A Framework for Analyzing Industries Michael Porter's Five Forces by broverya75

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									                          A Framework for Analyzing Industries:

                           Michael Porter’s Five Forces Analysis




             Michael Porter is a professor at Harvard University. His 1979 framework uses concepts
             developed in IO (Industrial Organization) economics to derive five forces that determine
             the attractiveness of a market. Porter referred to these forces as the microenvironment, 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.

             Four forces -- the bargaining power of customers, the bargaining power of suppliers, the
             threat of new entrants, and the threat of substitute products -- combine with other
             variables to influence a fifth force, the level of competition in an industry.




         1. The Five Forces

             Bargaining Power of Customers

             The power of buyers describes the effect that your customers have on the profitability of
             your business. The transaction between the seller and the buyer creates value for both
             parties. But if buyers (who may be distributors, consumers, or other manufacturers) have
             more economic power, your ability to capture a high proportion of the value created will
             decrease, and you will earn lower profit.

             The bargaining power of customers is likely to be high when

                ·   They buy large volumes and there is a concentration of buyers. For example, you
                    may have little negotiating power if you and several competing companies are
                    trying to sell similar products to one large buyer.
                ·   The supplying industry operates with high fixed costs.

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                 ·   The product is undifferentiated and can be replaced by substitutes. If your brand is
                     homogenous or similar to all of the others, buyers will base their decision mainly
                     on price.
                 ·   Switching to an alternative product is relatively simple and is not related to high
                     costs. For example, IBM customers might switch to Gateway or Dell, but it may be
                     inconvenient for them to consider Macintosh.
                 ·   Customers have low margins and are price sensitive. Customers may not price
                     shop for a quart of oil, but they will price shop if purchasing a new vehicle.
                 ·   Customers could produce the product themselves. Anheuser-Busch, Coors, and
                     Heinz are examples of companies that have integrated back into metal can
                     manufacturing to fill the balance of their container needs.
                 ·   The product is not strategically important to the customer.
                 ·   Customers have access to and are able to evaluate market information. You have
                     less room for negotiation if buyers know market demand, prices, and your costs.



             Bargaining Power of Suppliers

             Any business requires inputs—labor, parts, raw materials, and services. The cost of your
             inputs can have a significant effect on your company’s profitability. Whether the strength of
             suppliers represents a weak or a strong force hinges on the amount of bargaining power
             they can exert and, ultimately, on how they can influence the terms and conditions of
             transactions in their favor. Suppliers would prefer to sell to you at the highest price
             possible or provide you with no more services than necessary. If the force is weak, then
             you may be able to negotiate a favorable business deal for yourself. Conversely, if the
             force is strong, then you are in a weak position and may have to pay a higher price or
             accept a lower level of quality or service. The bargaining power of suppliers increases
             when

                 ·   The market is dominated by a few large suppliers rather than a fragmented source
                     of supply. For instance, if you are making computers and need microprocessors,
                     you will have little or no bargaining power with Intel, the world’s dominant supplier.
                 ·   There are no substitutes for the particular input. If you use a certain enzyme in a
                     food manufacturing process, changing to another supplier may require you to
                     change your entire manufacturing process. This may be very costly to you, thus
                     you will have less bargaining power with your supplier.
                 ·   The supplier’s customers are fragmented, so their bargaining power is low. If the
                     supplier does not depend on your business, you will have less power to negotiate.
                     Of course the opposite is true as well. Wal-Mart has significant negotiating power
                     over its suppliers because it is such a large percentage of suppliers’ business.
                 ·   The switching costs from one supplier to another are high. For example, if you
                     recently invested in a unique inventory and information management system to
                     work effectively with your supplier, it would be expensive for you to switch
                     suppliers.


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                 ·   There is the possibility of the supplier integrating forwards in order to obtain higher
                     prices and margins. This threat is especially high when the buying industry has a
                     higher profitability than the supplying industry, or forward integration provides
                     economies of scale for the supplier.
                 ·   Suppliers can sell directly to your customers, bypassing the need for your
                     business. For example, a manufacturer could open its own retail outlet and
                     compete against you.
                 ·   You do not have a full understanding of your supplier’s market. You are less able
                     to negotiate if you have little information about market demand, prices, and
                     supplier’s costs.



