Porter’s five forces model of competitive analysis is one of the most popular business analysis tools that are used used in strategic management to analyze the market competitiveness of business organizations. Porter’s model of competitive analysis uses five industry forces to determine the intensity of competition in an industry and its profitability level.
The model was developed by Michael E. Porter in 1979 and it’s one of the traditional, well-known, and most widely used strategic macro analysis framework. The Five Forces model was derived from industrial organization economics to identify the fundamental economic forces that shape every industry.
The basic idea of the competitive forces starts with the notion that competition is often looked at too narrowly by managers. Five Forces recognizes competing with direct competitors, but it goes beyond that. 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.
Ideally, when you understand the forces affecting your industry, you’ll be in a better position to adjust your strategy to boost profitability, and stay ahead of the competition. Essentially, the model can be applied to particular companies, market segments, industries or regions.
Steps to Developing Porter’s Five Forces Framework
The purpose of a five forces analysis is to give you a full and exhaustive picture of your industry and how to create a competitive advantage within that industry. So, probe exhaustively, and don’t skip over details that you think might not affect you or that seem unimportant. Porter’s Five Forces analysis isn’t simply a place to list things you already know—it’s a process to uncover new information that might affect your company’s survival.
Brainstorming
At the stage, you gather the information on your market research, and brainstorm with you team on the determining factors of each on the building blocks. Then, create lists for each of the five categories. In doing this, you need to consider your entire industry and include companies providing substitute or complementary products or services
Rating Forces in Porter’s Analysis
When you have computed all of the relevant factors on each block, then determine the overall effect of each force. Rate the factors according to how they affect the company. An easy way of doing this is to use a single “+” sign for a force that’s moderately in your favor, or a “-” sign for a force that’s moderately against you. Use “++” for a force that’s strongly in your favor, or “–” for one that’s strongly against. For a neutral force, you can use “o.”
Determine your strategy
With the knowledge about rating of each of the forces, the organizations can develop strategies to influence them in a way that improves their competitiveness. Therefore, if you have mostly negative forces affecting your situation, it would be time to find ways to improve your potential in your market.
For mostly positive factors, think about ways to use them for advantageously. The result of your analysis could be developing a new strategic direction, e.g., a new positioning, differentiation, cost leadership, strategic partnerships, etc.
Regular Market Evaluation and Analysis
Five Forces market competitive analysis should be conducted regularly in order to keep track of changes in your industry and take stock of the effectiveness of your business strategies. Therefore, you need to view it as a dynamic model that keep you on a continual look out of what is happening in the industry, and where it’s headed.
Components of Porter’s Five Forces Model of Competitive Analysis
The key components of Porter’s Five Forces Model or the five market forces in Porter Analysis include:
- Threat of new market entrants
- Bargaining power of suppliers
- Bargaining power of buyers
- Threat of substitute products
- Rivalry among existing competitors
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.
When new companies enter an industry, the potential for profitability drops. Existing businesses lose some pricing power and often have to deal with higher production costs. The number of customers you can reach drops as their options increase.
Additionally, if the new company can rely on a pre-established reputation, knowledge, or cash flow, they may force smaller competitors out of business. Within the force of new market entrants, there are two factors to consider:
- how hard it is to enter the market
- how existing competition will respond to the new entrants
Essentially, if competitors can enter your market with little resources and effort, you may need to adapt your strategy to handle any potential rivals. If an industry is profitable and there are few barriers to enter, rivalry soon intensifies. When more organizations compete for the same market share, profits start to fall. Therefore, it is essential for existing organizations to create high barriers to deter new entrants.
Examples of Threat to Market Entry
• Existing loyalty to major brands
• Incentives for using a particular buyer
• High fixed costs
• Scarcity of resources
• Government restrictions or legislation
• Entry protection (patents, rights, etc.)
• Brand equity
• Sunk cost
• Capital requirements
• Access to distribution
• Absolute cost advantages
• Learning curve advantages
• Expected retaliation by incumbents
How to determine the significance of the threat of entrants
To weigh the importance of the threat posed by new market entrants, you should consider the following questions.
• Is there regulation in the market?
• How complicated is the product or service?
• What budget would be required?
• What would the existing players response be?
• What are the barriers to entry?
• Have new players arrived recently? If so, how did they do?
• How much does it cost and how long does it take to enter your market?
• What are the barriers to entry (e.g., patents, rights, etc.)?
• What does it take to make the business scalable?
• Have you protected your key technologies?
Bargaining Power of Suppliers
This force analyzes how much power and control a company’s supplier 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 more suppliers you have to choose from, the easier it will be to switch to a cheaper alternative.
