User:Tommyeon/Porter's five forces analysis

A graphical representation of Porter's five forces

Porter's Five Forces Framework is a method of analysing the operating environment of a competition of a business. The five force determined the underlying structure of an industry and potential change of the structure, a business can evaluate how they affect profitability of a business and find the positions in the industry to effectively compete against those forces. It commonly utilised by professionals who are dedicated to pursuing the performance of the business including security analyst, business management and operation consultants with the intention of develop business strategy that can respond to changes of the industry and conduct industry analysis for identifying investment opportunities.

 It draws from industrial organization (IO) economics to derive five forces that determine the competitive intensity and profitability. The survivability and profitability of a business is highly influenced by various economic and society factors. Therefore the primary function of the Porter Five force is to develop a strategy to infer how a business will react and against it in corresponding to different external forces by identifying the strengthness and weakness and flexibly positioning itself within the industry. However, the combination of the strength of five forces are distinct in different industries. Despite the fact that the characteristics of each industry are heterogeneous, the fundamental of driving forces are identical. Thus, the Porter’s Five Forces is a board tool that can be applied in any industry to comprehend the circumstance of the competition and profitability

According to Porter Five Forces, a high intensity of competition force and an industry have the feature of perfect competition can enormously erode the profitability of an industry especially if it has low barrier to entry, numerous competitors with undifferenced products and limited bargaining power with customer or supplier. Such industry is generally dominated by several forces and the average return of invested in these industries basically tend to be poor. The five-forces perspective is associated with its originator, Michael E. Porter of Harvard University. This framework was first published in Harvard Business Review in 1979.

Porter refers to these forces as the microenvironment, to contrast it with the more general term macroenvironment. The evolution of the industry is constantly changing over time, regardless of the underlying structure and the strategies of its competitors and thereby it is necessary for the business to make a significant adjustment for the purpose of keep up with time and prevent from eliminated by the new era. However, it is nothing but the interaction between each structure, and a comprehensive picture of the industry can be thoroughly manifested by analysing each force and the economic factors behind the story and to adopt strategy in responding to change.

To achieve a profit above the average of the industry, a business is required to position itself by selecting an appropriate strategy such as Cost leadership, Benefit leadership and Specialization based on an analysis of their strengths and weaknesses in corresponding to the pressure created by the five force compared to its competitors in the industry. Here is a brief example about the airline industry, the profitability of airline industry is relatively low profitability compared to others industry due to high intensity driven by the five force, including limited switching cost, high barrier of exits and the nature of high fixed cost and undifferenced product, high bargaining power of customer (High price sensitivity), high bargaining power of supplier (Boeing), and substitution (Car, train and Ship) all contribute to the competitive environment. However, the pressure of new entrant is mild due to high barrier of entry, such as government regulation, economies of scales and capital requirement.

The primarily reason is the competitive characteristics of airline industry which require the companies to maintain the competitiveness by investing heavily in capital expenditures every year. And the maintenances, compliance and repair equipment must meet the safety standards by the government's regulation. So, for the purpose of reduce the negative effect of fixed costs on profitability, the airline companies tend to expand the capacity by taking advantage of economies of scales to spread the fixed cost over the consumers and thus this naturally triggers to an intense price war simultaneously among the existing companies. Nevertheless, the fundamental structure mentioned above have extensively limited the profitability of business in the airline industry, and yet there is a one exception: Southwest Airline has a unique perspective that focuses on operational efficiency over differentiation. By offering a relatively low fare and maximises the capacity of its planes with point-to-point network and target on consumer who have a high sensitivity of price, not focus on flight experience, short domestic travel in order achieve high volume of passenger to spread the cost over the consumer. Therefore, Southwest Airlines has proved that adopting an effective cost lead-ship strategy can overcome the inherent difficulties and find a right position to achieve above average return under the pressure of the intense five force. A few carriers – Richard Branson's Virgin Atlantic is one – have tried, with limited success, to use sources of differentiation in order to increase profitability.