             Threat of New Entrants

             The competition in an industry becomes higher, the easier it is for other companies to
             enter the industry. In such a situation, new entrants could change major determinants of
             the market environment (e.g. market shares, prices, customer loyalty) at any time. There
             is always a latent pressure for reaction and adjustment for existing players in this industry.
             The threat of new entries will depend on the extent to which there are barriers to entry.
             Threat of new entrants is greatest when

                 ·   Processes are not protected by regulations or patents. In contrast, when licenses
                     and permits are required to do business, such as with the liquor industry, existing
                     firms enjoy some protection from new entrants.
                 ·   Customers have little brand loyalty. Without strong brand loyalty, a potential
                     competitor has to spend little to overcome the advertising and service programs of
                     existing firms and is more likely to enter the industry.
                 ·   Start-up costs are low for new businesses entering the industry. The less
                     commitment needed in advertising, research and development, and capital assets,
                     the greater the chance of new entrants to the industry.
                 ·   The products provided are not unique. When the products are commodities and
                     the assets used to produce them are common, firms are more willing to enter an
                     industry because they know they can easily liquidate their inventory and assets if
                     the venture fails.
                 ·   Switching costs are low. In situations where customers do not face significant
                     one-time costs from switching suppliers, it is more attractive for new firms to enter
                     the industry and lure the customers away from their previous suppliers.
                 ·   The production process is easily learned. Just as competitors may be scared
                     away when the learning curve is steep, competitors will be attracted to an industry
                     where the production process is easily learned.
                 ·   Access to inputs is easy. Entry by new firms is easier when established firms do
                     not have favorable access to raw materials, locations, or government subsidies.
                 ·   Access to customers is easy. For instance, it may be easy to rent space to sell
                     produce at a farmer’s market, but nearly impossible to get shelf space in a grocery


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                     store. You are more likely to find new entrants in the food business using the
                     farmer’s market distribution system over grocery stores.
                 ·   Economies of scale are minimal. If there is little improvement in efficiency as scale
                     (or size) increases, a firm entering a market won’t be at a disadvantage if it doesn’t
                     produce the large volume that an existing firm produces.



             Threat of Substitutes

             A threat from substitutes exists if there are alternative products with lower prices of better
             performance parameters for the same purpose. They could potentially attract a significant
             proportion of market volume and hence reduce the potential sales volume for existing
             players. This category also relates to complementary products. Substitutes are a greater
             threat when

                 ·   Your product doesn’t offer any real benefit compared to other products. What will
                     hold your customers if they can get an identical product from your competitor?
                 ·   It is easy for customers to switch. A grocer can easily switch from paper to plastic
                     bags for its customers, but a bottler may have to reconfigure its equipment and
                     retrain its workers if it switches from aluminum cans to plastic bottles.
                 ·   Customers have little loyalty. When price is the customer’s primary motivator, the
                     threat of substitutes is greater.



             Rivalry among Competitors

             High competitive pressure results in pressure on prices, margins and on profitability for
             every single company in the industry. The most intense rivalries occur when

                 ·   One firm or a small number of firms have incentive to try and become the market
                     leader. In some cases, an industry with two or three dominant firms may
                     experience intense rivalry when these firms are battling to achieve market leader
                     status. In other situations, when competitors with diverse strategies and
                     relationships have different goals and the “rules of the game” are not well
                     established, rivalry will be more intense. The market is growing slowly or shrinking.
                     When the potential to sell products is stagnant or declining, existing firms are
                     unable to grow their market without taking market away from competitors. In this
                     situation rivalry is more likely.
                 ·   There are high fixed costs of production. When a large percentage of the cost to
                     produce products is independent of the number of units produced, businesses are
                     pressured to produce larger volumes. This may tempt companies to drastically cut
                     prices when there is excess capacity in the industry in order to sell greater
                     volumes of product.
                 ·   Products are perishable and need to be sold quickly. Sellers are more likely to