Conversely, the fewer suppliers there are and the more you rely on them for help, the stronger their position and their ability to charge you more is. Essentially, if your business is not capable of passing the costs along to customers, then it lowers your profit margin and your competitive position in the market.
Don’t think of the supplier analysis as examining a single supplier; rather, it involves the entire group of suppliers in the market.
Factors that Determine Supplier Bargaining Power
The bargaining power of suppliers depends on:
• Number of suppliers
• Size of suppliers
• Supplier concentration
• Availability of substitutes for the supplier’s products
• Uniqueness of supplier’s products or services
• 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
Questions to Weigh the Significance of Supplier Bargaining Power
• What is the cost of switching?
• How big a customer are you to your supplier?
• How many suppliers does your company have?
• How unique is the product or service that they provide?
• How many alternative suppliers can you find? How do their prices compare to your current supplier?
• How expensive would it be to switch from one supplier to another?
Bargaining Power of Buyers
This is the flip side of the power of the supplier. It’s how much pressure customers can place on a business. If one customer has a large enough impact to affect a company’s margins and volumes, then they hold substantial power. 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. Imagine a business where there are very few customers and switching between one supplier and the other is extremely easy.
Undeniably, this gives total control to customers to set the prices they want. For example, in a highly specialized industry where a handful of buyers account for the majority of sales, those buyers are able to demand more of a product or service. The more buyers a company has, the less reliant they are on that small group.
Factors that Determine the Power of Buyers
These are some of the key factors that determine buyer power:
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
Questions to Weigh the Significance of Buyer Power
• How many alternative options are there in the market for customers?
• How long are your contracts on average?
• Are customers price sensitive?
• How much of your product or service do customers purchase?
• How strong is your brand value and loyalty?
• How many buyers control your sales?
• How large are the orders you receive?
• Could your buyers switch suppliers—and how much would it cost for them to switch?
• How important is your product/service to your buyers?
Threat of Substitute Products
Substitute products are offerings that differ from the goods and services provided by the competitors in an industry but that fill similar needs to what competitors offer. 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. Substitutes could have two effects on industry competition and profitability.
First, the substitutes products establish a maximum price for products and services in the industry; exceeding the maximum would prompt customers to move to the substitute products that are available.
Secondly, substitutes can shape the competition in an industry to rise their marketing and promotional efforts to stem the outflow of customers. Indeed, every product that serves a similar need for customers should be taken into account. Therefore, what is the likelihood that someone will switch to a competitive product or service? If the cost of switching is low, then this poses to be a serious threat.
Factors that can determine the threat of substitutes
• Buyer propensity to substitute
• Relative price performance of substitutes
• Buyer switching costs
• Perceived level of product differentiation
• Technology change and product innovation
• Number of substitute products available
• Relative price performance of substitutes
• Substitute producer’s profitability & aggressiveness
Questions to Weigh the Significance of the Threat of Substitute Products
• Is the cost for a customer to switch low?
• What is the brand loyalty and strength like in the marketplace?
• How does the product or service compete?
• What are the differentiators between your product/service and the substitute?
• How many substitute products are available in this market?
• What is the cost of switching to a substitute product?
• How difficult would it be to make the switch?
• What products or services can you offer that might substitute a market leader?
Rivalry Among Existing Competitors
Understanding the intensity of rivalry among market competitors is important because the degree of intensity helps shape an industry’s profit potential. 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 competitor offering for a little cost.
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. Every industry is unique to some degree, but there are some general characteristics that help to predict the likelihood that fierce rivalry will erupt.
Rivalry tends to be fierce, for example, to the extent that the growth rate of demand for the industry’s offerings is low, fixed costs in the industry are high, competitors are not differentiated from one another, and exit barriers in the industry are high. Typically, when one business makes a significant market move it forces competitors to counter with their own.
This endless cycle of action and reaction is what limits profitability. It can particularly be harmful for businesses if the moving factor is the price. For many industries, competitive rivalry is the major determinant of competitiveness. Sometimes rivals compete aggressively and sometimes rivals compete in non-price dimensions such as innovation, marketing, etc.
Factors that Influence Rivalry Among Existing Competitors
• Number of competitors
• Diversity of competitors
• Industry concentration and balance
• Industry life cycle
• Quality differences
• Product differentiation
• Brand identity/loyalty
• Switching costs
• Barriers to exit
• Rate of industry growth
• Intermittent industry overcapacity
• Information complexity and asymmetry
Questions to Weigh the Significance of the Rivalry Among Existing Competitors
• How many competitors do you have in your industry?
