Understanding the Five Forces Model by Michael E Porter
Michael E Porter developed the Five forces Model in 1980. There are five important forces at the core of this model. Porter showed these forces were a part of every industry and market. They affected the intensity of competition and determined the profitability of any industry. Since then, the model has been highly popular as a tool for strategic planning.
By knowing the strength of these five forces, managers can develop strategies to make their businesses more competitive and profitable. They must look at opportunities of strengthening their organization’s position compared to the competitors. It helps them reduce the competitive pressure and strengthen their competitive advantage. The model studies five important forces and characteristics of the industry that affect competition and can be exploited for higher profits and growth.
Bargaining power of suppliers:
Suppliers mean the sources from which companies obtain raw materials for the purpose of production. The bargaining power of the suppliers against the companies is higher in cases where only a handful of suppliers dominate the market. Due to the limited number of suppliers, the company would have less options and the result would be higher dependence on a handful of suppliers. In cases where there are nearly no or very limited substitutes for the raw material then too the suppliers would enjoy higher bargaining power. Companies’ or the buyers’ bargaining power against the suppliers can also be low when buyers are fragmented.
In another case if the switching costs from one supplier to another are high, the bargaining power of suppliers would be high since companies would like to stick to the existing suppliers. There is also the threat of suppliers going for forward integration to obtain higher prices and profits. This threat is high when the barriers to entry are low and when suppliers stand to gain economies of scale through forward integration.
Moreover, if the buying industry is an obstruction to the growth of the supplying industry, then too the suppliers might feel tempted to go for forward integration or when the profitability is high in the buying industry. Otherwise if suppliers are fragmented or when there are multiple substitutes for the raw material, then the bargaining power of suppliers remains under control and lower then the buyers.
Customers’ bargaining power:
The bargaining power of customers is an important force since it affects the prices and margins. If the bargaining power of the customers is high, the pressure to keep the prices low will be high on the sellers. Generally, the customers’ buying power is high in cases when they buy in large volumes; the switching costs from one seller to another are low; the product is not of much importance; can be produced easily or has too many substitutes. In cases where the customer has the ability of backward integration, his bargaining power will be higher.
Moreover, if the customers are price sensitive or have the know-how of production and production costs, in that case too their bargaining power will be higher. It will be low if the customers buy small volumes, switching costs are high, number of substitutes is low, the product has got strategic importance or if the customers do not have much knowledge of production or the production costs.
Threat of New Entrants:
The entry of new players always has the ability to alter the market environment in important ways. It creates pressures on existing players who might be forced to make adjustments. However, there are several factors that act as barriers to the entry of the new players. These barriers can be of several types including financial, technological and even human resource related. High investments and fixed costs are the biggest barrier but copyright laws and brand loyalty of customers can also act as barriers.
Entry becomes even difficult when the supply of raw material and the distribution channels are controlled by the existing players. If the costs of switching are high for the customers or if their brand loyalty is high, new entrants would find it difficult to expand their customer base. Even if there is a scarcity of skilled human resources, it acts to discourage the new entrants. Apart from it, legislations and customer relations of the existing players are barriers to the entry of new players.
Threat of substitutes:
It is also an important force that can affect the prices and sales of products for the existing players. Availability of alternative products that serve similar purposes also affects sales. Such products that have their prices low can attract a larger volume of market share and reduce the sales volume of the existing players. There are several factors that affect the strength of this force like customers’ brand loyalty, customer relationships, switching costs, market trends etc. For the businesses that enjoy high brand loyalty from their customers and have maintained close relationships with them, the threat is generally low.
Competitive rivalry between the existing players:
The intensity of competition in the industry also decides the profitability of individual players. If the competitive rivalry between the players is high, the pressure related to prices and margins on each one will also be high. Generally competitive rivalry in an industry is high when there are several players of same size, they use similar strategies, the level of differentiation is low and so price competition high, or market growth rates are low and exit barriers are high. When there are several players with similar strategies and products, the price competition and competitive rivalry will be automatically high.
The information obtained from the five forces analysis can be used for making important decisions linked to entry and exit or for comparing how the same forces impact various players in the industry. Moreover, the five forces analysis can provide deep insights regarding the future of a particular industry and its attractiveness for investment. This model can be used to analyse the potential of businesses, industries, markets or even regions. This model is mainly based on economic factors like supply, demand and competition. Companies can devise unique strategies to affect the influence of these Five Forces on their business.