What are Porter’s Five Forces?
Porter’s Five Forces Framework is a tool for analyzing competition of business. A good businessman, therefore, has to understand concepts in business before applying them successfully. That is why a good understanding of concepts and theories is important for an effective and easier administration of your business.
In this article, we are going to have a deep insight into Porter’s five forces. What is Porter’s five forces? Well, this is a model upon which an industry’s weaknesses and strengths are gauged. It has been used by business analysts to identify an industry’s formation and help investors to identify possible industries where they can invest. It is a perfect tool to measure the intensity of competitiveness in the industry.
The porter’s model can be applied to various segments of an economy whereby analysts can gauge the competitiveness of the industry and give insights to companies and investors who wish to invest in a certain sector.
How Does This Tool Work?
The idea of this tool was created by Michael Porter after whom the tool was named. The framework was first published in the famous Harvard Business Review in 1979. It was an attempt by Porter to understand the impact of various competitive forces on an industry. Porter in creating this tool was trying to make something that was more comprehensive and could answer more questions compared to the SWOT analysis. He highly critiqued the SWOT analysis for being rigid.
BREAKING DOWN Porter’s Five Forces
Porter, therefore, compiled five forces that highly affect competition in a business environment. These forces are categorically listed as;
- Entry Barriers
- Threat of substitutes
- Bargaining Power of Suppliers
- Bargaining Power of Buyers
- Industry Rivalry
All these forces can easily explain the level of competition in an industry. The stronger these forces become, the less profitable the industry. A very competitive industry will translate to lower profits among the companies. Modern analysts, therefore, use this tool before giving out investment advice to investors.
A very competitive industry doesn’t offer much for businesses but it’s the ideal one for buyers who will enjoy better quality and availability of goods and services. That is why companies will do all things possible to make an industry as less competitive as possible. When there is no way to reduce competition in an industry, companies start to get creative and look for things that will give them an edge over their competitors.
At this point, let us go ahead and see how these forces affect the business environment in very fine detail.
In industry, there are barriers that are set that determine the entry of a new firm/company into the industry. Entry barriers can largely affect competition in an industry. If the barriers are very low, new firms can enter and pose a lot of competition to the existing companies in an industry. That is why most large companies will do anything just to prevent new players in an industry. Entry barriers are very low when the following circumstances are in place;
- When a new firm requires a low amount of capital to enter the industry
- There are little the existing firms can do to prevent entrants
- When the legal system hasn’t placed any barriers for new entrants
- When there are very low costs for switching industries (for firms).
- When existing firms do not possess patents and copyrights
- When loyalty among customers is very low
- When the products and services are very similar although made by different companies
- When the economies of scale can be easily achieved by entrant firms
All these factors will largely affect the entry of new firms into the industry. Consequently, when existing firms in the industry are faced by the above circumstances, they will try and get rid of such circumstances in order to kill competition from new firms. Getting patents is one of the classic ways firms use to deter new entrants into the industry.
Threat of Substitutes
Substitutes are alternatives to a product or a service. A good example is when a person chooses to take tea instead of coffee. Tea, in this case, is a perfect substitute for coffee. When consumers of goods do not like the quality, pricing and even the convenience of a good or service, they will eventually search for a substitute. A substitute should offer attractive prices, better quality.
Consumers are always seeking alternatives or substitutes to all the goods and services that they are not satisfied with. If consumers eventually decide to go for an alternative, firms lose their market base which translates to lower profit margins.
When it comes to the threat of substitutes, there is nothing much firms can do rather than improve their goods and services to the customer’s appeal. They can reduce prices or increase the quality so that their customers do not get to search for alternatives.
Rivalry Among Existing Competitors
The rivalry is the major determinant if you want to gauge the level of competition in an industry. Business rivalry is a classic phenomenon but the modern age has brought with its new dynamism. Companies are now doing all they can to beat off their competitors. When there are numerous rivals, the market share for each firm becomes smaller and consequently, the firms battle it out to have the largest portion of the market.
There are several factors that contribute intensify the level of rivalry in an industry and they include;
- The existence of many competing firms in an industry
- The existence of high exit barriers
- When an industry has slowed or stagnant growth
- When products can be easily substituted
- When competitors are of equal power in terms of market share and access to capital
- When there is very low customer loyalty
As long as the rivalry among states remains great, there will be low profits and such an industry will be very unattractive for new firms.
Bargaining Power of Suppliers
The suppliers are at the beginning of the supply chain. They provide goods and raw materials are turned into finished goods. Suppliers are therefore very important for industry and they hold some power over companies. The extent of their power will depend on some factors. The bargaining power of suppliers will be high if;
- There are few suppliers but numerous buyers
- The suppliers have enough capability to forward integrate
- There are few substitute raw materials available
- Suppliers hold scarce resources
- Cost of switching to alternative raw materials is very high
In an industry where there are very many suppliers and few buyers, firms hold a very big advantage as they can find goods at very low prices.
Bargaining Power of Buyers
The supply chain is geared towards selling goods for the buyer. The buyer, therefore, has some bargaining power by default. When the bargaining power of the buyer is strong, a firm is forced to produce higher quality goods and lower prices on their goods and services. This needs a lot of work and resources to achieve and can lead to lower profit.
A buyer has a very strong bargaining power when;
- They buy in large quantities
- There are very few buyers in the market
- When they can easily switch to another product/service
- When there are many substitutes
- When they are price sensitive
- When they can easily backward integrate
In many instances, the bargaining power of buyers is very strong which compels firms to make efforts and try to appease the buyer.