• Is the quality of their service or products comparable to yours? If yes, how?
• What will it cost your clients/customers to switch to a competitor?
• How big is the marketplace, can it sustain multiple successful companies?
• What is the industry growth looking like?
• What is the M&A news in this space?
• What are the exit barriers?
• Have you lost to competitors and, if so, why?
• Who are your biggest competitors?
• How does the quality of their products or services compare with yours?
• What distinguishes your company from the competition?
Strategic Approach to Market Competitive Analysis
Market Strategy Formulation
- positioning the company so that it can use its capabilities to defense against the competitive force; and/or
- influencing the balance of the forces through strategic moves, thereby improving the company’s position; and/or
- anticipating shifts in the factors underlying the forces and responding to them, with the hope of exploiting change by choosing a strategy appropriate for the new competitive balance before opponents recognize it.
This basically comes down to:
• Playing to your strengths
• Integration
• Being ahead of the curve
Positioning the company
Playing to your strengths is a bit of a conservative move, but that means a lower risk factor and can prove great for medium or even long-term success depending on the industry. This first approach takes the structure of the industry as given and matches the company’s strengths and weaknesses to it.
Knowledge of the company’s capabilities and of the causes of the competitive forces will highlight the areas where the company should confront competition and where avoid it. If the company is a low-cost producer, it may choose to confront powerful buyers while it takes care to sell them only products not vulnerable to competition from substitutes.
Influencing the balance
When dealing with the forces that drive industry competition, a company can devise a strategy that takes the offensive. This posture is designed to do more than merely cope with the forces themselves; it is meant to alter their causes.
For example, innovations in marketing can raise brand identification or otherwise differentiate the product. Capital investments in large-scale facilities or vertical integration could alter entry barriers. Vertical integration is a typical move for growth by large companies as they want to protect their market position, however, it comes with its own risks.
Exploiting industry change
Being ahead of the curve is the riskiest of all. Industry evolution is important strategically because evolution, of course, brings with it changes in the sources of competition. In the familiar product life-cycle pattern, for example, growth rates change, product differentiation is said to decline as the business becomes more mature, and the companies tend to integrate vertically.
Therefore, it’s the duty of the strategist to figure out how to render competition irrelevant. That could result to creating a blue ocean strategy.
Essentially, by doing your research and understanding your competitive space you can craft a strategy which allows you to plan effectively for the future and bypass the industry’s difficulties. Or, if you’re an investor, you can use these approaches to determine whether or not there’s a longterm future in the industry.
Industry Profitability
Porter’s five forces model can also be used to predict the eventual profitability of an industry. In long-range planning the task is to examine each competitive force, forecast the magnitude of each underlying cause, and then construct a composite picture of the likely profit potential of the industry.
The potential of the industry will depend largely on the shape of future barriers to entry, the improvement of the industry’s position relative to substitutes, the ultimate intensity of competition, and the power captured by buyers and suppliers.
Ways in Which Porter’s Competitive Analysis Model Can Help You Succeed in Business
Most business owners spend their whole careers learning about how competitive forces shape strategy. Markets and competitive forces are not static, and conducting regular reviews of your corporate strategy and the state of your industry are vital to your company’s success.
Porter’s Five Forces model of strategic analysis can make this process much easier and provide you with a consistent and uniform rubric for analyzing the changes in your market and evaluating your competitive advantage or lack thereof.
Here are three ways Porter’s Five Forces Model can be particularly useful:
1. When you’re starting a new business
Before you take the leap and decide to start a new business in an unfamiliar industry, conduct Porter’s Five Forces model of competitive analysis. Understanding the potential for industry growth, the existing distribution channels, and relative price sensitivity will give you a full picture of the level of competition you can expect and the capital requirements you need to start a viable business.
2. When you’re evaluating profit potential for existing businesses
For an existing business, a five forces analysis can be used to get an accurate picture of what future growth might look like. As a business owner it’s important to stay up to date with changing dynamics within your industry. Porter’s Five Forces model of market analysis can help make sure you are basing business decisions on accurate and up-to-date information about your industry and competition.
3. When gauging the effectiveness of a competitive strategy
Conducting an analysis using Porter’s Five Forces model after the implementation of a new business strategy can help you evaluate the effectiveness of a business strategy over time. Therefore, you will be able to identify where adjustment could be required, or how to hold on to your strengths.
Advantages and Disadvantages of Porter’s Five Forces Model of Competitive Analysis
Advantages of Porter’s Market Analysis
Helps to Estimate the Competition in the Industry
A primary advantage of the five forces is that it can help a company determine the current competition in its industry. Judging competition can be vital for a company because it can help in developing adequate response strategies.
