What is the Porter’s 5 Forces Framework?
Competitive environment scans like this framework or the SWOT Analysis are crucial for your company when assessing market entry or ensuring you don’t lose momentum and market share in your current industry. Whether you are a large corporation planning to enter a new market via acquisition, or an entrepreneur trying to assess whether a market is attractive, Porter’s 5 forces is a framework that consultants routinely use to organize projects that revolve around the status of a market.
Anyone assessing a market should use Porter’s 5 forces. Although it was created more than 40 years ago, the model still frames most business scenarios accurately. The framework features a central element with 4 other elements exerting force on it (See Figure 1). The central element is industry rivalry - the degree of competition in the current market. The 4 other elements that apply pressure onto the central element are:
The bargaining power of buyers
The bargaining power of suppliers
The threat of substitutes
The threat of new entrants
Porter’s 5 Forces was created by Michael Porter, professor at Harvard Business School, as a tool to assess competition in a market. Porter created several frameworks throughout his tenure that are still taught in business schools today.
As mentioned previously, industry rivalry is the central element in Porter’s five forces. When assessing this element, you should consider the number of competitors and the strength of each competitor. For example, although the cell phone industry in Canada has a relatively small number of competitors, each competitor has massive strength and deep pockets.
The strength of competitors is heavily dependent on the number of companies in a given market. Generally speaking, the more competition that exists in a market, the less power each individual company has when it comes to setting prices or undercutting other companies. This is because an industry with high rivalry allows buyers and suppliers to have much more flexibility to pursue lower prices or better deals.
Bargaining Power of Buyers
Next, the bargaining power of buyers is an often overlooked element when conducting market analyses. The bargaining power of buyers is primarily affected by the amount of buyers that exist in the market, how significant each buyer is individually, and the cost required to find new buyers.
For example, if you are running a B2B model it is likely that you will have a limited number of buyers. Although the larger ticket prices are good, it opens up a vulnerability to having buyers with strong leverage. Conversely, if there are many buyers in your market, each buyer has much less individual power.
Bargaining Power of Suppliers
The bargaining power of suppliers also has a large influence on the profitability of a business. We’ve seen examples of companies using one supplier for all of their products without any legal protection via intellectual property (IP) or patent protection. The supplier realized the leverage that they had, and vertically integrated downwards and made the company obsolete.
Conversely, companies like Trader Joe’s, take advantage of a lack of supplier bargaining power by establishing a monopsony. A monopsony is a firm that is the only buyer of another firm, which provides them with massive leverage to shrink costs and maximize profits.
Threat of New Entrants
The threat of new entrants can turn an appealing price-maker industry into an industry with tiny margins and a massive monopoly or oligopoly presence. By researching and brainstorming which firms could have a natural transition into your industry, you will be able to understand the future of the industry and its associated profitability. Researching can be as simple as using google to check whether any large corporations have announced expansion plans into your industry. Brainstorming can also be a simple process - assess which companies have infrastructure or technology that would lend to a natural spinoff into your industry. One of Warren Buffet’s biggest criteria for investments is the presence of a “moat” in a company. Large barriers to entry create a stable business environment and predictability, resulting in increased power for the established firms.
Threat of Substitutes
The threat of substitutes is likely one of the most obvious elements to assess when analyzing a market. An example of this would be a camera rental company being replaced by independent advertisement creators on Fiverr. Companies would no longer have to rent gear if they could outsource all of their production. Once again, “moats” play a big role in ensuring a product or service is difficult to replace, and products or services that are easily substituted lose influence in the market.
Putting it All Together
After analyzing your market through the lens of these 5 elements, you will probably see that generally, the common factors that make an industry attractive are the following:
A small number of established firms
Firms that your company can become the substitute for
A large number of consumers with high ticket prices
Potential for establishing a monopsony
Large barriers to entry to maintain market stability and limit new entrants
Using these factors, you can easily decide whether or not to enter a new industry, or what to do in your current industry, based on how your business is positioned relative to the 5 forces. Combine this with a SWOT Analysis to build a solid foundation for your company’s strategy.
Porter’s 5 Forces is a valuable tool for various business objectives such as performing a competitive analysis before entering a new market, scanning your current environment, or formulating strategies. Understanding how the 5 forces contribute to the strength of a given firm will allow you to adjust your strategy to focus on the optimal use of business resources to generate more growth and earnings.
Be sure you use this framework with a team of others to explore all of the forces in full, and consider using in tandem with a SWOT Analysis for a solid basis to your corporate strategy.
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