Porter’s Five Forces is one of the most traditional, well-known, and most widely used strategic macro analysis models. Used in conjunction with a PESTLE analysis, it helps you understand the competitive forces at work in an industry and how they affect the profitability of your business. The term was first introduced by Michael E. Porter in his classic 1979 Harvard Business Review article. In it, Porter outlines his model and demonstrates how it helps businesses assess an industry’s competition and gain strategic insight into competing more effectively. Now, the goal of this article is to give you:
- Solid working knowledge of the Five Forces Framework.
- An understanding of how to evaluate the profitability of an industry.
- Teach you how to apply it to your business.
By the time you’ve finished reading, I’m confident you’ll better understand your industry structure and be able to spot and exploit new strategic opportunities.
Table of Content
Who Is Michael E. Porter?
First of all, let’s start with the man himself. Born May 23, 1947, in Ann Arbor, Michigan, Michael Porter is a leading economist and professor at Harvard Business School. He is the author of more than 18 books over 125 articles on corporate and competitive business strategy. His models and theories received numerous awards leading to recognition as one of the most influential economists in history. His fame and recognition came off the back of developing the Five Forces Framework that bears his name. Along with the Five Forces Framework, his Value Chain, Diamond, and Four Corners Analysis models completely changed macro-business analysis around the world.
What Are Porter’s Five Forces?
Porter’s five forces (listed in no particular order) that affect the profitability of an industry are:
- New entries
- Provider Power
- buyer power
- competitive rivalry
Porter’s five forces model framework
In essence, Porter’s Five Forces were created to help us assess the profitability of an industry. This is, after all, why most companies exist. As I briefly highlighted earlier, the Five Forces are: ● The threat of existing substitute products . ● The threat of entry of new competitors , closely related to entry barriers. ● The power that providers have over you. ● The power that customers have over you. ● These four forces above combine to determine the competitive rivalry that exists within an industry.Once you understand them, you will be able to make better predictions, refine your strategy, and ultimately become more profitable.
“Understanding the five forces can help a company understand the structure of its industry and establish a position that is more profitable and less vulnerable to attack.” -Michael Porter
Now, to effectively use Porter’s Five Forces to analyze your industry, you’ll need to look at each threat individually.
The first of Porter’s Five Forces that we are going to discuss is new entrants, or the possibility (and probability) of firms entering an industry and driving competition. This probability is usually determined by what are known as barriers to entry . If they are low, and little effort, time, money (or reduced legislation) is needed, then the threat of being swamped by competitors is extremely high. Some examples of industries with higher barriers to entry are telecommunications (network infrastructure), pharmaceutical manufacturing (patents), and air travel. (purchase and fleet maintenance).Conversely, if the barriers to entry are high (expensive and strict legislation, long qualification process, etc.), this will discourage many companies and reduce competition. Some examples of industries with low barriers to entry are landscaping , home and office maintenance , and online advertising . Typical determinants of threat listed by Porter are:
- Brand loyalty (Do customers show a strong preference for the products of existing companies?)
- Legislation (Is there specific legislation governing an industry?)
- Government policy (What are the basic rules for operating within a given territory?)
- Response from new entrants (how will existing players and customers react?)
- Capital requirement (how much capital is needed?)
- Access to suppliers and distribution channels (will it be difficult to access?)
- Cost advantages (existing firms have more experience producing (X) products)
A substitute product can be anything that performs or carries out a similar function to your products or services. Email is a substitute for written mail, Slack is a substitute for email, and Microsoft Teams and Google Chat are substitutes for Slack… Many businesses tend to struggle with this section of the framework as they focus solely on direct competitors. But if you think about it, substitutes appear in many different shapes, sizes, and offerings and may differ vastly from your product. For example, Blockbuster famously failed to recognize the emergence of Netflix as a substitute product. It was an online streaming service, with no physical stores nor DVD and VHS stock. So how could they be genuinely classed as a competitor? Well, the rest, they say, is history…
This is an extreme case of what can happen if substitutes are left ignored, but in general, they pose a threat to an industry’s profit potential as they tend to set a “price ceiling” or limit on what can be charged. If an industry (as a whole) fails to acknowledge and/or adapt to substitutes through product performance, marketing, R&D, etc. it will suffer.
The next two factors we are going to look at are essentially the inverse of one another. The Bargaining Power of the Buyer vs. The Bargaining Power of the Supplier. Starting with the former, we are essentially talking about the buyer’s ability to drive and manipulate the industry. The more power they have, the easier it is for them to carve out value for themselves by driving down prices, demanding better quality products (consequently increasing supplier’s costs), and often playing industry competitors against one another. Of course, all this comes at the expense of industry profitability. This scenario can emerge when buyers have leverage over industry participants, especially if they are price-sensitive, using their advantageous position to force a reduction in prices. The typical determinants of buyer power threat are:
- Number of buyers (the more buyers, the lesser their bargaining power).
