1. Determine threat of substitutes by looking at switching costs, price/performance of substitutes, and brand loyalty.
2. Determine bargaining power of customers by analyzing buyer concentration, customer knowledge, price sensitivity, product differentiation, and backward integration.
3. Determine bargaining power of suppliers by considering supplier concentration, switching costs, and forward integration.
4. Determine intensity of competition by focusing on industry concentration, capacity levels, industry life cycle, product differentiation, and storage costs.
5. Determine threat of new entrants by investigating technological advances, government regulation, economies of scale, initial investments, required expertise, patents, and supply and distribution channels.
In 1979 Michael Porter of the Harvard Business School identified five competitive forces that affect a company’s ability to make a profit. This framework gives analysts a tool to understand the industry structure that a firm operates in and determine its long-term attractiveness. Stronger forces of competition are associated with less attractive industries. The five forces include (1) threat of substitutes, (2) buyer power, (3) supplier power, (4) intensity of competition, and (5) threat of new entrants. The forces do not follow any particular order, though the final two are generally thought to be the most important.
1. Threat of Substitute Products
Products (or services) from one industry can often be replaced by products from another. Substitutes are products that serve the same function and offer similar benefits as the industry’s product. They pose a risk because they reduce the potential sales volume for existing firms and constrain how high prices can be raised. A firm’s profitability is therefore weakened to the degree there are more substitutes available in the market. Substitutes are a greater threat when the following factors are presents.
- Switching Costs: In some cases it is costly or inconvenient for customers to switch to another product. In other instances it is relatively easy to switch. The threat of substitutes is strongest when another product offers an advantage, there is no risk to changing products, and customers do not experience a loss of productivity by switching.
- Relative Price for Performance: Substitute products may be available in the market for lower prices. Alternative products may also offer more features or benefits to customers. Substitution risk is greatest if a substitute product is cheaper and equal or superior in quality.
- Brand Loyalty: Even if switching costs are low and substitute products are available at discount prices, customers may still have loyalty to a particular brand. Substitutes are a greater threat when customers have little to no loyalty and price is their primary motivator.
2. Bargaining Power of Customers
The bargaining power of customers/buyers impacts the attractiveness of an industry. Buyers can be consumers, distributors, or other manufacturers. Key factors that increase the bargaining power of customers include the following.
- Buyer Concentration: Whether customers can put downward pressure on industry profitability depends on the relative concentration of buyers. If the supplying industry has a large number of small operators and buyers are few and large, then customers are more concentrated than sellers. On the other hand, many fragmented buyers cannot affect profitability since losing a few customers isn’t critical.
- Customer Knowledge: Customers have bargaining power if they’re well educated regarding the product. They have less control if the market is complicated or hard to understand. The more customers know about the product’s features, competitors, market demand, and production costs, the more intelligently they are able to bargain for lower prices.
- Price Sensitivity: The bargaining position of buyers is greater when they are price-sensitive. Customers are most sensitive to price when the purchase represents a relatively large expense or they operate with low margins. These factors increase the likelihood that a customer will price shop when marking a purchase.
- Product Differentiation: When a product is not unique and can be purchased from other suppliers then buyers will base their decision mainly on price. Undifferentiated (i.e. homogenous) products are relatively easy to switch between without suffering switching costs. The risk of customers switching to competitors’ products is even greater when brand loyalty is low or non-existent.
- Backward Integration: It is sometimes possible for buyers to integrate backward in the supply chain and produce the product themselves. Buyers can set up their own supply production or purchase a competitor providing the product. The extent to which prices are kept competitive due to this threat depends in part on how difficult it would be for buyers to integrate backwards.
- Other: If the supplying industry operates with high fixed costs then they are more likely to negotiate on price with customers to maximize volume of sales. Buyers also have more power when the product is not of strategical importance to them and the buyer’s own end-product is unaffected.
3. Bargaining Power of Suppliers
Supplier power represents the opposite side of buyer power. Factors that increase supplier bargaining power are as follows.
- Supplier Concentration: A low concentration of suppliers is an indication that suppliers have a weaker bargaining position. If however the market is dominated by a few large suppliers then bargaining power is high. A small number of large suppliers can use their market position to charge preferential prices for their inputs and put downward pressure on industry profitability. Suppliers can even cooperate formally or informally to control pricing and supply.
- Switching Costs: Supplier bargaining power is likely to be strong when the cost of switching from one supplier to another is high. Switching costs can be imposed on buyers by penalizing them when they change to another supplier. They can also arise from unique inputs, which make switching suppliers more difficult since fewer substitutes are available.
- Forward Integration: There is the possibility that suppliers will integrate further up the supply chain in order to increase control of distribution channels and obtain higher margins. This threat is especially high when the buying industry has a higher profitability than the supplying industry, barriers to entry are low in the buying industry, and forward integration provides economics of scale for the supplier. There is the additional risk that suppliers can find a way to sell directly to customers, thereby becoming a direct competitor.
- Other: Suppliers have more power when their product is critical to the end-product of the industry they sell to or buyers do not have a full understanding of the supplier’s product or market. The negotiating power of the industry is further reduced when the product does not represent a material portion of the supplier’s business.
