Michael Porter, a professor of strategy at Harvard, made a tool for evaluating a company’s microenvironment.
Porter’s Five Forces is a method for analysing the impact of various microenvironmental groups on a business within a particular industry. Each of the forces represents a facet of competition that influences the likelihood of a company’s success in its industry.
Every company is part of an industry, a group of companies that produce similar goods or provide similar services, such as automakers or airlines. As we’ll see in a moment, firms within an industry may or may not directly compete with one another. Still, they all face similar situations in terms of customer interests, supplier relations, and industry growth or decline.
Porter’s Five Forces is a business analysis model that shows why different business sectors can be profitable. The Five Forces model is often used to look at an industry’s structure and a company’s business strategy.
Given the total shift in industry knowledge, a change in any of the factors usually necessitates a re-evaluation of the marketplace by a business unit. The sector’s attractiveness as a whole does not indicate that every company in it will be profitable.
With certain limitations, Porter identified five irrefutable factors that shape every global market and sector. The five forces are commonly used to assess an industry’s or market’s competitiveness, attractiveness, and profitability.
The first of Porter’s forces is industry rivalry. Note that the arrows in the diagram show that rivalry and all the other forces are linked in both directions. This is because each force can influence the degree to which firms within an industry must compete with one another for customers, establish favourable supplier relationships, and defend against new firms entering the industry.
An analyst will use Porter’s model to figure out if each force has a strong or weak effect on firms in an industry. In the context of rivalry, the question of strength focuses on how fiercely firms must compete with industry competitors (rivals) for customers and market share. Strong competition in an industry reduces the profit potential of all firms because consumers can base at least a portion of their purchasing decisions on price when they have numerous firms from which to choose. An industry with weak rivalry will have few firms, indicating that there are enough customers for everyone, or firms that have each staked out a unique position within the industry, meaning that customers will be more loyal to the firm that meets their specific needs the best.
The Threat of New Entrants
In an industry, incumbent (existing) firms compete against one another as competitors. However, if a sector has a growing or highly profitable market, it may attract new entrants. These companies are either new entrants to the industry or firms from another that have expanded their capabilities or target markets to compete in a new industry.
Different industries may be easier or more challenging to enter based on entry barriers, which prevent new firms from competing successfully in the industry. Common entry barriers include cost, brand loyalty, and industry expansion. For instance, firms in the airline industry rarely face competition from new entrants due to the high cost of acquiring equipment, airport landing rights, and specialised knowledge.
Brand loyalty can also prevent new firms from entering an industry, as customers accustomed to a well-known brand may be reluctant to try a new, unfamiliar brand. Industry expansion can increase or decrease the likelihood of success for a new entrant. New customers are scarce in an industry with low growth, and a company can only increase its market share by acquiring the customers of competing companies. Consider all the advertisements you see and hear for competing cell phone service providers. The cell phone industry is experiencing slower growth, and companies must offer consumers incentives to switch to another provider.
On the other hand, high-growth industries have a growing customer base, and new firms can successfully attract new customers by offering them something existing firms cannot. It is important to note that entry barriers are not always external; firms frequently lobby politicians for regulations that can act as entry barriers. These types of obstacles will be covered in greater depth in courses at a higher level.
Threat of Substitutes
In the context of Porter’s model, a substitute is any other product or service that meets the same customer need as the industry’s offerings. Avoid conflating substitutes with competitors. They offer similar goods or services and compete directly with one another. Substitutes are products or services consumers would be willing to use instead of their current favourites.
For instance, the fast food industry offers inexpensive, quickly prepared, and convenient meals. Customers can choose McDonald’s, Wendy’s, Burger King, and Taco Bell, all of which compete for business. However, their customers are merely hungry individuals. What else could one do if they were starving? You could go to the supermarket and purchase food to cook at home.
McDonald’s and Kroger are in different industries, so they do not directly compete with customers. However, McDonald’s faces a threat from grocery stores because they both sell food. How does McDonald’s defend itself against Kroger as a potential substitute? By ensuring that their food is prepared and easy to purchase, you can buy a burger or salad without having to exit your vehicle.
Almost every business has suppliers who sell components, materials, labour, or products. Supplier power is the equilibrium of power between firms and their suppliers in an industry. If a supplier offers specialised products or controls scarce resources, they have the upper hand in a relationship.
For instance, when Sony develops a new PlayStation model, it frequently collaborates with a single supplier to create the most advanced processor chip possible for the game console. This indicates that the processors’ supplier will be able to command a relatively high price, indicating the supplier’s power. In contrast, a company whose operations require commodity resources such as oil, wheat, or aluminium will have numerous suppliers to choose from and can easily switch to a new partner if the price or quality is superior. Typically, commodity suppliers have little influence.
The final of Porter’s five forces is buyer power, which refers to the balance of power between a company and its clients. If a company offers a one-of-a-kind product or service, it will have the ability to charge premium prices, as its customers will have no other option but to purchase from it. In contrast, when customers have multiple potential sources for a product, firms will need to offer lower prices or greater value for the money to attract customers if they wish to sell their products.
Switching costs, the penalty incurred by consumers when they decide to use a product manufactured by a different company, are a form of defence for businesses against buyer power. Switching costs can be monetary (the additional price paid to select an alternative product) or practical (the time or hassle required to switch to a different product). Consider, for instance, your smartphone. What would be the cost of switching to a non-Apple smartphone if you own an iPhone? Would the new phone be the only expense? Even when cell phone service providers offer free smartphones to new customers, many people still do not switch. The loss of compatibility with other Apple products, the need to transfer apps and phone settings to a different system, and the absence of beloved iPhone features such as iMessage are sufficient to keep many people loyal to their iPhones.
Is Porter’s Five Forces still relevant today?
Porter’s Five Forces isn’t going away anytime soon. The fundamental concept of each firm working in a network of buyers, suppliers, substitutes, new entrants, and competitors remains true. Each of the five forces is influenced by the three new forces. Because of the Internet, buyers were able to get a lot more information, which gave them more bargaining power.
Also, firms’ investments in high-tech have made it harder for new companies to get into the market, which discourages them from doing so. The ‘New Economy’ differs from the ‘Old Economy,’ which is the foundation of the Five Forces concept.