Porter’s Five Forces Analysis

Porter's five forces analysis is a framework for the industry analysis and business strategy development developed by Michael E. Porter of Harvard Business School in 1979. It uses concepts developed in Industrial Organization (IO) economics to derive five forces which determine the competitive intensity and therefore attractiveness of a market. Attractiveness in this context refers to the overall industry profitability. An "unattractive" industry is one where the combination of forces acts to drive down overall profitability. A very unattractive industry would be one approaching "pure competition".
Porter referred to these forces as the micro environment, to contrast it with the more general term macro environment. They consist of those forces close to a company that affect its ability to serve its customers and make a profit. A change in any of the forces normally requires a company to re-assess the marketplace. The overall industry attractiveness does not imply that every firm in the industry will return the same profitability. Firms are able to apply their core competences, business model or network to achieve a profit above the industry average. A clear example of this is the airline industry. As an industry, profitability is low and yet individual companies, by applying unique business models have been able to make a return in excess of the industry average.

Main Aspects of Porter’s Five Forces Analysis
The original competitive forces model, as proposed by Porter, identified five forces which would impact on an organization’s behaviour in a competitive market. These include the following:
•The rivalry between existing sellers in the market.
•The power exerted by the customers in the market.
•The impact of the suppliers on the sellers.
•The potential threat of new sellers entering the market.
•The threat of substitute products becoming available in the market.
Understanding the nature of each of these forces gives organizations the necessary insights to enable them to formulate the appropriate strategies to be successful in their market.

Force 1: The Degree of Rivalry
The intensity of 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. The most valuable contribution of Porter's “five forces” framework in this issue may be its suggestion that rivalry, while important, is only one of several forces that determine industry attractiveness.
•This force is located at the centre of the diagram;
•Is most likely to be high in those industries where there is a threat of substitute products; and existing power of suppliers and buyers in the market.

Force 2: The Threat of Entry
Both potential and existing competitors influence average industry profitability. The threat of new entrants is usually based on the market 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 is difficult or not economically feasible for an outsider to replicate the incumbents’ position (Porter, 1980b; Sanderson, 1998) The most common forms of entry barriers, except intrinsic physical or legal obstacles, are as follows:
•Economies of scale: for example, benefits associated with bulk purchasing;
•Cost of entry: for example, investment into technology;
•Distribution channels: for example, ease of access for competitors;
•Cost advantages not related to the size of the company: for example, contacts and expertise;
•Government legislations: for example, introduction of new laws might weaken company’s competitive position;
•Differentiation: for example, certain brand that cannot be copied (The Champagne)

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. It also involves:
•Product-for-product substitution (email for mail, fax); is based on the substitution of need;
•Generic substitution (Video suppliers compete with travel companies);
•Substitution that relates to something that people can do without (cigarettes, alcohol).

Force 4: Buyer Power
Buyer power is one of the two horizontal forces that influence the appropriation of the value created by an industry (refer to the diagram). 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. Kippenberger (1998) states that 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.
•This force is relatively high where there a few, large players in the market, as it is the case with retailers an grocery stores;
•Present where there is a large number of undifferentiated, small suppliers, such as small farming businesses supplying large grocery companies;
•Low cost of switching between suppliers, such as from one fleet supplier of trucks to another.

Force 5: Supplier Power
Supplier power is a mirror image of the 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 (Porter, 1998). Bargaining power of suppliers exists in the following situations:
•Where the switching costs are high (switching from one Internet provider to another);
•High power of brands (McDonalds, British Airways, Tesco);
•Possibility of forward integration of suppliers (Brewers buying bars);
•Fragmentation of customers (not in clusters) with a limited bargaining power (Gas/Petrol stations in remote places).
The nature of competition in an industry is strongly affected by suggested five forces. The stronger the power of buyers and suppliers, and the stronger the threats of entry and substitution, the more intense competition is likely to be within the industry. However, these five factors are not the only ones that determine how firms in an industry will compete – the structure of the industry itself may play an important role. Indeed, the whole five-forces framework is based on an economic theory know as the “Structure-Conduct-Performance” (SCP) model: the structure of an industry determines organizations’ competitive behaviour (conduct), which in turn determines their profitability (performance). In concentrated industries, according to this model, organizations would be expected to compete less fiercely, and make higher profits, than in fragmented ones. However, as Haberberg and Rieple (2001) state, the histories and cultures of the firms in the industry also play a very important role in shaping competitive behaviour, and the predictions of the SCP model need to be modified accordingly.

