10. Porter’s 5 Forces

10.1. What are Porter’s Five Forces

Porter’s Five Forces is a model that identifies and analyzes five competitive forces that shape every industry, and helps determine an industry’s weaknesses and strengths. Frequently used to identify an industry’s structure to determine corporate strategy, Porter’s model can be applied to any segment of the economy to search for profitability and attractiveness.

The model is named after Michael E. Porter.

Key Takeaways

Porter’s Five Forces is a framework for analyzing a company’s competitive environment. The number and power of a company’s competitive rivals, potential new market entrants, suppliers, customers, and substitute products influence a company’s profitability. Analyzing these elements can be used to guide business strategy to increase competitive advantage.

10.2. Understanding Porter’s Five Forces

Porter’s Five Forces is a business analysis model that helps to explain why different industries are able to sustain different levels of profitability. The model was published in Michael E. Porter’s book, “Competitive Strategy: Techniques for Analyzing Industries and Competitors” in 1980. The model is widely used to analyze the industry structure of a company as well as its corporate strategy. Porter identified five undeniable forces that play a part in shaping every market and industry in the world, with some caveats. The forces are frequently used to measure competition intensity, attractiveness, and profitability of an industry or market. These forces are:

  1. Competition in the industry
  2. Potential of new entrants into the industry
  3. Power of suppliers
  4. Power of customers
  5. Threat of substitute products

10.3. Competition in the Industry

This force refers to the number of competitors and their ability to undercut a company. The larger the number of competitors, along with the number of equivalent products and services they offer, the lesser the power of a company. Suppliers and buyers seek out a company’s competition if they are able to offer a better deal or lower prices. Conversely, when competitive rivalry is low, a company has greater power to charge higher prices and set the terms of deals to achieve higher sales and profits.

10.4. Potential of New Entrants Into an Industry

A company’s power is also affected by the force of new entrants into its market. The less time and money it costs for a competitor to enter a company’s market and be an effective competitor, the more a company’s position may be significantly weakened. An industry with strong barriers to entry is an attractive feature for companies that allows them to charge higher prices and negotiate better terms.

10.5. Power of Suppliers

This force addresses how easily suppliers can drive up the cost of inputs. It is affected by the number of suppliers of key inputs of a good or service, how unique these inputs are, and how much it would cost a company to switch from one supplier to another. The fewer the number of suppliers, and the more a company depends upon a supplier, the more power a supplier holds to drive up input costs and push for advantage in trade. On the other hand, when there are many suppliers or low switching costs between rival suppliers a company can keep input costs lower increasing profits.

10.6. Power of Customers

This specifically deals with the ability that customers have to drive prices down. It is affected by how many buyers or customers a company has, how significant each customer is, and how much it would cost a company to find new customers or markets for its output. A smaller and more powerful client base, means that each customer has more power to negotiate for lower prices and better deals. A company that has many, smaller, independent customers will have an easier time charging higher prices to increase profitability.

10.7. Threat of Substitutes

Substitute goods or services that can be used in place of a company’s products or services pose a threat. Companies that produce goods or services for which there are no close substitutes will have more power to increase prices and lock in favorable terms. When close substitutes are available, customers will have the option to forgo buying a company’s product, and a company’s power can be weakened.

Understanding Porter’s Five Forces and how they apply to an industry, can enable a company to adjust its business strategy to better use its resources to generate higher earnings for its investors.

10.8. Understanding SWOT Analysis

SWOT analysis is a technique for assessing the performance, competition, risk, and potential of a business, as well as part of a business such as a product line or division, an industry, or other entity.

Important

Using internal and external data, a SWOT analysis can tell a company where it needs to improve internally, as well as help develop strategic plans.

Using internal and external data, the technique can guide businesses toward strategies more likely to be successful, and away from those in which they have been, or are likely to be, less successful. An independent SWOT analysis analysts, investors or competitors can also guide them on whether a company, product line or industry might be strong or weak and why.

10.9. A Visual Overview

Analysts present a SWOT analysis as a square with each of the four areas making up one quadrant. This visual arrangement provides a quick overview of the company’s position. Although all the points under a particular heading may not be of equal importance, they all should represent key insights into the balance of opportunities and threats, advantages and disadvantages, and so forth.

Fast facts

SWOT Analysis was first used to analyze businesses. Now it’s often used by governments, nonprofits, and individuals, including investors and entrepreneurs.

10.10. Example of SWOT Analysis

In 2015, a Value Line SWOT analysis of The Coca-Cola Company noted strengths such as its globally famous brand name, vast distribution network and opportunities in emerging markets. However, it also noted weaknesses and threats such as foreign currency fluctuations, growing public interest in “healthy” beverages and competition from healthy beverage providers.

Its SWOT analysis prompted Value Line to pose some tough questions about Coca-Cola’s strategy, but also to note that the company “will probably remain a top-tier beverage provider” that offered conservative investors “a reliable source of income and a bit of capital gains exposure.”

Strengths describe what an organization excels at and what separates it from the competition: a strong brand, loyal customer base, a strong balance sheet, unique technology, and so on. For example, a hedge fund may have developed a proprietary trading strategy that returns market-beating results. It must then decide how to use those results to attract new investors. Weaknesses stop an organization from performing at its optimum level. They are areas where the business needs to improve to remain competitive: a weak brand, higher-than-average turnover, high levels of debt, an inadequate supply chain, or lack of capital. Opportunities refer to favorable external factors that could give an organization a competitive advantage. For example, if a country cuts tariffs, a car manufacturer can export its cars into a new market, increasing sales and market share. Threats refer to factors that have the potential to harm an organization. For example, a drought is a threat to a wheat-producing company, as it may destroy or reduce the crop yield. Other common threats include things like rising costs for materials, increasing competition, tight labor supply and so on.

10.11. Advantages of SWOT Analysis

A SWOT analysis is a great way to guide business-strategy meetings. It’s powerful to have everyone in the room to discuss the company’s core strengths and weaknesses and then move from there to define the opportunities and threats, and finally to brainstorming ideas. Oftentimes, the SWOT analysis you envision before the session changes throughout to reflect factors you were unaware of and would never have captured if not for the group’s input.

A company can use a SWOT for overall business strategy sessions or for a specific segment such as marketing, production or sales. This way, you can see how the overall strategy developed from the SWOT analysis will filter down to the segments below before committing to it. You can also work in reverse with a segment-specific SWOT analysis that feeds into an overall SWOT analysis.