Porter 5 Forces Model - Explained | Industry analysis

Porter 5 forces

Porter 5 forces model, a strategic framework that probably every business students and practitioner has heard about. But do you also know how to use it properly? Today you will be finding it out because I'm going to tell you everything you need to know about Porter's 5 forces.

 

History: 

In 1979, Michael Porter, one of the founding fathers of business strategy published an article called “how competitive forces shape strategy?” In this article, he argued that we often view competition way too narrowly and as a solution came up with “five basic forces” that together shape the industry structure and determine the competitive intensity of an industry. In the end, these forces affect the long-term profit potential in industry and therefore its attractiveness. We will come back to that in a second because we're talking about competitive forces.

 

Porter's five forces include the following five forces:

 

1.      Rivalry among existing competitors

2.      Threat of new entrants

3.      Threat of substitute products or services

4.      Bargaining power of suppliers

5.      Bargaining power of buyers

 

Before we going to each force separately it is important to understand that the main purpose of this model is to “evaluate” the root causes of profitability in an industry. True to competitive forces, porter, therefore, draws a connection between competition on the one hand and profitability on the other hand. If competitive forces in an industry are high or intense the profit potential of a firm in that specific industry will decrease as you will be reading it further in this article, each of the five forces are able to affect the profit potential in the industry both positively and negatively. We will be illustrating this dynamic relationship between competition and profitability throughout this article with some examples from the airline industry.


Rivalry among existing competitors

 

It defines the level of competition in an industry or the level of profitability in an industry. This looks at the number of competitors and their strengths in comparison to you. So if competitors in the industry generate a lot of profit or are really strong in comparison to you, there is a potential for them to generate a lot of profit if they're not already doing so. In terms of an industry if the rivalry in an industry is intense then companies often have to lower their prices and provide various other types of incentives to attract customers and continue trading and continue generating enough interest in their products. If the rivalry is not intense in an industry then the profits are generally high throughout. So, what actually influences competitive rivalry which influences profitability?


Bargaining power of suppliers

 

So if suppliers have high bargaining powers in an industry they can influence pricing obviously and thereby influencing profits and when do suppliers in the industry have a lot of power, when there are a few of them, then they become very powerful automatically. When the customers are actually small or irrelevant in terms of their power in relation to supplies. If there are fewer substitutes available to suppliers and if the cost of switching these supplies is high.

Now throughout the course of this article, we're going to look at one single example. We might look at others but the primary example is going to be from the automotive industry and if we look at the automotive industry some suppliers could be companies like Michelin or Continental or Bosch. Now if Continental decides to increase their prices then obviously the price of the whole manufacturing process increases. So if you're thinking about setting up a manufacturing unit that's one of the factors to be considered. Now let’s move on to the second factor.

 

Bargaining power of customers

Bargaining power of customers or the power of customers can actually pressurize and drive prices down. When do customers in an industry is powerful? when there are few of them. Obviously when there are few groups of customers or when the industry has few customers in general, then they have the capability to exert a certain amount of power on their supplies and they have plenty of suppliers to choose from and the switching costs are low then obviously the power of the customers go up automatically and again obviously selected customers to purchase significant quantities of products or services. Now if there are a few customers then this is bound to happen so it does actually tie in with the first point 

Now examples from the automotive sector can be actual car manufacturers as opposed to suppliers of parts dealerships. Well, individual dealerships can also have an influence. Rental and leasing companies now because of the growth of the rental and leasing markets these are also significant factors for an automotive company to actually think of before jumping into the industry.

 

Threat of substitutes

What are substitutes?

Substitutes are alternatives that serve the same need that other existing products in the industry could provide. So, the higher number of substitutes, the price point normally gets lower because substitutes can drive your prices down and ultimately influence profits and if the number of substitutes in the industry is low then it can result into a monopoly for that particular industry.

 For example,

1)      You can bypass driving altogether. You know driving between cities for instance by choosing a budget airline overtaking other modes of transportation or driving yourself so that obviously it can actually drive the demand for automotive down in a way.

2)      Choosing taxi services to personal vehicles, so with the increase of usage of companies like uber and various other similar companies in various parts of the world, what has happened is a lot of people think that taking a taxi to work in a lot of different countries it doesn't apply everywhere, for instance, if you talk about the United States there's clear evidence, that taking a taxi can sometimes turn out to be cheaper than they're actually driving to work on a regular basis. So obviously that, in the long run, will have some sort of an effect on the manufacturing of cars or the manufacturing of Motor Vehicles.

3)      Now we look at a completely different example, here a threat of substitute can be solar energy companies for traditional energy providers.

 

Threat of new entrants

Now every market place has established market leaders and dominant players, dominant forces and new forces that are trying to enter a market place and establish a name for themselves and these new entrants can eat into the market share of the existing leaders. If barriers to entry for these new firms, new concepts are low, then the threat to existing players is obviously high and barriers can include things like the amount of investment required to start a company in the industry, various government regulations that need to be followed to start trading in a particular industry and access to various suppliers. Now, this is quite important because if you have a network of suppliers that you've been dealing with for a number of years, you get good prices from them, you get better prices from them. Instead of selling goods on a recommended retail price they actually sell it to you on a trade price rather so you can set a competitive price for your products and your overall pricing strategy can change and you can actually generate higher profits

For example:

1)   A new entrant to existing automotive companies a few years ago was electric car companies like Tesla, so it actually influenced the market place to an incredible extent, so much that almost every leading automotive manufacturer has a lineup of electric cars of their own now.

 

Summing up:

So this is a brief overview of Porter's 5 forces model and as always we like to look at some shortcomings of the model, a very important shortcoming and a very important observation to make is that the Five Forces model is applicable to an “industry” and not to an individual company. A lot of people apply it to individual organizations as opposed to industries, that is not the purpose of the Five Forces model and it doesn't clarify it sufficiently. As per multiple forums, we see, a lot of people use the Five Forces model in conjunction with sort of like a SWOT analysis so the applicability of to a specific industry is to be understood and it is not actually applicable to specific organizations. It is used to gauge the profitability of an industry and not an organization. Again, another major shortcoming is that it doesn't take into account collisions or collaborations between buyers. There can be situations where buyers collaborate with one another or suppliers collaborate with one another and set guide prices or recommended retail prices to their resellers, so it doesn't take any of those factors into consideration. So it can be considered as a shortcoming and the model works primarily for understanding profit-oriented industries and organizations and there's nothing for nonprofit organizations or government entities. It is purely for profitable organizations looking for a bottom mined result.


Hopefully, that was useful for you, Thanks for reading and do share with your friends. If any doubt feel free to leave a comment and we will get back to you.

Check out our popular article: 

12 Pointers Checklist to pick a Multibagger Stock

How to read annual report 

A Complete Guide on Stock Market


 

The Finance Magic.

Let's spread financial literacy!

Newest
Previous
Next Post »

Please do not spam ConversionConversion EmoticonEmoticon