Porter’s Five Forces
Porter’s 5 Forces is an analytical model used to help identify the structure of an industry and to help companies determine if any potential new business is viable and potential business strategies to combat these forces. The model was developed by Harvard Business School professor Michael E. Porter as part of his book “Competitive Strategy: Techniques for Analyzing Industries and Competitors,” published in 1980.
The model can be applied to any segment of the industry and can be split to look at different aspects of your product portfolio. For example, Friendlier Organics can use this model to look at its coaching business, its business management consulting business, and as an overview of Friendlier Organics as a whole.
As the name suggests, there are five factors that makeup Porter’s 5 Forces. They are all external, so they have little to do with the internal structure of a corporation.
- Industry competition: A higher degree of competition means the power of competing companies decreases. When competition is low, companies can do whatever they need to in order to increase their profits.
- New players in the industry: New (and more) entrants into the market means a company’s power also decreases. Most companies prefer to operate in a market or industry where there are fewer players.
- Supplier (seller) power: This factor examines how suppliers can use their power to increase the price of goods and services. The fewer suppliers there are in the market means they have more power.
- Buyer (customer) power: When consumers have more bargaining power, they may be able to affect the price of goods and services, driving them down.
- The threat of substitutes: Products and services by a rival that can easily be substituted are also a threat to a business’ profitability. This is an area that many small and medium size businesses fail to fully analyze.
Competition in the Industry
The first of the five forces refers to the number of competitors and their ability to undercut a company. The larger the number of competitors, along with the number of equivalent products and services they offer, the lesser the power of a company. Suppliers and buyers seek out a company’s competition if they are able to offer a better deal or lower prices. Conversely, when competitive rivalry is low, a company has greater power to charge higher prices and set the terms of deals to achieve higher sales and profits.
Potential of New Entrants Into an Industry
A company’s power is also affected by the force of new entrants into its market. The less time and money it costs for a competitor to enter a company’s market and be an effective competitor, the more an established company’s position could be significantly weakened. An industry with strong barriers to entry is ideal for existing companies within that industry since the company would be able to charge higher prices and negotiate better terms.
Power of Suppliers
The next factor in the five forces model addresses how easily suppliers can drive up the cost of inputs. It is affected by the number of suppliers of key inputs of a good or service, how unique these inputs are, and how much it would cost a company to switch to another supplier. The fewer suppliers to an industry, the more a company would depend on a supplier. As a result, the supplier has more power and can drive up input costs and push for other advantages in trade. On the other hand, when there are many suppliers or low switching costs between rival suppliers, a company can keep its input costs lower and enhance its profits.
Power of Customers
The ability that customers have to drive prices lower or their level of power is one of the five forces. It is affected by how many buyers or customers a company has, how significant each customer is, and how much it would cost a company to find new customers or markets for its output. A smaller and more powerful client base means that each customer has more power to negotiate for lower prices and better deals. A company that has many, smaller, independent customers will have an easier time charging higher prices to increase profitability.
Threat of Substitutes
The last of the five forces focuses on substitutes. Substitute goods or services that can be used in place of a company’s products or services pose a threat. Companies that produce goods or services for which there are no close substitutes will have more power to increase prices and lock in favorable terms. When close substitutes are available, customers will have the option to forgo buying a company’s product, and a company’s power can be weakened.
Understanding Porter’s Five Forces and how they apply to an industry, can enable a company to adjust its business strategy to better use its resources to generate greater growth, ideally must consistently monitor to foresee any changes in the five forces and adjust your business and marketing strategies accordingly.
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