Porter 5 Forces: Analyzing the structure of an industry
Porter's Five Forces is a very popular framework for analyzing the competitive dynamics of an industry. It is well taught to MBA students all over the world, yet I admit it is the one I use the least in Competitive Analysis. Not because I don’t find it useful, but rather because it’s a snapshot in time for an industry structure.
The premise is that by understanding the five forces, a company can identify the key factors that determine the competitiveness of an industry, and use this information to make informed decisions about how to position itself in the market.
It was developed by Michael Porter back in 1979, and described in detail in his book titled “Competitive Strategy”. It remains one of the most used tools in competitive strategy analysis. However, like I said, I, personally, don’t use it as often as others.
The five forces are:
Threat of new entrants, which refers to the likelihood of new competitors entering the market and potentially reducing profitability for existing firms.
Threat of substitute products or services, which refers to the possibility of customers switching to alternative products or services.
Bargaining power of suppliers, which refers to the ability of suppliers to charge higher prices or reduce the quality of their inputs.
Bargaining power of buyers, which refers to the ability of customers to negotiate lower prices or demand higher quality.
Competitive rivalry, which refers to the intensity of competition among existing firms in the market.
Visually, it is depicted like this.
Uses
When the goal is to formulate competitive strategy, one of the first steps is to understand or characterize the environment. The industry structure and attributes determine the competitive rules of the game. The state of competition in an industry depends on the 5 forces of the model.
Therefore, the best practical use cases for this, is when the company is considering a new industry, such as launching a new product in a new market, or a new offer for a new industry vertical. Also, when there are significant changes in external factors, to the point that the industry has been affected completely. This last one, is a rare occurrence.
I have found that in the former use case, while the Bargaining Power forces typically remain constant, the threat of new entrants and threat of substitutes are the most dynamic. This will then help in determining barriers of entry (i.e. Economies of scale, product differentiation, capital requirements, switching costs, access to distribution, cost disadvantages independent of scale, or government regulations) which become very useful in identifying tactics and actions.
Cautions
This framework has value as a tool for analyzing the competitive dynamics, but it has two important limitations.
- It is based on the assumption that an industry is static, and that companies within an industry are all the same. In actuality, industries are constantly evolving, and companies within an industry are very different from one another.
- It is widely known that the framework does not account for the role of non-market forces, such as globalization, regulations, or a pandemic such as the one we experienced a few years ago. Porter claims that these are considered external factors, and since all forces are affected the same by them, it does not affect the end result. However, the reality is otherwise.
Therefore, the 5 forces framework must be used in conjunction with other tools, such as TOWS and 4 Corners analysis, whenever possible.
The recommended approach is to (1) start with a 5 Forces analysis to understand the environment; then (2) run down strengths and weaknesses to take offensive and defensive actions in order to react to the 5 competitive forces; and then (3) conduct a 4 Corners analysis of the top competitors to understand where their heading. Most people jump into creating a simplistic SWOT 2x2 table, without context, action, or even time variable.
Michael Porter describes the 5 Forces model as part of the structural analysis of industries (Chapter 1 of his book), while uses the 4 Corners analysis as a framework for competitor analysis (Chapter 3 of his book). They are different tools, that can be used together, yet some are used more frequent than others in the business world. Although I rarely use 5 Forces, it is something that I feel obligated to write about.
Happy Analysis!