- Product standardization (if buyers believe they can find the same product elsewhere, price sensitivity comes into play).
- Switching costs (how much does it cost to change providers?)
- Buyer backward integration (when buyers can produce the industry’s product themselves if they deem vendors too expensive).
- Purchase volume (High-volume buyers are particularly powerful in industries with high fixed costs).
- Customer influence (do distributors exert a strong influence over end customers? Therefore affecting their power over suppliers).
What happens, then, when the shoe’s on the other foot? With suppliers in the driving seat, you’ll often see a threat of increased prices for goods and services, reduced product quality, or a shift of costs to other industry partners. A good example is the software industry. Take the likes of Microsoft, Apple, and Salesforce. They practically monopolize their respective markets, leaving little leverage room for buyers. We can tell when suppliers have the upper hand by spotting some of the typical determinants of supplier power threat:
- A dependence on sector for income (if they are more dependant, they are less likely to take risks with buyers).
- Number of competitors.
- Switching costs.
- Buyer backward integration.
- Patented products (is the supplier the only one legally able to produce the product?).
- Product substitutes (are there available substitutes?).
The final and arguably most important factor is competitive rivalry. Competitive rivalry is a familiar concept to many business owners and entrepreneurs, manifested through heavy discounting, innovative product introductions, marketing campaigns, and service improvements. As might be expected, high levels of rivalry severely affect the profitability of an industry. Typically, when one business makes a significant market move it forces competitors to counter with their own. This endless cycle of action and reaction is what limits profitability. It can particularly harmful (for businesses) if the moving factor is the price… The typical determinants of threats of competitive rivalry are:
- Number of competitors.
- Industry growth.
- Exit barriers (anything stopping a company from leaving an industry, such as high exit costs or specialized assets).
- Fixed costs.
- Switching costs.
- Product differentiation.
Porter’s Five Forces Template
While you might understand the theory and logic behind Porter’s Five Forces Framework, but it’s true that the practical application can be very challenging. This is one of the reasons we brought business strategist Aaron Montgomery on board to teach a dedicated module of Porter’s Five Forces in our online business program:
Aaron Montgomery teaching ThePowerMBA students Porter’s Five Forces
Speaking of transforming logic into practice, there’s another fantastic resource in Dr. Michael E. Dobbs’ research paper Guidelines for Applying Porter’s Five Forces Framework. Not only does he coherently lay out the biggest challenges in the practical implementation of the Five Forces, but more importantly, he includes a handy set of templates. This is extremely useful in teaching business owners how to turn their analysis into strategic action. Dr. Dobbs’ templates help you to identify where the key opportunities are in your industry. What are the principal threats you are dealing with? Where are they coming from? And how should you deal with them? They’re also incredibly easy to use, as I’ll quickly run through now.
How to Use Dr. Dobbs’ Five Forces Template
I’ve grabbed an example competitive rivalry template to give you a better understanding of how it works. Now I know it’s fairly self-explanatory, but I’ll walk you through it nonetheless. As you can see, the specific force to be analyzed is listed at the top of the template. Underneath, you’ll see there are eight sources of threat affecting the profitability and structure of your industry. Dobbs notes that these have been selected after carefully combing through a collection of Porter’s published works. Each of these sources is accompanied by a threat level indicator bar scored from low, to high. The farther right you score that source, the higher the perceived level of threat is. The space below the source is to be filled with notes detailing the reason behind the given scores. Finally, space is provided for you to indicate key opportunities and threats you feel are facing the organization as a result of your analysis. As mentioned earlier, you must directly link analysis to strategic action. This turns Porter’s Five Forces from “academic framework” into “actionable analysis”.
Competitive Strategy Book (Michael Porter)
If you’re looking to seriously implement porter’s five forces as part of your macro business analysis then I highly recommend you grab yourself a copy of Competitive Strategy. Porter runs through hundreds of examples of his Five Forces Framework analysis in a wide range of industries. Also, towards the end of the book, Porter demonstrates which strategic actions should be taken when faced with specific threat sources – extremely helpful for first-time analysts. Combine that with Dr. Dobbs’ research and our list of other must-read books for entrepreneurs and you’ll have a nice collection to add to your bookshelves.
Learn Porter’s Five Forces
If you’re serious about your business and want an instructor who can comprehensively break down and explain the Five Forces framework, then ThePowerMBA might be worth a quick look . As mentioned above, an entire module of our online business program is dedicated to the topic. It’s designed to help you extract actionable insights from your analysis and discover how you can more effectively compete within your industry. So take a look. 😉 Also, if you have any success with the templates, please let us know in the comments below! It would be great to get your feedback.