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                      price aggressively if they risk losing inventory due to spoilage or if storage costs
                      are high.
                 ·    Products are not unique or homogenous. Undifferentiated products (commodities)
                      compete mainly on price, because consumers receive the same value from the
                      products of different firms. Because firms do not experience any insulation from
                      price competition, there is more likely to be active rivalry.
                 ·    Customers can easily switch between products. Intense rivalry is likely when
                      customers in a given industry can easily switch to other suppliers. In these
                      situations, the businesses in the industry will be vying for market share.
                 ·    There are high costs for exiting the business. If liquidation would result in a loss,
                      businesses that invested heavily in their facilities will try hard to pay for them and
                      may resort to extreme methods of competition.




         2.   Reducing the Power of Five Forces

              Companies could take action to reduce the power of the five forces to strength their
              positions in the market.

              Reducing the Bargaining Power of Suppliers

                  ·   Partnering
                  ·   Supply chain management
                  ·   Supply chain training
                  ·   Increase dependency
                  ·   Build knowledge of supplier cost and methods
                  ·   Take over a supplier

              Reducing the Bargaining Power of Customers

                  ·   Partnering
                  ·   Supply chain management
                  ·   Increase loyalty
                  ·   Increase incentives and value added
                  ·   Move purchase decision away from price
                  ·   Cut off powerful intermediaries (go directly to customer)

              Reducing the Treat of New Entrants

                  ·   Increase minimum efficient scales of operations
                  ·   Create a marketing / brand image (loyalty as a barrier)
                  ·   Patents, protection of intellectual property
                  ·   Alliances with linked products / services


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                  ·   Tie up with suppliers
                  ·   Tie up with distributors
                  ·   Retaliation tactics

              Reducing the Threat of Substitutes

                  ·   Legal actions
                  ·   Increase switching costs
                  ·   Alliances
                  ·   Customer surveys to learn about their preferences
                  ·   Enter substitute market and influence from within
                  ·   Accentuate differences (real or perceived)

              Reducing the Competitive Rivalry between Existing Players

                  ·   Avoid price competition
                  ·   Differentiate your product
                  ·   Buy out competition
                  ·   Reduce industry over-capacity
                  ·   Focus on different segments
                  ·   Communicate with competitors



         3.   Critique

                 When trying to apply the five-force analysis to your industry study, there are some
                 problems to be considered.

                 ·    In the economic sense, the model assumes a classic perfect market. The more an
                      industry is regulated, the less meaningful insights the model can deliver.
                 ·    The model is best applicable for analysis of simple market structures. A
                      comprehensive description and analysis of all five forces gets very difficult in
                      complex industries with multiple interrelations, product groups, byproducts and
                      segments. A too narrow focus on particular segments of such industries, however,
                      bears the risk of missing important elements.
                 ·    The model assumes relatively static market structures. This is hardly the case in
                      today’s dynamic markets. Technological breakthroughs and dynamic market
                      entrants from start-ups or other industries may completely change business
                      models, entry barriers and relationships along the supply chain within short times.
                      The Five Forces model may have some use for later analysis of the new situation;
                      but it will hardly provide much meaningful advice for preventive actions.
                 ·    The model is based on the idea of competition. It assumes that companies try to
                      achieve competitive advantages over other players in the markets as well as over
                      suppliers or customers. With this focus, it does not really take into consideration


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                    strategies like strategic alliances, electronic linking of information systems of all
                    companies along a value chain, virtual enterprise-networks or others.



         References

             Porter, M., Competitive Strategy: Techniques for Analyzing Industries and Competitors,
                     The Free Press, New York, 1998
             Purdue University Agricultural Innovation and Commercialization Center, Industry
                     Analysis: The Five Forces, 2002
             Recklies Management Project, Porter’s Five Forces, 2001
             Wikipedia, Porter 5 forces analysis




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