The five forces model was developed by Michael E. Porter to help companies assess the nature of an industry’s competitiveness and develop corporate strategies accordingly. The framework allows a business to identify and analyze the important forces that determine the profitability of an industry.
In this article, we will study the Porter’s five forces model for industry analysis. We will look at 1) introduction to the model, 2) Porter’s five forces, 3) how to use the model, 4) model do’s and dont’s, 5) criticisms of the model, and 6) example – IKEA.
Through his model, Porter classifies five main competitive forces that affect any market and all industries. It is these forces that determine how much competition will exist in a market and consequently the profitability and attractiveness of this market for a company. Through sound corporate strategies, a company will aim to shape these forces to its advantage to strengthen the organizations position in the industry.
For the purpose of this model, industry attractiveness is the overall profitability potential of the industry. An attractive industry will be one where the combined power of the competitive forces will increase profitability potential. While an unattractive industry will be one where the collective impact of the forces will drive down profitability potential.
These forces, termed as the micro environment by Porter, influence how a company serves its target market and whether it is able to turn a profit. Any change in one of the forces might mean that a company has to re-evaluate its environment and realign its business practices and strategies.
An attractive market place does not mean that all companies will enjoy similar success levels. Rather, the unique selling propositions, strategies and processes will put one company over the other.
Composition of Forces
Within each industry, the effect of different forces will be different. This is why it becomes imperative to develop this model separately for every industry even if the same company is competing across different markets and industries. As an example, the airline industry has fierce competition among the two producers, Airbus and Boeing. The bargaining power of the buyers, all airlines, is fairly high. On the other hand, there is almost no threat of new entry into the market given high degrees of proprietary knowledge and high investments. There is also no threat of substitutes and the power of suppliers is also generally benign. On the other hand in the film business, there is a high threat of substitutes from various other forms of entertainment. In addition, the power of suppliers (e.g. filmmakers, etc.) is also high as they supply the vital most input for the industry.
Whatever the industry, there may be one or two forces that end up driving all strategy formation. It is not always easy to determine which force is the key one. An obvious force may not be the one increasing or decreasing profitability.
In 1979, Harvard Business School professor Michael E. Porter developed the five forces model. It was his first article for the Harvard Business review titles “How Competitive Forces Shape Strategy”. It was later detailed in his book on Competitive strategy. This model aimed to provide a new way to use effective strategy to identify, analyze and manage external factors in an organization’s environment.
Porter’s work has been recognized as extremely important in the field. Despite criticisms regarding its applicability in a much altered world, it remains one of the most widely used methods of industry analysis.
The Five Competitive Forces That Shape Strategy – Interview With Michael E. Porter
PORTER’S FIVE FORCES
The five forces identified by Porter are divided into:
- Horizontal forces: Threat of substitutes, threat of new entrants, competitive rivalry
- Vertical forces: Bargaining power of buyers and bargaining power of customers
1. Competitive Rivalry
One important force that Porter describes is the degree of rivalry between existing companies in the market. If there are more companies competing with each other, the resulting competitive pressure will mean that prices, profits and strategy will be driven by it.
One company may end up having little or no power in its own industry if there is a variety of quality products are offered in the market in direct competition with it. Customers have the option of simply moving on to a different company easily. Conversely, in the absence of this rivalry, the company may be able to freely set prices and profit margins without being dictated by what the customer finds attractive.
When is competitive rivalry high?
Competitive rivalry may be higher when:
- Similar sized companies operate in one market
- These companies have similar strategies
- Products on offer have similar features and offer the same benefits
- Growth in the industry is slow
- There are high barriers to exit or low barriers to entry
2. Threat of new Entrants
The competitive threat to a company’s business may not only be from existing players in the market but also from potential new entrants into the market place. If an industry is profitable, or attractive in a long term strategic manner, then it will be attractive to new companies. Unless there are barriers to entry in place, new firms may easily enter the market and change the dynamics of the industry.
The particular dynamics of an industry that restrict entry into it are called barriers to entry The most attractive scenario for a new company is when a potential market has low barriers to exit but high barriers to entry. The economics of any industry will determine the level of difficulty faced when trying to enter this market.
When are barriers for new entrants high?
Barriers to entry may stem from things like:
- patents and proprietary knowledge
- access to specialized technology or infrastructure
- economies of scale or government driven obstacles
- high initial investment needed
- high switching costs for consumers, loyal consumers
- difficulty in accessing raw material and difficulty in accessing distribution channels
3. Threat of Substitutes
Within the framework defined by Porter, substitute products are those that exist in another industry but may be used to fulfill the same need. The more substitutes that exist for a product, the larger the company’s competitive environment and the lower the potential for profit. An example of this is that for a boxed juice producer, fresh juice, water and soft drinks are all substitutes though they exist in separate categories.
A high threat of substitutes will impact a company’s ability to set prices that it wants. If a substitute is priced lower or fulfills a need better than it may end up attracting consumers towards it and reduce sales for existing companies.
When is there a threat from substitutes?
The threat of substitutes is affected by factors such as brand loyalty, switching costs, relative prices, as well as trends and fads.
4. Bargaining Power of Buyers
When buyers have the power to affect prices in an industry, it becomes an important factor to consider for a company.
When is buyer power high?
Buyers tend to have power over an industry if they are important to the company, this may be if the industry is such that buyers either buy in bulk, or can easily switch to another supplier. A limited number of strong buyers may be able to exert significant control over a seller. In addition, if a product is similar to its competitor with little or no differentiation, then there are chances that the company may need to let the supplier dictate terms in order to avoid losing the customer.
