralph Lauren should identify key competitors (Liz Claiborne, Calvin Klein, etc.) and provide a numeric score of their success or failure in each category. Through this competitive analysis, Ralph Lauren can improve its competition.
Competitor profiling facilitates this strategic objective in three important ways:
- First, profiling can reveal strategic weaknesses in rivals that the firm may exploit.
- Second, the proactive stance of competitor profiling can allow the firm to anticipate its rivals’ strategic response to the firm’s planned strategies, the strategies of other competing firms, and changes in the environment.
- Third, this proactive knowledge can give the firm strategic agility. Offensive strategy can be implemented more quickly in order to exploit opportunities and capitalize on strengths. Similarly, defensive strategy can be employed more deftly in order to counter the threat of rival firms exploiting the firm’s own weaknesses.