Strengths of the Five Competitive Forces Model Benefits
•The model is a strong tool for competitive analysis at industry level. Compare: PEST Analysis
•It provides useful input for performing a SWOT Analysis.

Limitation of Porter’s Five Forces Model
•Care should be taken when using this model for the following: do not underestimate or underemphasize the importance of the (existing) strengths of the organization (Inside-out strategy).
•The model was designed for analyzing individual business strategies. It does not cope with synergies and interdependencies within the portfolio of large corporations.
•From a more theoretical perspective, the model does not address the possibility that an industry could be attractive because certain companies are in it.
•Some people claim that environments which are characterized by rapid, systemic and radical change require more flexible, dynamic or emergent approaches to strategy formulation. Sometimes it may be possible to create completely new markets instead of selecting from existing ones.

Porter's Six Forces model and its relationship to the standard Five Forces model
Porter’s Five Forces model actually has an extension referred to as Porter’s Six Forces model. It is considerably less popular than the Five Forces model as its acceptance has been less positive than the Five Forces model. The Six Forces model though is very similar to the Five Forces model with the only difference being the addition of the sixth force in the framework. This sixth force in the model is termed as the relative power of other stakeholders, and can refer to a number of other groups or entities, depending on the factor which has the greatest influence including:

• Complementors – One school of thought looks at the sixth force to be complementors, which are businesses offering complementary products to the sector in focus and being analysed (Grove 1996). The author states that these complementary businesses, as a sixth factor, affect the industry as changes in these businesses (such as new techniques, approaches or technologies) can impact on the dynamics between the industry and the complementors.
• The government – The sixth force in the framework can also be considered to be the government, and is included in the framework if it has potential to impact on all the other five forces (Gordon, 1997). Thus, the government can have direct impact in the industry as the sixth force, but can also have indirect impact or influence by affecting the other five forces, whether favourably or unfavourably.
• The public – Yet other viewpoints look at the public as the sixth force in the model, particularly if the public has a strong influence in the dynamics of the sector resulting in changes to the other forces or in the sector as a whole.
• Shareholders – This group can also be considered potentially as the sixth force. This is more important in recent years where shareholder activity has increased significantly in the boardroom, and management of firms has been scrutinised much more and even given ‘threats’ if certain actions favoured by the shareholders were not pursued.
• Employees – Employees could also be considered as the sixth force if they wielded extraordinarily strong influence on the firm in a particular sector. The status of employees seems to follow similar rules in certain sectors, and thus could be considered a strong influence in these sectors. For example, in the automobile sector in the US, a large part of the work force are unionised, and thus could be considered the sixth force instead of the government or complementors.
While a sixth force has been added to Porter’s original Five Forces model, the acceptance of this framework has been somewhat limited. This could be for two reasons. First, is that there is no definite and specific sixth force in all sectors, as it is different for each sector. Second, while a sixth force could be defined for all sectors, the influence of this factor can also be captured in the other five forces and thus the necessity of having it in the framework is less compelling.

Ecological Model of Competition

The ecological model of competition is a reassessment of the nature of competition in the economy. Traditional economics models the economy on the principles of physics (force, equilibrium, inertia, momentum, and linear relationships). This can be seen in the economics lexicon: terms like labour force, market equilibrium, capital flows, and price elasticity. This is probably due to historical coincidence. Classical Newtonian physics was the state of the art in science when Adam Smith was formulating the first principles of economics in the 1700s.
According to the ecological model, it is more appropriate to model the economy on biology (growth, change, death, evolution, survival of the fittest, complex inter-relationships, and non-linear relationships). Businesses operate in a complex environment with interlinked sets of determinants. Companies co-evolve: they influence, and are influenced by, competitors, customers, governments, investors, suppliers, unions, distributors, banks, and others. We should look at this business environment as a business ecosystem that both sustains, and threatens the firm. A company that is not well matched to its environment might not survive. Companies that are able to develop a successful business model and turn a core competency into a sustainable competitive advantage will thrive and grow. Very successful firms may come to dominate their industry (referred to as category killers).