6 MIN READ
Porter's Five Forces
Understanding Competitive Forces to Maximize Profitability
Porter's Five Forces is a simple but powerful tool for understanding the competitiveness of your business environment, and for identifying your strategy's potential profitability.
This is useful, because, when you understand the forces in your environment or industry that can affect your profitability, you'll be able to adjust your strategy accordingly. For example, you could take fair advantage of a strong position or improve a weak one, and avoid taking wrong steps in future.
In this article and video, we explore each of Porter's Five Forces. We look at how they can help you to analyze the strengths and weaknesses of your position, and how they can impact your long-term profitability.
Click here to view a transcript of this video.
Understanding Porter's Five Forces
The tool was created by Harvard Business School professor Michael Porter, to analyze an industry's attractiveness and likely profitability. Since its publication in 1979, it has become one of the most popular and highly regarded business strategy tools.
Porter recognized that organizations likely keep a close watch on their rivals, but he encouraged them to look beyond the actions of their competitors and examine what other factors could impact the business environment. He identified five forces that make up the competitive environment, and which can erode your profitability. These are:
Competitive Rivalry. This looks at the number and strength of your competitors. How many rivals do you have? Who are they, and how does the quality of their products and services compare with yours?
Where rivalry is intense, companies can attract customers with aggressive price cuts and high-impact marketing campaigns. Also, in markets with lots of rivals, your suppliers and buyers can go elsewhere if they feel that they're not getting a good deal from you.
On the other hand, where competitive rivalry is minimal, and no one else is doing what you do, then you'll likely have tremendous strength and healthy profits.
Supplier Power. This is determined by how easy it is for your suppliers to increase their prices. How many potential suppliers do you have? How unique is the product or service that they provide, and how expensive would it be to switch from one supplier to another?
The more you have to choose from, the easier it will be to switch to a cheaper alternative. But the fewer suppliers there are, and the more you need their help, the stronger their position and their ability to charge you more. That can impact your profit.
Buyer Power. Here, you ask yourself how easy it is for buyers to drive your prices down. How many buyers are there, and how big are their orders? How much would it cost them to switch from your products and services to those of a rival? Are your buyers strong enough to dictate terms to you?
When you deal with only a few savvy customers, they have more power, but your power increases if you have many customers.
- Threat of Substitution. This refers to the likelihood of your customers finding a different way of doing what you do. For example, if you supply a unique software product that automates an important process, people may substitute it by doing the process manually or by outsourcing it. A substitution that is easy and cheap to make can weaken your position and threaten your profitability.
Threat of New Entry. Your position can be affected by people's ability to enter your market. So, think about how easily this could be done. How easy is it to get a foothold in your industry or market? How much would it cost, and how tightly is your sector regulated?
If it takes little money and effort to enter your market and compete effectively, or if you have little protection for your key technologies, then rivals can quickly enter your market and weaken your position. If you have strong and durable barriers to entry, then you can preserve a favorable position and take fair advantage of it.
The Five Forces are brought together in Figure 1, below.
According to Porter, these Five Forces are the key sources of competitive pressure within an industry. He stressed that it is important not to confuse them with more fleeting factors that might grab your attention, such as industry growth rates, government interventions, and technological innovations. These are temporary factors, while the Five Forces are permanent parts of an industry's structure.
Using the Tool
To understand your situation, look at each of the forces in turn, then write your observations on our free worksheet.
Brainstorm the relevant factors for your market or situation, and then check against the factors listed for the force in the diagram above.
Next, write the key factors on the worksheet, and summarize the size and scale of the force on the diagram. An easy way of doing this is to use a single "+" sign for a force that's moderately in your favor, or a "-" sign for a force that's moderately against you. Use "++" for a force that's strongly in your favor, or "--" for one that's strongly against. For a neutral force, you can use "o." You'll see these used in the example, below.
Finally, look at the situation that you find using this analysis and think through how it affects you. Bear in mind that few situations are perfect – however, looking at things in this way helps you to think through what you could change to improve your industry position and increase your profitability with respect to each force.
What's more, if you find yourself in a structurally weak position, this tool helps you to think about what you can do to move into a stronger one.
Example of Porter's Five Forces in Action
Martin Johnson is deciding whether to switch career and become a farmer – he's always loved the countryside, and he wants a job where he can be his own boss. He creates the following Five Forces analysis to help him to decide:
His findings worry him:
- The threat of new entry is quite high. If anyone looks as if they're making a sustained profit, new competitors can come into the industry easily, reducing profits.
- Competitive rivalry is extremely high. If someone raises prices, he or she will be quickly undercut. Intense competition puts strong downward pressure on prices.
- Buyer Power is strong, again implying a strong downward pressure on prices.
- There is some threat of substitution.
Unless Martin is able to find some way of changing this situation, this looks like a very tough industry to survive in. Maybe he'll need to specialize in a sector of the market that's protected from some of these forces, or find a related business that's in a stronger position.
Porter's Five Forces Analysis is an important tool for understanding the forces that shape competition within an industry. It is also useful for helping you to adjust your strategy to suit your competitive environment, and to improve your potential profit.
It works by looking at the strength of five important forces that affect competition:
- Supplier Power: the ability of suppliers to drive up the prices of your inputs.
- Buyer Power: the strength of your customers to drive down your prices.
- Competitive Rivalry: the strength of competition in the industry.
- The Threat of Substitution: the extent to which different products and services can be used in place of your own.
- The Threat of New Entry: the ease with which new competitors can enter the market if they see that you are making good profits (and then drive your prices down).
By thinking about how each force affects you, and by identifying its strength and direction, you can quickly assess your position.
You can then look at what strategic changes you need to make to deliver long-term profit.
For more information on this tool, and on Michael Porter's approaches to competitive analysis, read Competitive Strategy: Techniques for Analyzing Industries and Competitors by Michael E. Porter.
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