Porter's five forces include three forces from 'horizontal competition' – the threat of substitute products or services, the threat of established rivals, and the threat of new entrants – and two others from 'vertical' competition – the bargaining power of suppliers and the bargaining power of customers.

Porter developed his five forces framework in reaction to the then-popular SWOT analysis, which he found both lacking in rigor and ad hoc. Porter's five-forces framework is based on the structure–conduct–performance paradigm in industrial organizational economics. Other Porter's strategy tools include the value chain and generic competitive strategies.

Five forces that shape competition

Threat of new entrants

Barrier to entry make it difficult for intruder to enter the market and expansion of the existing companies within an industry. Economically, an industry that has considerable return is likely to attract the potential competitors who desired to get a cut from the market and it leads earn a zero-economic profit in long run. It is because the increase ins supply leads to lower sales price and a decrease in the produce quantity of business which diminishing the cost advantage by expanding the capacity because it restricts the positive effect of economics scale as the degree of the fixed cost spread over a smaller quantity. The threat of new entrants is particularly intense if they are diversifying from another market as they can leverage existing expertise, cash flow, and brand recognition which puts a strain on existing companies profitability.

Barriers to entry restrict the threat of new entrants. If the barriers are high, the threat of new entrants is reduced, and conversely, if the barriers are low, the risk of new companies venturing into a given market is high. Barriers to entry are advantages that existing, established companies have over new entrants.[3][4]

Michael E. Porter differentiates two factors that can have an effect on how much of a threat new entrants may pose:

Barriers to entry

The most attractive segment is one in which entry barriers are high and exit barriers are low. It is worth noting, however, that high barriers to entry almost always make exit more difficult.

Michael E. Porter lists 7 major sources of entry barriers:

• Supply-side economies of scale – The fixed costs are spreader over an increasing quantity of output. The economies of scale is driven by the value chain and vary with different industries such as Acquisition, Research & Development, Marketing, Production, Human resource, distribution and information technology. This can discourage a new entrant because they either have to start trading at a smaller volume of units and accept a price disadvantage over larger companies, or risk coming into the market on a large scale in an attempt to displace the existing market leader.
• Demand-side benefits of scale – this occurs when a buyer's willingness to purchase a particular product or service increases with other people's willingness to purchase it. Also known as the network effect, people tend to value being in a 'network' with a larger number of people who use the same company.
• Customer switching costs – A one-time cost are incurred in the process of the consumer transferring from supplier or product to anothers, such as cost of training, cost of time to adapt the new resource, cost of emotional and cost of compatibility. These increases the difficulty for intruder to attract consumer from the incumbent.
• Capital requirements –  The industry requires an enormous capital investment in the early stage to maintain competitiveness especially for capital-intensive industries such as automobile manufacturing, airline, mining and chemical manufacturing. These industries required a significant capital invest in factory, equipment and research & development with unrecoverable costs that can deterring potential intruder from entry the industry.
• Cost disadvantage independent of scale – A business has an unique advantage of cost and quality over its competitors and intruder regardless of the size such as patent, trademark , geographical location, accessible of raw material, government subsidy and accumulation of learning experience
• Unequal access to distribution channels – The barrier of entry arises when a business require the permission of access to distribution channels and the incumbent has already capture a considerable proportion of distribution  channels. To overcome this barrier the intruder might have to take some action to earn acceptance by advertising, lowering the sales price and engaging intensive marketing to convince the distribution channels.
• Government policy — A barrier to entry can be created in some industry required a license or permission of access the raw materials from the government and the regulation for safety standards, such as the food industry, chemical industry, health industry and airlines industry are required to meet a specific benchmark which increase the cost and technical requirement of entering these industries

Expected retaliation

The expected reaction of the incumbent will also be a barrier for inducer to entry, as if the incumbent has a reputation of high sensitive of the new entrant and will take some action to deterring the new entrant such as price predatory to increase the sunk cost and decrease the distance between sunk cost and the present value of the post-entry profit stream.
There are signal regarding of deterring new entrant: 1. Adopt a strategy(Predatory pricing, Limit pricing and Capacity expansion) to deterring the new entrant with a considerable resource 2. Slow growth industry 3. A past record of retaliation

Threat of substitutes

A substitution can creates an identical or similar utility for consumers, but with distinct user experience. However, it can prevent the industry from earning higher profit, since it limits the ability of an industry to raise prices, therefore, it depends hugely on the price elasticity of the substitution.)(Example: meat can be substituted by fish or poultry, landlines can be substituted by cellular telephones, airlines can be substituted by trains or car, beer can be substituted by wine. The difference between the substitution and the industry can be increased by increase the differentiation of the product or service such as advertisement or marketing and thus reduce the threat of substitution to profitability and the potential growth of the industry)

(The threat of substitution is high if:

1.     The Cost performance ratio of substitution is higher than the industry: If the price of the substitution is strictly lower and provides equal or slightly higher satisfaction to consumer or if the price of substitution product is slightly higher but provides a strictly higher satisfaction to consumer. This creates an better alternative options for consumer and thus the price of industry is restricted unless the industry improvement in terms of the function or differentiation. For example of Amazon has created convenience and time-saving for the public by providing a platform for consumer to shop at bookstores around the world. This has decreased the cost of time and provided diverse options and quality.

2. The Cost of switching to substitution is low: The cost of switching from the industry to the substitution is low, therefore there is restriction for consumer is not exist . For example there was no cost incurred in the process of the customer transfer from bookstore to Amazon.

Bargaining power of customers

The threat of customer to the industry’s profit is imposed when a powerful customer has the ability to extract excessive value from the industry and exerting pressure by request a lower sales price and demand higher quality or service and the strength of the customer’s bargaining is often coercive and depends on various characteristics, such as

• High Concentration of consumer if the purchase volume of the buyer has take a significant proportion of the seller’s sales
• Homogenous Product — The buyer review multiple identical supplier and pick the one who provide lower price and higher quality
• The acquisition involve high proportion cost — It will induce a higher price sensitivity of the buyer
• Low switching cost — The buyer can easily transfer from one supplier to another
• Symmetrical information — The buyer have a certain knowledge in term of the actual price, demand and thus the buyer will refuse the supplier who has an unreasonable offer price.
• High price sensitivity
• The quality of buyer’s product is independent of the industry’s product

Bargaining power of suppliers

The threat of suppliers to the industry’s profit is imposed when a powerful suppliers has the ability to extract excessive value from the industry and exerting pressure by raising the sales price and supply lower quality or service and the strength of the supplier’s bargaining is often coercive and depends on various characteristics, such as:

• High concentration of Supplier or The ratio of Supplier to Consumer is low
• The competition between Supplier and it’s substitution is mild
• The industry is not major consumer
• The industry’s product is highly depend on the supplier’s input
• Differential Product
• Existence of Switching Cost

Competitive rivalry

Competitive Rivalry among existing competitors is interdependent and the competitiveness can be either fierce or mild depending on the market structure of the industry and the strategies of the competitors. Different kinds of actions that a business can take, such as price reduction, advertisement, publish of new product , R&D and after-sells service and potentially trigger a war within the industry and is contingent upon the sensitivity of how the competitions react to these strategy and an action or reaction can be either benefit or harm the entire industry.

“Know thyself, know the enemy. A thousand battles, a thousand victories.” The primary objective of competitive strategy is to determine how a business position itself and differentiates from its competitors according to its strengths in order to avoid an unnecessary conflict and generate a stable and sustainable profitability in long-run. Therefore, certain knowledge regarding the competitors is crucial to design the competitive strategy either make a aggressive or defensive move when against the competitors, such as what action will the competitors is going to take, how they react the changes in the competitive environment and others companies’ actions.

