Porter's five Forces Model

Porter’s Five Forces Understanding the dynamics of competitors within an industry is critical for several reasons. First, it can help to assess the potential opportunities for your venture, particularly important if you are entering this industry as a new player. It can also be a critical step to better differentiate you from others that offer similar products and services. One of the most respected models to assist with this analysis is Porter’s Five Forces Model. This model, created by Michael E. Porter and described in the book “Competitive Strategy:

Techniques for Analyzing Industries and Competitors”, has proven to be a useful tool for both business and marketing-based planning.

Background The pure competition model does not present a viable tool to assess an industry. Porter’s Five Forces attempts to realistically assess potential levels of profitability, opportunity and risk based on five key factors within an industry. This model may be used as a tool to better develop a strategic advantage over competing firms within an industry in a competitive and healthy environment. It identifies five forces that determine the long-run profitability of a market or market segment.

1. Suppliers 2. Buyers 3. Entry/Exit Barriers 4. Substitutes 5. Rivalry

1. Supplier Power

• Supplier concentration
• Importance of volume to supplier
• Differentiation of inputs
• Impact of inputs on cost or differentiation
• Switching costs of firms in the industry
• Presence of substitute inputs
• Threat of forward integration
• Cost relative to total purchases in industry

2. Buyer Power

• Bargaining leverage
• Buyer volume
• Buyer information
• Brand identity
• Price sensitivity
• Threat of backward integration
• Product differentiation
• Buyer concentration vs. industry
• Substitutes available
• Buyers' incentives

3. Entry/Exit Barriers

• Absolute cost advantages
• Proprietary learning curve
• Access to inputs
• Government or other binding policy
• Economies of scale
• Capital requirements
• Brand identity
• Switching costs
• Access to distribution
• Expected retaliation
• Proprietary products

4. Substitutes

• Switching costs
• Buyer inclination to find alternatives
• Price-performance
• Trade-off of the available substitute products or services

5. Rivalry

• Exit barriers
• Industry concentration
• Fixed costs
• Perceived value add
• Industry growth
• Overcapacity status
• Product differences
• Switching costs
• Brand identity
• Diversity of rivals
• Corporate stakes

6. Service

• Level of service compared to others
• Added value perceptions
• Dynamics with other attributes

Power of Suppliers An industry that produces goods requires raw materials. This leads to buyer-supplier relationships between the industry and the firms that provide the raw materials. Depending on where the power lies, suppliers may be able to exert an influence on the producing industry. They may be able to dictate price and influence availability. A segment is unattractive when an organization’s suppliers have the ability to:

• Increase prices without suffering from a decrease in volume
• Reduce the quantity supplied
• Organize in a formal or informal manner
• Compete in an environment with relatively few substitutes
• Provide a product/material that is a critical part of the end product or service
• Impose switching costs on their customers when they depart
• Integrate downstream by purchasing or controlling the distribution channels

One example of this is DeBeers ability to wield influence within the diamond industry. DeBeers’ high level of control over some of the most productive diamond mines in the world gives them extreme power within the industry.

The best defence in mitigating the power of suppliers is to build win–win relationships with suppliers or arrange to use multiple suppliers.

Power of Buyers The power of buyers describes the impact customers have on an industry. When buyer power is strong, the relationship to the producing industry becomes closer to what economists term a monopoly. A Monopoly is a market where there are many suppliers and one buyer. Under these market conditions, the buyer has the most influence in determining the price. Few pure monopolies actually exist, but there is often a connection between an industry and buyers that determines where power lies.

The bargaining power of buyers increases when they have the ability to:

• Be “organized” in some form with others providing similar products and services
• Purchase a product that represents a significant fraction of the buyer’s costs
• Buy a product that is undifferentiated
• Incur low switching costs when they change vendors
• Be price sensitive, with other options available
• Integrate upstream, to purchase the providers of the goods.

To mitigate the power of buyers, sellers can seek to select buyers with less power to negotiate, switch suppliers, or develop superior offers that strong buyers cannot refuse. Barriers to Entry/Exit The possibility of new firms entering the industry affects competition. A key is to assess how easy it is for a new player to enter an industry. The most attractive segment has high entry barriers and low exit barriers. Although any firm should be able to enter and exit a market, each industry often presents varying levels of difficulty, commonly driven by economics. Manufacturing-based industries are more difficult to enter than many service-based industries. The definable characteristics of each industry protect profitable areas for firms and inhibit additional rivals from entering the market. These inhibitive characteristics are referred to as barriers to entry. Barriers to entry are more than the expected ebb and flow that markets typically experience. For example, when industry profits increase, one would expect firms to enter the market to take advantage of the high profit levels, which will eventually result in reducing profits.