Porter's five Forces

Introduction

In this article, I would like to propose a methodology that can help any organization to articulate its own position in the competition and to develop effective strategies for successful competition. The methodology I would like to introduce to you was developed by the American economist Michael Eugene Porter and is generally known as Porter’s Five Forces, also known as industry structure analysis.

Motivation and conditions

The idea behind Porter’s five forces is based on the insight that the factors influencing a company’s business model fall into five categories, the five forces.

Namely the influences through:

1. the suppliers that are necessary with their respective services for the business model
2. new business models that could jeopardize the company’s business
3. Products that are suitable for replacing the company’s products
4. other market participants and the corresponding competitive pressure and
5. for certain the buyers and customers of the company’s products.

Porter’s five forces

Before I talk about the five forces in detail, I would like to discuss some basic assumptions about the framework and underlying terminology.

Porter assumes a closed environment in which the five forces can relate to each other. The corresponding overall framework is defined as industry level. For the factors influencing the conflict between buyers and sellers of products, the so-called market level is defined, which is an inherent part of the industry level.

Industry

An industry is a group of companies whose products are interchangeable and therefore potentially in competition with each other.
Examples are the automobile manufacturers or the pharmaceutical industry. The term industry is most likely to be compared to a business area of a company or a specific business model, but less so to complex companies with many business fields or different business models. Here, a separate analysis for each of the individual business models would be more appropriate than an attempt to analyze the entire company using the five forces.

Market

A market is a group of potential or actual buyers and sellers of a product.

The distinction between industry and market is based on the assumption that an industry can combine different markets. Accordingly, the industry level is understood as the totality of all actors who have a potential or actual interest in the industry. The market level is understood as the totality of all actors who have a potential or actual interest in the market.

The idea of the competition analysis is to find a position within the industry from which an organization can best handle the influences caused by the 5 forces or influence these 5 forces in favor of the organization.

The knowledge of the various influencing factors helps to assess the critical strengths and weaknesses of a company and can help a company to understand its market position. One of the added value is identifying those strategic decisions that promise the biggest win, the highest pay-off. The corresponding structural analysis is the foundation in the development of a competitive strategy.

The five influencing factors on the business model (Porter’s five forces)

Each of the five forces features specific characteristics that describe their effects. I would like to discuss this in more detail below.

Market participants and competitive pressure – market competitors

I would like to start with the market participants and the competitive pressure.

Competitive pressure and market participants

The extent of competition between market participants can be determined by various factors.

• Competition concentration:
  several competitors with similar market share lead to increased competition. The competition is potentially lower if there is a clear market leader who enjoys a correspondingly high cost advantage. A clear market leader can be said to have at least 50% more market share than the next largest competitor.
• Growth of the market:
  low market growth potentially leads to higher competition, strong market growth dampens competitive pressure.
• Cost structure:
  High fixed costs potentially lead to falling prices in order to enable economic high volumes sales of of a product.
• Unique features:
  Commodity products lead to increased competition, while unique selling propositions are likely to reduce competitive pressure. This is especially true for unique selling points which are difficult to imitate or duplicate for competitors.
• Cost of change:
  If the cost of a change between competitive products is potentially high for the customer, for example because it is a highly specialized product, this reduces competitive pressure. Typical investments that prevent customers from switching are training costs that would be incurred in the event of a product change or costs for product adjustments that would be necessary in order to introduce the competing product to the customer without friction loss.
• Market exit barriers:
  Market exit barriers are barriers to leaving the market, for example because of high costs (for example, the decommissioning of power plants). These barriers can have their reason in a high degree of dependence or some other, e.g. emotional attachement on that market. If the barriers to exit are potentially high, this typically leads to increased competition within the market than if market exit barriers are low.

Taking into account these factors, companies must be careful not to bring a stable competitive situation into imbalance to their own disadvantage. This includes, in particular, the balance between a strong position within the market and the health of the entire industry. For example, entering into a price war or special discounts can lead to a company gaining market share in the short term. In the long term, however, the profitability of the business model may decline as competitors tend to respond to price wars and special discounts with lower prices and better discounts. Therefore, it is important for companies to recognize those situations in which the fundamental protection of the business model must be given priority over the pursuit of short-term benefits.

Suppliers and their market power

In the following I would like to consider the influences by suppliers.

Bargain of suppliers

The cost of materials and the cost of necessary components or external services can have a significant impact on the profitability of a business model. The higher the influence that suppliers can take the higher the corresponding costs. The negotiating position of suppliers is the higher, the stronger the following influencing factors are given.