The degree of intensity of competition) The competition is intense if :

• Numerous of existing competitors : With a higher number of companies within an industry with a higher chance that some companies would take actions to destabilize the equilibrium of industry.
• Slow growth rate of the industry: Those companies will put a lot of effort and action to capture a considerable portion of market share within industry .
• High exit barrier: There are some factors that the company has experienced a period of deficit but still remain in the industry and thus cause excessive capacity: Specialise assets, Fixed Cost of Exit , Strategy interrelationship, Government , Emotional
• Lack of understanding of each other — As without a good knowledge between companies in the same industry can lead to unintended actions that would lead possibly interrupt the equilibrium of the industry.

(Potential incentive of price war)

• Homogenous or undifferenced products — Due to the consumer have less loyal in term of the products and service are identical, therefore, the companies within the industry tend to compete on price or service.
• High fixed or storage Cost — The pressure given by the fixed cost forces the companies to expand capacity and leads to the price reduction, therefore the price completion will become intense.
• Excessive Capacity or Economics of scale — Economies of scale induce the companies within the industry constantly expand the capacity to decrease fixed cost per unit and to achieve the cost advantage over the competitors. Hence, due to the fact that it will indicate adversely impact on the equilibrium of demand and supply and thus induce the price war because of the excessive capacity.

Factors, not forces

Other factors below should also be considered as they can contribute in evaluating a firm's strategic position. These factors can commonly be mistaken for being the underlying structure of the firm; however, the underlying structure consists of the five factors above.

Industry growth rate

The concept of high growth rate has been idealised and mislead some individuals to believe that it is parallel with the high return (Return on Equity, Return on Assets, Return on Invested Capital). However, the reality is often cruel and most of the individual choose to believe what they believe and ignore the fact. The intrinsic value of rapid growth business are tenuous and it is just like the water in the middle of the desert induce the countless intruder into the industry as if the barrier of entry is relatively low and thus accompanied by the enhance the bargaining power of supplier and customer, hence, it makes the exist companies hard to make progress even a single step. While fast growth rate indeed could provide a certain degree of buffer against the intensity of the competition position, but it is insufficient to compensate the potential risks associated with it. Despite the fact that the challenges from the competitors are unavoidable and uncontrollable in the rapid growth industry and timing is essential in order to remain sustainability in the rapid growth industry, therefore, it is necessary for the business to pay close attention to the competitive environment and adapt the changes with the market at the right timing with the appropriate means by recognize the current and potential threat that the competitors might impose in the current market.

For example, Blockbuster dominated the rental market and experienced significant growth rate throughout 1990. However, the outstanding performance of the growth rate induce new entrant and the sustainability was interrupted by the new entrant such as Redbox,  Netflix, Hollywood and Movie Gallery. However, Netflix adopted a innovative strategy by launching online rental services and undermine the dominate position of Blockbuster. And eventually the Blockbuster was falling behind and bear the unrevised consequence because of it missed the prime time to react the threat that imposed by Netflix but by the time Blockbuster had realised, Netflix had already established a solid customer base by offering a relatively reasonable price and reluctant to switch from Netflix to Blockbuster.

Technology and innovation

Technology & Innovation are indeed facilitating improved welfare to human being, instead of represent a best investment opportunities, because the attractiveness of an industry is on the base of the competitive structure rather than by the concept of excessive praise. Therefore, a company engage a normal business with low sensitive buyer, high switching cost and high barrier of entry could generate a higher returns than the technology company with unlimited potential.

Government

The intervention of government is not consider as an independent force but rather a factor that directly affects the five forces and as a result the competitive structure. In other word, identifying whether the intervention of the government is advantageous or disadvantageous require the application of porter’s five force. The government can assists an industry through regulation, subsidy and tax reduction for example : The US government to encourage the development and adoption of electric vehicle, it has provided a considerable funding to the reverent companies via Department of Energy’s Vehicle Technologies, plus, tax credit up to $7500 to consumers who purchase it. Therefore, the action taken by the US government has fostered the acceptance substitution industry and created an enormous threat to the traditional vehicle industry simultaneously.

Complementary products and services

Complementary product or service are necessary to combine with others industry product to generate a synergy and enhance the value in terms of the user experience they provides to consumer. Example include cameras and lenses, beds and mattresses, printer and ink cartridges, computer and software etc… . The impact of complementary product and service to the industry have similar feature as the government, it that cannot be seen as an independent force and required to apply five force to determine the impact is whether positive or negative.

Usage

Strategy consultants occasionally use Porter's five forces framework when making a qualitative evaluation of a firm's strategic position. However, for most consultants, the framework is only a starting point and value chain analysis or another type of analysis may be used in conjunction with this model. Like all general frameworks, an analysis that uses it to the exclusion of specifics about a particular situation is considered naïve .

According to Porter, the five forces framework should be used at the line-of-business industry level; it is not designed to be used at the industry group or industry sector level. An industry is defined at a lower, more basic level: a market in which similar or closely related products and/or services are sold to buyers (see industry information). A firm that competes in a single industry should develop, at a minimum, one five forces analysis for its industry. Porter makes clear that for diversified companies, the primary issue in corporate strategy is the selection of industries (lines of business) in which the company will compete. The average Fortune Global 1,000 company competes in 52 industries.

Criticisms

Porter's framework has been challenged by other academics and strategists. For instance, Kevin P. Coyne and Somu Subramaniam claim that three dubious assumptions underlie the five forces:

• That buyers, competitors, and suppliers are unrelated and do not interact and collude.
• That the source of value is a structural advantage (creating barriers to entry).
• That uncertainty is low, allowing participants in a market to plan for and respond to changes in competitive behavior.

An important extension to Porter's work came from Adam Brandenburger and Barry Nalebuff of Yale School of Management in the mid-1990s. Using game theory, they added the concept of complementors (also called "the 6th force") to try to explain the reasoning behind strategic alliances. Complementors are known as the impact of related products and services already in the market. The idea that complementors are the sixth force has often been credited to Andrew Grove, former CEO of Intel Corporation. Martyn Richard Jones, while consulting at Groupe Bull, developed an augmented five forces model in Scotland in 1993. It is based on Porter's Framework and includes Government (national and regional) as well as pressure groups as the notional 6th force. This model was the result of work carried out as part of Groupe Bull's Knowledge Asset Management Organisation initiative.

Porter indirectly rebutted the assertions of other forces, by referring to innovation, government, and complementary products and services as "factors" that affect the five forces.

It is also perhaps not feasible to evaluate the attractiveness of an industry independently of the resources that a firm brings to that industry. It is thus argued (Wernerfelt 1984) that this theory be combined with the resource-based view (RBV) in order for the firm to develop a sounder framework.

Other criticisms include:

• It places too much weight on the macro-environment and doesn't assess more specific areas of the business that also impact competitiveness and profitability
• It does not provide any actions to help deal with high or low force threats (e.g., what should management do if there is a high threat of substitution?)

See also

• Coopetition
• Economics of Strategy
• Industry classification
• Marketing Strategy
• National Diamond
• Strategic management
• Porter's four corners model
• Nonmarket forces
• Value chain
• Marketing management

Further reading

• Coyne, K.P. and Sujit Balakrishnan (1996),Bringing discipline to strategy, The McKinsey Quarterly, No.4.
• Porter, M.E. (March–April 1979) How Competitive Forces Shape Strategy, Harvard Business Review.
• Porter, M.E. (1980) Competitive Strategy, Free Press, New York.
• Porter, M.E. (January 2008) The Five Competitive Forces That Shape Strategy, Harvard Business Review.
• Ireland, R. D., Hoskisson, R. and Hitt, M. (2008). Understanding business strategy: Concepts and cases. Cengage Learning.
• Rainer R.K. and Turban E. (2009), Introduction to Information Systems (2nd edition), Wiley, pp 36–41.
• Kotler P. (1997), Marketing Management, Prentice-Hall, Inc.
• Mintzberg, H., Ahlstrand, B. and Lampel J. (1998) Strategy Safari, Simon & Schuster.