Michael E. Porter is famous for his theories on economics, business strategy, as well as social causes. Porter is credited for creating Porter’s five forces analysis model. It is a model that identifies as well as analyzes five competitive forces that shape every industry. This model also helps to determine an industry’s weaknesses and strengths. The model mentioned above is also frequently used to identify an industry’s structure to determine corporate strategy.
It is also possible to apply Porter’s five forces to any segment of the economy to understand the level of competition within the industry and enhance a company’s long-term profitability.
Thanks to this business analysis model it is easier to explain why various industries are able to sustain different levels of profitability. The history of this model dates back to the 20th century. In 1980, the model was published in Michael E. Porter’s book “Competitive Strategy: Techniques for Analyzing Industries and Competitors”. Porter’s five forces model is widely used to analyze the industry structure of a company and its corporate strategy.
Michael E. Porter identified five undeniable forces that play a part in shaping every market as well as the industry in the world, with some caveats. This model is frequently to measure the competition intensity, attractiveness, and profitability of an industry or market.
Let’s take a look at Porter’s five forces. 1. The competition in the industry. 2. Potential of new entrants into the industry. 3. Power of suppliers. 4. Power of customers. 5. Threat of substitute products.
Porter’s five forces and main findings
The first of Porter’s five forces model refers to the number of competitors and their ability to undercut a company. Importantly, the larger the number of competitors the lesser the power of a company. Suppliers, as well as buyers, seek out a company’s competition if they are able to offer a better deal or lower prices. On the contrary, when competitive rivalry is low, a company has greater power to charge higher prices and set the terms of deals to maximize sales and profits.
Now, let’s discuss the second of five forces. A company’s position is also influenced by the force of new entrants into its market. For instance, the less time and money it costs for a competitor to enter a company’s market and be an effective competitor, the more an established company’s position could be noticeably weakened. So, an industry with strong barriers to entry is ideal for existing companies within the industry. When it comes to such industries, companies have the ability to charge higher prices. They can also negotiate better terms.
The third factor addresses how easily suppliers can drive up the cost of inputs. This is a very interesting factor. Interestingly, it is affected by the number of suppliers of key inputs of a product or service, how unique these inputs are, and how much it would cost a company to switch to another supplier. Consequently, the supplier has more power and can drive up input costs and push for other advantages in trade. Conversely, when there are many suppliers or low switching costs between rival suppliers, a company can keep its input costs lower and enhance its profits.
Porter’s five forces and main problems
Porter’s five forces model also has its problems. So, before discussing the two last factors, let’s learn more about its issues. The first problem is its composition. It is a static model. Thus, it provides a snapshot of the wider industry at some point in the past. Notably, this can be useful for informing short-term strategy.
However, the window of applicability for the information coming out of this model has also been narrowed by rapidly evolving factors. We are talking about the trends like globalization and technological progress. The trends mentioned earlier were not as prominent when Porter devised his framework.
The other issue is that a lot of people use Porter’s five forces in ways it was never intended. We can have a look at the most common mistake. Some people are trying to apply this model to a specific company rather than an industry as a whole. This model can provide information to enlighten strategic discussions. Nonetheless, it is not an individual-company analysis tool. It is better to use a SWOT analysis for the specific business and not Porter’s five forces as data input.
Investors can use this model to look at the attractiveness of taking a position in an industry. Still, investors need to dive into company-specific financials unless they use a vehicle like an industry-specific ETF.
Power of customers and threat of substitutes
Now, we can discuss the last two factors. The fourth factor is the power of customers. Customers have the ability to increase or decrease prices. Companies should not underestimate the power of customers. As a reminder, it is affected by how many buyers or customers a company has, how significant each customer is, etc. A smaller, as well as more powerful client base, means that each client has more power to negotiate for lower prices and better deals. In contrast, a company that has many smaller customers will have an easier time charging higher prices to increase profitability.
The fifth and the last of Porter’s five forces focus on substitutes. Unsurprisingly, companies that produce goods for which there are no close substitutes will have more power to increase prices. The situation is completely different when close substitutes are available. That means customers will have the option to forgo buying a company’s product or service. As a result, it will be harder to increase the price of its products.
Companies and experts should pay more attention to this model. In return, companies will be able to adjust their business strategies. They will be able to make more thanks to Porter’s five forces.
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