Step-by-Step Five Forces Analysis
Porter's Five Forces Analysis is an important tool in the project planning stage. Porter's Five Forces Analysis makes a strong assumption that there are only five important forces that could determine the competitive power in a business situation. Using the following three steps:
- Identify the different factors that bring about the competitive pressures for each of the five forces:
- Who are the suppliers?
- Who are the customers?
- What are the substitute products?
- Is it difficult to enter this industry?
- Who are the major competitors in this industry?
- Based on the factors identified, determine if the pressures are:
- Determine whether the strength of the five forces is favorable to earning attractive profits in the industry. Using the Five Forces model can help answer the following questions:
- Is the state of competition in the industry stronger than "normal"?
- Can companies in this industry expect to earn decent profits in light of the competitive forces?
- Are the competitive forces sufficiently powerful enough to undermine industry profitability?
Components of Porter's Five Forces
The Porter's five forces analysis include the following components:
The bargaining power of suppliers: it represents the extent to which the suppliers can influence the prices. When there are a lot of suppliers, buyers can easily switch to competition because no supplier can, actually, influence the prices and exercise control in the industry. On the contrary, when the number of suppliers is relatively small, they can push the prices up and be powerful. Thus, supplier bargaining power is high when:
- The market is conquered by a few big suppliers.
- There are no alternative products available.
- The supplier customer base is fragmented, making their bargaining power low.
- High switching costs from one to another supplier.
Possibility of supplier integration forward, to obtain higher profits and margins.
The bargaining power of Customers: The bargaining power of customers looks at customers' ability to affect the pricing and quality of products and services. When the number of consumers of a particular product or service is low, they have much more power to affect pricing and quality. The same holds true when a large proportion of buyers can easily switch to a different product or service. When consumers buy products in low quantities, the bargaining power is low. Factors affecting this force are buyer concentration, the degree of dependency on the product, overall bargaining leverage, readily available purchasing information, substitute products, price sensitivity, and total volume of trade. Thus, customer bargaining power is high when:
- Customers procure large volumes.
- The supplying industry consists of several small operators.
- The supplying industry is controlled with high fixed costs.
- The product has substitutes. Switching products is easy and simple.
- Switching products does not incur high costs.
- Customers are price responsive. Customers could manufacture the product themselves.
The threat of new entrants: when the barriers to entry into an industry are high, new businesses can hardly enter the market due to high costs and strong competition. Highly concentrated industries, like the automobile or the health insurance, can claim a competitive advantage because their products are not homogeneous, and they can sustain a favorable position. On the other hand, when the barriers to entry into an industry are low, new businesses can take advantage of the economies of scale or key technologies. Possible barriers to entry could include:
- Economies of scale. High initial investment costs or fixed costs
- Cost advantage of existing players.
- Brand loyalty.
- Intellectual property like licenses, etc.
- Shortage of important resources.
- Access to raw materials is controlled by existing players.
- Distribution means are controlled by existing players.
- Existing players have secure customer relations. Elevated switching costs for customers.
- Legislation and government acts.
The threat of substitutes: when customers can choose between a lot of substitute products or services, businesses are price takers, i.e. buyers determine the prices, thereby lessening the power of businesses. On the contrary, when a business follows a product differentiation strategy, it can determine the ability of buyers to switch to the competition. This threat is determined by things such as:
- Brand dependability of customers.
- Secure customer relationships.
- Switching costs for customers.
- The relative price for performance of substitutes.
- Up-to-date trends.
Competitive rivalry: in highly competitive industries, firms can exercise little or no control on the prices of the goods and services. In contrast, when the industry is a monopolistic competition or monopoly, businesses can fully control the prices of goods and services. Rivalry between existing players is likely to be high when:
- Players are the same size.
- Players have comparable strategies.
- Little or no differentiation between players and their products leading to price competition.
- Low market growth rates.
- Barriers for exit are high.
These forces can be neatly brought together in a diagram like the one below.
Why do you buy Nike over Adidas? The answer lies in the term competitive advantage. Competitive advantage is a set of unique features of a company and its products that are perceived by the target market as significant and superior to the competition. It is the reason behind brand loyalty, and why you prefer one product or service over another. There are three different types of competitive advantages that companies can actually use. They are price, product differentiation, and cost.
Price is one of the most influential factors that can affect the company's profit. Companies can take advantage by reducing and increasing the price of the product, but it is generally taken to have short term benefits. Because in long term, many other factors like quality, substitutes also impacts.
"When a product or service has a valuable, unique offering for their customer"
In economics and marketing, product differentiation (or simply differentiation) is the process of distinguishing a product or service from others, to make it more attractive to a particular target market. Generally an industry with high rivalry or moderate rivalry will have the homogeneous kind of product. Difference in the company's product could not be seen. So, to gain an advantage, a company may differentiate its product from that of the competitor. It will help them gaining an advantage.
Product cost is also a factor which decides the overall profitability of the organization. If the cost of the product is higher than the competitor's product, then the profit earned by the company will be less. To take an advantage, firm may try to reduce the cost and employ effective techniques of production, so that the firm's profit will increase.
Porter's Five Forces Example - Footwear Company
NiceWare is a leading Footwear company that operates in the athletic apparel industry.
Based on Porter's Five Forces model the threat of new entrants is moderate as there are high capital costs, mostly related to advertising and promotion, especially when a new product line is launched. On the other hand, company A can expand in the performance apparel industry and cross-sell its products.
The bargaining power of suppliers is relatively low because the company has many different suppliers both in the US and abroad.
The bargaining power of customers is higher in the wholesale customers as they can switch at a low cost to the competition, thereby gaining a higher margin. With respect to the retail customers, the bargaining power is lower as customers are loyal to the brand.
The threat of new entrants is high as the entry barriers are low - low R & D expense, not much specialized knowledge is required in operating the business, low production and labour cost in some cities.
The threat of substitute products is relatively low because brand loyalty is high. Hence, the demand for the company's products is expected to continue in the long-term.
The competitive rivalry in the industry is high as there are a lot of well-established companies with significantly larger resources and process patents.
These forces are be neatly brought together in a diagram below: