Porter’s 5 Forces Model

All organizations must consider their competition, whether it is local or geographically dispersed, whether it is direct or indirect competition striving for the consumer’s share of the mind and share of the market. Both nonprofit and for-profit organizations compete for customers’ resources, and both have different objectives for doing so. Pepsi and Coke are direct competitors in the soft drink sector, Sheraton and Hilton are competitors in the hospitality sector, and organizations such as United Way and the American Cancer Society compete for resources in the nonprofit organizations.

A group of competitors that provide similar products or services form an industry. Michael Porter, a professor at Harvard University and a leading authority on competitive strategy, developed an approach for analyzing industries. Called the “Five Forces Model”, the framework helps organizations understand their current competitors as well as organizations that could become competitors in the future. As such, firms, organizations and other entities can find the best way to defend their position in the industry.

Competitive Analysis

When an organization attempts to perform a competitive analysis within the industry where they are operating, they tend to focus on direct competitors and try to determine a firm’s strengths and weaknesses, its image, and its resources. Doing so helps the firm figure out how much money a competitor may be able to spend on things such as research, new product development, promotion, and new locations. Competitive analysis involves looking at any information (annual reports, financial statements, news stories, observation details obtained on visits, etc.) available on competitors. Competitors battle for the customer’s dollar and they must know what other firms are doing. Individuals and teams also compete for jobs, titles, and prizes and must figure out the competitors’ weaknesses and plans in order to take advantage of their strengths and have a better chance of winning.

According to Porter, in addition to their direct competitors (competitive rivals), organizations must consider the strength and impact the following could have:

  • Substitute products
  • Potential entrants (new competitors) in the marketplace
  • The bargaining power of suppliers
  • The bargaining power of buyers

Porter's Five Forces

Force 1: the degree of rivalry
The intensity of competitive rivalry, which is the most obvious of the five forces in an industry, helps determine the extent to which the value created by an industry will be dissipated through head-to-head competition. This is an indicator of the profitability of any industry on which the analysis is being made. The most valuable contribution of Porter’s “five forces” framework in this issue may be its suggestion that rivalry and competitive forces, while important, is only one of several forces that determine industry attractiveness and its sustained profitability in the longer run.

Force 2: the threat of entry
Both potential and existing competitors influence average industry profitability. The key concept in analysing the threat of new entrants are the entry barriers. They can take diverse forms and are used to prevent an influx of firms into an industry whenever profits, adjusted for the cost of capital, rise above zero. In contrast, entry barriers exist whenever it becomes somewhat difficult or not economically feasible for an external player to replicate the existing organizations position. The most common forms or sources of entry barriers, except intrinsic social, geographical or legal barriers, are usually the knowledge, scale of operations and the capital expenditure or investment required to enter an industry as an efficient competitor.

Force 3: the threat of substitutes
The threat that substitute products pose to an industry’s profitability depends on the relative price-to-performance ratios of the different types of products or services to which customers can turn to satisfy the same basic need. The threat of substitution is also affected by switching costs – that is, the costs in areas such as retraining, retooling and redesigning that are incurred when a customer switches to a different type of product or service. The substitution process follows an S-shape curve. It starts slowly as a few trendsetters risk experimenting with the substitute, picks up steam if other customers follow suit, and finally levels off when nearly all the economical substitution possibilities have been exhausted.

Force 4: buyer power
Buyer power is one of the two horizontal forces that influence the appropriation of the value created by an industry. The most important determinants of buyer power are the size and the concentration of customers. Other factors are the extent to which the buyers are informed and the concentration or differentiation of the competitors. It is often useful to distinguish potential buyer power from the buyer’s willingness or incentive to use that power, willingness that derives mainly from the ‘‘risk of failure’’ associated with a product’s use.

Force 5: supplier power
Supplier power is the mirror image of buyer power. As a result, the analysis of supplier power typically focuses first on the relative size and concentration of suppliers relative to industry participants and second on the degree of differentiation in the inputs supplied. The ability to charge customers different prices in line with differences in the value created for each of those buyers usually indicates that the market is characterized by high supplier power and at the same time by low buyer power

When any of these factors change, companies may have to respond by changing their strategies. For example, because buyers are consuming fewer soft drinks these days, companies such as Coke and Pepsi have had to develop new, substitute offerings such as vitamin water and sports drinks. However, other companies such as Dannon or Nestlé may also be potential entrants in the flavored water market. When you select a hamburger fast-food chain, you also had the option of substitutes such as getting food at the grocery or going to a pizza place. When computers entered the market, they were a substitute for typewriters. Most students may not have ever used a typewriter, but some consumers still use typewriters for forms and letters.

Suppliers, the companies that supply ingredients as well as packaging materials to other companies, must also be considered. If a company cannot get the supplies it needs, it’s in trouble. Also, sometimes suppliers see how lucrative their customers’ markets are and decide to enter them. Buyers, who are the focus of marketing and strategic plans, must also be considered because they have bargaining power and must be satisfied. If a buyer is large enough, and doesn’t purchase a product or service, it can affect a selling company’s performance. Walmart, for instance, is a buyer with a great deal of bargaining power. Firms that do business with Walmart must be prepared to make concessions to them if they want their products on the company’s store shelves.

Lastly, the world is becoming “smaller” and a more of a global marketplace. Companies everywhere are finding that no matter what they make, numerous firms around the world are producing the same “widget” or a similar offering (substitute) and are eager to compete with them. Employees are in the same position. The Internet has made it easier than ever for customers to find products and services and for workers to find the best jobs available, even if they are abroad. Companies are also acquiring foreign firms. These factors all have an effect on the strategic decisions companies make.

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