Showcase where the Strengths and Threats Exist
Porter’s five forces model provide the output of understanding the supplier and buyer forces with risk of new entrants and substitute products. This will enable the senior executive to find out where their company’s strengths reside and where the threat exist. Management will therefore be able to take precautionary actions for the threats while enhancing the strengths more.
Identify which Entities Holding the Power
There are three entities to which Porter’s Five Forces are related. Those are suppliers, buyers (consumers), and competitors. The analysis provides insight into the entities that hold more power and less power. This will enable the companies to make decisions on the best strategies to handle these entities.
Display Opportunities to Expand the Business
Porter’s five forces evaluates the power of suppliers and buyers in the industry. This will help the company to make decisions on whether to proceed with vertical integration to acquire suppliers and buyers to reduce their power and expand the business
Assist to Understand Business Risks
Porter’s five forces provide valuable insights into the power of suppliers, power of consumers, and power of competitors. All of this information helps the company to understand the corporate risk of the business, and make responses to those risks adequately.
Helpful in Making Corporate Strategy and Vision
The corporate strategy helps the company to make strategic decisions by looking across all aspects of the business to determine how best possible to create the most value. Porter’s five forces provide valuable information for the corporate strategist to be more accurate by considering the impact of the external forces.
Disadvantages of Porter’s Five Forces Analysis
Limitation on the Composition of Business and Market Factors
Porter’s five forces only concentrate on the power of suppliers, power of consumers, substitution, and new competition. But factors like technology and internal business strategies that may impact the company are not considered. Also, external forces such as government policies, taxation policies, cross-border business risk, environmental impact, etc. are not considered.
Quantitative Dimensions
There is no built-in method to conducting quantitative analysis of the external factors. This tool does not provide a quantitative idea of the depth and impact of the five forces. Also, there is no quantitative idea of which forces out of the five are most important and least important.
Impractical to use on Large Companies
Practically it is difficult to use this analytical framework for a company that has a large product portfolio and operates in different market segments.
Not Applicable to All Industries Universally
Porter’s five forces cannot be used for some industries. For example, not-for-profit organizations cannot use this method for their analysis. Also, companies conducting activities like R&D will not have much benefit from this.
Does Not Consider Business Risk Factors
External business risk factors like foreign exchange instabilities, natural catastrophes, methods of financing, legal constraints, fast technological evolutions, fluctuations in interest rates, etc. are not considered on the framework. These are major factors that determine the business risk of a company.
Predisposition to Subjective Results
Susceptibility to subjectivity is another problem with the Five Forces Model. The framework promotes the identification of qualitative data. For untrained individuals, sources of these qualitative data might be based merely on anecdotes, hearsays, or superficial observations
Susceptibility to Biased Results
In consideration of subjectivity, it is also important to highlight the fact that bias can affect the integrity of the analysis. Regardless of whether the bias is intentional or unintentional, lack of proper training in research and analysis, as well as the absence of proper evaluation can produce results that are too shortsighted.
One-Dimensional Framework
The tool also disregards collusion among suppliers, co-competition and strategic alliances. These limitations of the Five Forces Model stem from the fact that it is a simple and one-dimensional framework that disregards complexities.
Criticism of Porter’s Strategic Business Analysis Model
There are also economists and business strategists who believe that the attractiveness of an industry cannot be assessed without considering the resources that the organization brings to that industry as well.
This would suggest that it’s best to use the Five Forces approach alongside an “inside out” or “resource-based” view of the organization, where competitive advantage is derived from leveraging resources and competences within the organization. They believe the success of most organization’s is based on resource-based view, rather than external forces that the organization might not have full control over.
Porter’s Five Forces model was drawn from industrial organization economics to identify and describe the fundamental economic forces that shape every market segment. The five forces of Porter’s analysis are competition in the industry, potential of new entrants, power of suppliers, power of customers, and threat of substitute products.
These forces determine the intensity of competition and hence the attractiveness and profitability of an industry. Essentially, awareness of the five forces can help you to understand the structure of your industry, and therefore stake a position that is less vulnerable.
The model says that the higher the competitive forces, the lower the industry’s profit potential. Conversely, the lower the competitive forces, the higher the profit potential of that industry.
The real power of Porter’s Five Forces model is that it gives you a starting point to think about how you can shape the forces to be in your favor. Therefore, when you understand the forces affecting your industry, you’ll be able to adjust your strategy to boost your profitability, and stay ahead of the competition.