Porter's five forces model

Porter's five forces model is a popular framework used as part of the strategic analysis stage of the strategic planning process.

Porter looked at the structure of industries. In particular,he was interested in assessing industry attractiveness, by which he meant how easy it would be to make above average profits (for shareholders and to fund adequate investment).

He concluded that industry attractiveness depends on five factors or forces:

• competitive rivalry
• threat of new entrants
• threat of substitutes
• power of customers / buyers
• power of customers

The five forces model

Threat of new entrants

New entrants into a market will bring extra capacity and intensify competition.

The threat from new entrants will depend upon the strength of the barriers to entry and the likely response of existing competitors to a new entrant.

Barriers to entry are factors that make it difficult for a new entrant to gain an initial foothold in a market. Major sources of barriers to entry are:

• Economies of scale, where the industry is one where unit costs decline significantly as volume increases, such that a new entrant will be unable to start on a comparable cost basis.
• Product differentiation, where established firms have good brand image and customer loyalty. The costs of overcoming this can be prohibitive.
• Capital requirements, where the industry requires a heavy initial investment (e.g. steel industry, rail transport).
• Switching costs, i.e. one-off costs in moving from one supplier to another (e.g. a garage chain switching car dealership).
• Access to distribution channels may be restricted (e.g. for some major toiletry brands in the UK 90% of sales go through 12 buying points, i.e. chemist multiples and major retailers). It is therefore difficult for a new toiletry product or manufacturer to gain shelf space.
• Cost advantages of existing producers, independent of economies of scale, e.g. patents, special knowledge, favourable access to suppliers, government subsidies.
• Know-how. It is much more difficult to penetrate a business where considerable know-how and skills are needed than to enter a simple, basic market.
• Regulation. Governments or professional bodies might supervise and limit new entrants.

Threat of substitute products

This threat is across industries (e.g. rail travel versus bust ravel versus private car) or within an industry (e.g. long life milk as a substitute for delivered fresh milk).

Porter explains that 'substitutes limit the potential returns by placing a ceiling on the price which firms in the industry can profitably charge. The better the price-performance alternative offered by substitutes, the more readily will customers switch.

Bargaining power of customers

Powerful customers can force price cuts and/or quality improvements. Either way, margins are eroded.

Bargaining power is high when a combination of factors arises. Such factors could include where

• a buyer's purchases are a high proportion of the supplier's total business or represent a high proportion of total trade in that market
• a buyer makes a low profit
• the quality of purchases is unimportant or delivery timing is irrelevant, and prices will be forced down
• there are similar alternative products available from other suppliers.

Bargaining power of suppliers

The power of suppliers to charge higher prices will be influenced by the following:

• the degree to which switching costs apply and substitutes are available
• the presence of one or two dominant suppliers controlling prices
• the extent to which products offered have a uniqueness of brand, technical performance or design not available elsewhere.

Competitive rivalry

Intensity of existing competition will depend on the following factors:

• Number and relative strength of competitors. The competition in a market can range from perfect competition through to monopoly.
• Rate of growth. Where the market is expanding, competition is low key.
• Where high fixed costs are involved companies will cut prices to marginal cost levels to protect volume, and drive weaker competitors out of the market.
• If buyers can switch easily between suppliers the competition is keen.
• If the exit barrier (i.e. the cost incurred in leaving the market) is high, companies will hang on until forced out, thereby increasing competition and depressing profit.

Criticisms

Over the last three decades business has focused on one fundamental idea – the pursuit of sustainable competitive advantage.

While the idea of competition is not new, Michael Porter expanded the concept from competing with rivals to incorporating the struggle for power between the firm and five competitive forces. Porter argued that each of these forces can reduce overall industry profitability and the individual firm’s share of that profit – their ‘profit potential’ – because they can influence prices,
costs and the level of investment required.

Not everyone agrees with Porter – some would argue that the idea of satisfying customer needs should not be abandoned in favour of a view that sees customers either as direct competitors or as means to the firm's end. Customers are not objects whose reason for being is to be fought over by competitors seeking ‘sustainable competitive advantage’.

Porter’s model might thus distract managers from seeing customers as potential partners.

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