Understanding Porter’s Five Forces Analysis

by Thom Tracy

3 min read

The Porter’s Five Forces model was created by Michael Porter of Harvard University to analyze competition within an industry, and it also serves as a business strategy tool. The model looks at five separate competitive forces. Using the model helps a business understand its strengths and weaknesses with much more context. The five forces of the model are competitive rivalry, bargaining power of suppliers, bargaining power of customers, threat of new entrants, and threat of substitute products or services.

Competitive Rivalry

Competitive rivalry is all about the number of current competitors to a business’s products or services in the marketplace. Identifying competitors and seeing precisely what they are capable of is the heart of this force. Rivalry is particularly high when there are fewer competitors, the industry itself is growing, or when consumers can easily switch to another competitive product. The main outcome of high rivalry is price wars between companies that can drastically affect profit margin. Quantitatively, rivalry can be measured with the concentration ratio, which is the sum of the market shares of the top four companies in the industry, expressed as a percentage. Some other factors affecting this force are exit barriers, fixed and variable costs, intermittent overcapacity, and corporate stakes.

Bargaining Power of Suppliers

The bargaining power of suppliers focuses on the potential power of a supplier and its ability to raise prices. This has a direct effect on a business’s profitability through lower margins. Beyond this factor, this force also identifies and analyzes the actual number of suppliers in the industry. If there are fewer suppliers, they have more power, which is more detrimental to a business. As a small business, the stronger industry to be in is one where there are a large number of suppliers. The strength of distribution channels and the importance of material volume are also factors in this force. Suppliers also have strength in the following ways:

  • The cost of a business switch suppliers.
  • The availability of identical substitute suppliers.
  • The supply purchase cost relative to substitute suppliers.

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.

Threat of New Entrants

The threat of new entrants examines the ability and ease of a new company to enter the marketplace and offer a viable product in the industry. When a competitor has an easier time entering the marketplace, the business doing the analysis has a greater probability of losing market share. Easier entry always equals risk of market share depletion. When a small business analyzes the barriers to entry, it should measure the cost advantages of the company, access to inputs for the product and/or service, economies of scale, and the value of company brands. Absolute cost advantages, proprietary learning curves, government policy, capital requirements, brand identity, switching costs, possible retaliation effects, and proprietary products also affect this force and must be analyzed.

Threat of Substitute Products or Services

The threat of substitute products or services analyzes the ability and ease for a customer to switch products or services completely. One item to analyze is how many competitors there are in the market and how their prices and quantity of products compare to the business in question. Another key analysis point is how much profit these competitors are making on their products. Upon close analysis and research, a company can attempt to determine the ability for each of its competitors to lower prices, thereby directly affecting the business’s profitability. These threats are examined by reviewing switching costs and the short- and long-term inclination for a consumer to change brands and companies. Overall, the price-performance tradeoff is a key component to the force of a threat of substitutes. Some other factors that affect this part of the Porter analysis are relative price performance to a substitute, the perceived level of product differentiation, ease of substitution, number of possible substitutes, product quality, quality depreciation, and the immediacy of extremely close substitutes in the current marketplace.

References & Resources

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