4. Intensity of Competition
Intensity of competition among incumbents is often the strongest of the five competitive forces. Intra-industry rivalry puts pressure on prices, margins, and therefore the profitability of every firm in the industry. Competition between existing players can be centered on price or other attributes that customers value. The following factors determine the intensity of competitive rivalry.
- Industry Concentration: Industries concentrated among a relatively small number of large companies usually have less competition. Fragmented industries where there are many sellers of the same size on the other hand tend to be highly competitive. The level of industry concentration can be evaluated by analyzing relative market shares. Rivalry is more intense where each company’s market share is roughly equal or where two or more firms are struggling for market leadership. Unstable market shares are also an indicator of competitive rivalry. Two additional measures of competitive rivalry are the Concentration Ratio (CRx) and the Herfindahl-Hirschman Index (HHI).
- The CRx ratio is used to show the extent of market control of the largest firms in the industry (e.g. the top three companies account for 80% of the market share). If a few firms hold a significant share of the market they can more easily maintain competitive advantages and abnormal profits using lobbying power and legal savvy to shape regulation in their favor .
- The HHI measures the amount of competition in an industry by giving greater weight to larger organizations. An index value close to zero indicates a large number of small organizations. Values near one represent a small number of large organizations.
- Capacity Level: Analysts should consider the current and future changes in industry capacity levels since excess capacity fosters greater competition. Industries with high barriers to exit are the most prone to over-capacity. Exit costs are greatest for businesses with highly specialized equipment because liquidation would result in significant losses. Instead of abandoning their investments, these firms will resort to extreme methods of competition and continue to operate despite being unprofitable. Excess capacity is also characteristic of firms that are highly capital intensive. Since it takes longer for new capacity to meet increases in demand, capacity additions often overshoot long-run demand. These same businesses face high fixed costs of production and are pressured to produce larger volumes to achieve economies of scale, thereby causing excess capacity and price cuts.
- Life Cycle: Where an industry is in its life cycle affects the level of competition among incumbents. If the market is growing slowly or shrinking then firms are unable to growth without taking market away from competitors. As a result, firms will strongly defend their existing market share and attempt to gain a greater share at the expense of others.
- Product Differentiation: Products that are not unique or homogenous compete mainly on price. In some cases, low levels of product differentiation can be achieved by improving service levels or developing strong brand identities. Competition is greatest when products are straightforward and uncomplicated, such as commodities.
- Storage Costs: To avoid high storage costs or losing inventory to spoilage, sellers will aggressively price their products in order to sell them more quickly. Industries in the business of supplying highly perishable items are therefore characterized by more intense competition.
5. Threat of New Entrants
The threat of new competitors entering the market is greatly determined by the barriers to entry. Higher barriers are associated with less competitive industry conditions. Lower hurdles encourage new entrants, which will capture market share and put downward pressure on prices. A good rule of thumb for thinking about barriers is to examine the stability of industry market shares over time and note how often new companies enter the industry. Profitable industries yielding high returns are the most likely to attract competition. The following barriers to market entry help evaluate the threat of new entrants.
- Technological Advances: Competitive forces are not static but change in response to ongoing advances in technology. Incumbent market leaders can lose their dominance to emerging competitors who leverage new technology.
- Regulation: Governments can often influence the level of competition in an industry through regulation that restricts new firms from entering the industry.
- Economies of Scale: There is a cost-efficient level of production for every product. Some industries must attain large levels of production to realize profitable operations while others don’t face any disadvantage by producing small volumes. Rival firms are more likely to enter an industry and increase competition when economies of scale are minor.
- Initial Investment: Industries that require large up-front investments create a barrier to potential entrants. Most barriers stem from irreversible resource commitments that must be made in order to enter the industry but cannot be easily recovered if the venture fails. Expensive start-up costs include specialty assets or technology, marketing campaigns, or research and development.
- Expertise: It is difficult for new rivals to enter an industry if it requires proprietary knowhow or involves a steep learning curve. The need for new organizations to acquire such intellectual capital (including qualified expert staff) therefore protects the profit levels of existing providers by limiting competition. Industries with a common technology base or easily learned production processes, on the other hand, attract potential competitors.
- Patents: Protected intellectual property like patents and licenses provide incumbents with a competitive advantage. The level of threat from new entrants is therefore greatest when the industry does not depend heavily on patents and the like.
- Supply and Distribution Channels: Barriers to entry exist if distribution channels are controlled by existing firms or firms have favorable access to industry inputs. New entrants pose a threat if it’s easy to acquire customers and resources are neither scarce nor inaccessible.
The strongest criticism of the five forces framework is that it provides only a snapshot of an industry at a particular point in time. It is valuable insofar as the market structure of the industry remains static. Although this assumption may have held in the late 1970s when the model was developed, it is hardly the case in today’s dynamic markets. Modern industries are characterized as volatile, uncertain and ambiguous. Technological breakthroughs and start-ups are constantly altering business models and disrupting relationships all along the supply chain.
The most difficult aspect of applying the tool is accurately defining the market and working out who are the relevant competitors. Many firms carry a diverse portfolio of product groups, thereby making it appropriate to create a separate model for each area. It is finally worth noting that overall industry attractiveness does not imply that every firm in the industry will share the same profitability.
Free Management eBooks. Porter’s Five Forces.
Purdue University. Industry Analysis: The Five Forces.