In recent posts we have looked at the limitations of SWOT Analysis, and considered how this can be ‘supercharged’ through the use of PESTEL analysis. In this article we look at another way of enhancing your strategic analysis through the use of Porter’s 5 Forces Analysis.
Porter’s Five Forces is an analysis framework used to gain an understanding of the industry context within which a firm operates. It is used by strategists to determine the attractiveness of an industry sector by considering the 5 competitive forces proposed by Michael E. Porter.
This approach, when combined with PESTEL analysis, provides the analyst with a detailed perspective of the competitive market a firm operates, or wishes to operate, within. The analyst is then able to determine how attractive an industry sector may be, and to develop insightful strategies that will allow it to compete effectively.
How does this analysis work?
Porter’s 5 Forces identifies 5 key factors that determine the relative strength of competitive power within an industry. These forces are:
- Supplier power
- Buyer power
- Threat of substitution
- Threat of new entry
- Competitive rivalry
Any production industry requires access of raw materials such manufacturing components, labour supply and so on. This creates a relationship between the buyer and the firm that provides the essential raw materials to manufacture the products (the supplier). If the supplier is a leader in its market, or perhaps supplies a unique product that is required by the buyer, they have a significant influence over the supply chain and can dictate to a certain extent how the production industry operates.
When assessing the competitive market, an organisation needs to understand how easy it may be for suppliers to push up prices – supplier power can be measured by the number of suppliers available for each core input the firm needs. The fewer the suppliers and the more dependent the firm is on those inputs, the more power the supplier has, and vice versa.
This refers to the impact consumers have on the industry. In extreme cases, if consumer power is strong it can create an economic market known as a monopsony – a market where suppliers are many but there is only one buyer of the product. In such market conditions, the buyer will often set the price, though such cases are rare.
This means that a business needs to assess the ease with which buyers can drive prices down in the market – how many buyers are in the market, how important they are to the business and what is the cost of them switching from your product to buy products from a rival firm?
Threat of Substitution
A threat of substitution occurs where the product in demand is affected by the price change of a substitute product. In economic terms, the price elasticity of a product can be affected by substitutes – the demand for a particular product may become elastic if consumers perceive other new substitutes to be as good.
For an organisation, it is helpful to establish whether you have product power or not. If your clients can easily switch to a substitute product, or the substitute has a price decrease, then you are limited in terms of implementing price increases, and at significant risk from substitutes.
Threat of New Entry
If it costs little time or money for a rival company to enter your market, then your chances of monopolistic power are greatly reduced. This also applies if the firm has less control over the core technologies used and doesn’t enjoy economies of scale. An organisation can only exercise monopolistic power in a market if it can create legitimate barriers to entry in the market.
Beware of anti-competitive behaviour however. This is an area fraught with peril for the firm that gets on the wrong side of the competition watchdogs!
If the market contain several competitors offering similar products, achieving competitive advantage is necessary to maintain relevance in the market. The Concentration Ratio is a useful tool that is used to measure the number of competitors in a given industry – a high concentration ratio means the industry is crowded, while a low ratio indicates fewer competitors. A disciplined industry is one where rivalry is low and it is possible to create competitive advantage.
Firms can carry out a number of strategies to help establish competitive advantage, for example:
- Raise or lower prices to gain a partial advantage
- Product differentiation – improve product features, applying innovations in the manufacturing procedure
- Creating channels of distribution that are reliable
- Exploiting buyer-supplier relationships
Porter’s Five Forces Analysis is covered in detail during our Tools and Techniques of Strategy Analysis course.