5. Bargaining Power of Suppliers
Suppliers provide the raw material needed to provide a good or service. This means that there is usually a need to maintain strong steady relationships with suppliers. Depending on the industry dynamics, suppliers may be in the position to dictate terms, set prices and determine availability timelines. Powerful suppliers may be able to increase costs without affecting their own sales volume or reduce quantities that they sell.
When do suppliers have power?
Supplier may enjoy more power if there are less of them. Costs of switching to an alternate are high, or there are no alternates. A supplier may also be the only provider of a certain raw material. This may be the case in instances where a supplier holds a patent or have proprietary knowledge. Because of a lack of alternates, they may be able to withhold quantities or increase prices without losing sales.
HOW TO USE THE MODEL
The Porter’s five forces model is often used as a starting point to evaluate a company’s position in its industry and to assess its level of competitiveness. Though this framework is generic and applicable to any industry, it is only effective if it is used in a specific context that applies directly to the company undertaking the evaluation.
Porter also emphasized the importance of using this model at more basic industry level. If an organization operates in different industries, then it must develop a separate five forces model for each of its industries.
Steps To Follow When Performing Analysis
A company may follow three basic steps when performing an industry analysis,
- Gather information on each force
During the first step, the company should gather information about their industry using the five forces as a guide for classifying this information.
- Analyze results and display in a diagram
After substantial information has been gathered, a team may sit down and analyze how each of the identified factors affect the industry. Every industry will have different factors affecting it differently. This makes it vital to not compare across industries or use another industry’s data.
- Formulate Strategy based on conclusions
The analysis of factors affecting the industry can now be translated into specific strategies to further the interests of the company.
Navigating the Model Development: Before, During and After
It is beneficial for a company working on a Porter’s five forces analysis to maintain an analytical frame of mind before the process begins, during the process and after everything has been completed. Some aspects to keep in mind are:
- Understand the goals of the analysis and expectations from it
- Understand the scope of the analysis and who are the potential beneficiaries
- Allow open and honest brainstorming session regarding these questions.
- Keep a focus on the future
- Do not focus on what could’ve been done better in the past, but focus on future improvements
- Analyze positives and negatives
- Be open to new ideas and possibilities
- Identify lessons learnt and how they can be used in the future
- Document positives and negatives. Identify best practices
- Understand whether the analysis had the required impact
- Follow up on implementation plans
- Record information from the analysis to be used in future decisions
Porter’s Five Forces of Analysis: How to Determine the Attractiveness of an Industry
MODEL DO’S AND DONTS
As with any framework, there are specific ways to use this one successfully. In order to gain any benefits from a Porter’s five forces analysis it should:
- Not be used on an individual company but rather in the entire industry. These findings can then be used to devise strategies for the company itself.
- Be used when there are at least three or more competing firms in the market
- Consider the impact of the government on the industry
- Consider which stage in the lifecycle the industry is
- Consider the changing nature of industries and markets
Over the years, people have challenged underlying principlesthat Porter based his five forces model on. Some of these criticisms have been:
Academics such as Stewart Neill, have taken exception to what they call the three dubious assumptions made within the model. These are:
- The assumption that buyers, competitors and suppliers are separate entities that never interact, never collude and never influence each other directly
- The assumption that structural advantage or the creation of entry barriers is the source of value
- The assumption that there is always low uncertainty which allows participants in a market to always be able to plan ahead and counter competitor actions.
The 6th Force
Through game theory, Adam Brandenburger and Barry Nalebuff of Yale, added a new concept to the Porter’s five forces model. In the mid 1990s, they proposed the idea of complementary force which may have been termed a 6th force by Andrew Grove, former CEO Intel. These complementary forces may be the government or the public.
Porter himself countered this addition to the model by the assertion that the government or public are factors that affect the five forces.
EXAMPLES – IKEA
IKEA is a Swedish company that sells furniture and home accessories. The furniture is modern and ready to assemble. As of 2008, it was the biggest retailer of furniture in the world. It was created in 1943 by 17 year old Ingvar Kamprad. In addition to simplistic furniture design and eco friendly solutions, the company is known to control costs, focus on operational details and efficiency and a continuous focus on new product development. This strategy has allowed the company to maintain its low costs over the years. At present, there are 349 IKEA stores in 43 countries.
Porter’s Five Forces Analysis for IKEA
- Competitive Rivalry
There is significant competition in the discount furniture market with companies like Ashley Furniture Home Stores, Home Depot or other local players. But IKEA has managed to create a clear differentiated position in the market and remains the global market leader in its industry.
- Threat of new Entrants
There is little threat from new entrants. The requisite expertise is difficult to replicate and financial investments are significantly high. In addition the market is saturated enough with the existing players that there is little attraction for a competitor large enough to threaten IKEA’s position.
- Threat of Substitutes
There is little threat of substitutes as the target market for IKEA is unlikely to switch to higher end more classic styles of furniture. There are not many alternates that offer the breadth of options that are available at IKEA.
- Bargaining Power of Buyers
There is enough competition in the market to afford some power to the buyers in the industry. Since IKEA has built up its USP with its competitive prices, customers can choose to switch if there is any increase in the prices. There is little switching cost, though loyalty may be a factor that prevents a switch.
- Bargaining Power of Suppliers
Suppliers do not have substantial bargaining power as there many options available to IKEA around the world. There are numerous factories that have the requisite expertise to partner with IKEA. Despite this IKEA attempts to firm long term strategic partnerships with suppliers which benefits both supplier and the firm.