• external delivery services depend on a few suppliers, especially if there are fewer suppliers than potential demand for their products.
• the products or services of the suppliers are subject to unique selling points or high switching costs in case the supplier is to be exchanged.
• the supplier is not dependent on the industry with its entire portfolio
• the suppliers are potential future competitors who could take over the business model of the company.
• the buyers of the products of suppliers can not produce these products themselves
• the market is not essential for the suppliers’ business model

However, a company can strengthen its negotiating position with suppliers,

• by opening up new sources of supply
• by acquiring the ability to provide the product or the performance of the suppliers themselves and
• by setting up their own business model based on standardized components that can be produced by a large number of suppliers.

These approaches correspond to the analysis of market participants and competitive pressure.

Buyers and their market power

After the suppliers, I would like to examine the influences of buyers and customers of products and services.

Market power of customers

The negotiating position of buyers is the stronger, the more the following influencing factors are given.

• there are only a limited number of customers and / or customers are buying in large purchase quantities.
• customers are in a position to manufacture or provide the products and / or services themselves.
• the products purchased by customers are standard products without unique selling points.
• there are many vendors and / or sellers for the product or service.
• customers have low-margin business models, so they are under constant pressure to lower their procurement costs.
• the product or service is of little relevance to the customer’s business model, and low procurement costs are important.

A company can strengthen its bargaining position towards its customers

• by increasing the number of customers,
• by the fact that the business model which the customers on the basis of the services or products furnish can also be taken over by the company or
• by the fact that the own products are high-quality and provided with unique selling points.

In the retail business the market leader’s products potentially have the highest margins. This is particularly because market leadership means that a retailer has to run the market leaders product in order to be attractive to its customers and thus weaken its own bargaining position towards the manufacturer.

Customers who buy a product and are not end users (such as OEMs or distributors) can be analyzed in the same way as all other buyers. However, they can achieve an enormously strong negotiating position if they manage to directly or indirectly influence the buying decisions of the end customers.
Over the years, for example, the chemical company DuPont has gained a tremendous influence on its suppliers and the retail sector by putting enormous marketing effort into its own brand “Teflon” and thus decisively controlling the buying behavior of end customers.

Alternative products – substitutes

After considering the suppliers and the buyers, I would like to discuss the threat of the business model by alternative products.

Threat of alternative products

The availability of alternative products and the regarding impact on pricing can reduce the attractiveness and profitability of an industry.

If a business model is successful and generates high profits, it is likely that competitors will address the market with alternative products in order to secure a share of the potential profits. The threat of alternative products depends on the following factors.

• the willingness of buyers to engage in a replacement product
• the price difference and the quality difference of the replacement products
• the costs incurred when changing to alternatives

The threat of replacement products can be reduced by high switching costs. These costs can also be psychological. Examples of this are the creation of strong and distinctive brands as well as the consideration of a price difference which corresponds to the perceived added value by the customers.

New Business Models and Market Participants – New Entrants

Finally, I would like to address the threats caused by new business models or new competitors.

Threat of disruptive business models

New business models and market participants can increase competition within an industry. Above all, the danger posed by new business models and market participants depends on the height of the entry barriers to the market.
However, market entry barriers can be influenced.

For example by:

• the presence or absence of scaling effects in production
• unique selling points of the products or services as well as a distinct brand, which contributes to customer loyalty
• financial prerequisites which a new competitor must provide for production
• switching costs for the customer when changing providers
• a hard-to-get access to distribution channels

Market entry barriers can make even a potentially attractive market unattractive or even unattainable for new competitors. Consequently it is all the more worthwhile not passively waiting for new competitors, but actively seeking opportunities to increase market entry barriers as much as (within the limits permitted by law) possible.

High marketing and research efforts as well as clearly communicated countermeasures, if a new competitor wants to enter the market, are proven ways to keep the market entry barriers high. However, some business decisions can also unintentionally lower the market entry barriers. For example, cost reductions in product design, production, or branding can make it possible for competitors to attack a previously well-secured business model.

Summary

In this article, I’ve suggested a method for competitive business model analysis with Porter’s five forces. The 5 forces consider the influences of competitors, suppliers, buyers, the threat management regarding new entrants and the threat management regarding replacements and alternative products. While the original idea behind the 5 forces was presumably the maximization of the competitive advantage of a company, the model can also be used to develop strategies for inter-firm collaboration.

I hope this article has helped you with your own business development and competitive analysis challenges and wish you every success in using Porter’s five Forces.