Monday, March 19, 2012

Performing Industry Analysis with Porter's Five Forces

According to business strategy expert Michael Porter, "the essence of formulating competitive strategy is relating a company to its environment." The state of competition in an industry depends on five basic competitive "forces": the threat of new entrants, bargaining power of suppliers, bargaining power of buyers, threat of substitute products or services, and rivalry among existing firms. The goal of competitive strategy for a business unit is to find a position in the industry where the company can best defend itself against these competitive forces or can influence these forces in its favor. Porter's "Five Forces" framework is also widely used in evaluating the attractiveness or suitability of an industry for investment or entry, or the competitive standing of a particular player within an industry.

Threat of new entrants

New entrants inject substantial resources and bring new capacity to an industry, thus increasing competition and placing additional pressure on profitability among all players. The threat posed by new entrants primarily depends on the barriers to entry that are present: the higher the barriers to entry, the lower the threat from new entrants. Major barriers to entry include economies of scale, product differentiation (brand identification and customer loyalties), capital requirements, switching costs, access to distribution channels, and cost disadvantages independent of scale (proprietary product technology, favorable access to raw materials, favorable locations, government subsidies, learning or experience curve, etc.), and government policy. Also, if existing competitors respond forcefully to make the entrant’s stay an unpleasant one, the entry may well be deterred: specifically, the threat of entry into an industry can be eliminated if incumbent firms price products and services low enough

Bargaining power of suppliers

Suppliers can exert bargaining power over participants in an industry by threatening to raise prices or reduce the quality of purchased goods and services.

A supplier group is powerful if: it is dominated by a few companies; it is not obliged to contend with other substitute products for sale to the industry; the industry is not an important customer of the supplier group; the suppliers’ product is an important input to the buyer’s business; the supplier group’s products are differentiated or it has built up switching costs; and finally, the supplier group poses a credible threat of forward integration.

A firm can improve its situation through strategies such as enhancing its threat of backward integration or eliminating switching costs.

Bargaining power of buyers

Buyers compete with the industry by forcing down prices, bargaining for higher quality or more services, and playing competitors against each other--all at the expense of industry profitability.

A buyer group is powerful if: it is concentrated or purchases large volumes relative to seller sales; the product it purchases from the industry represents a significant fraction of the buyer’s costs or purchases; the products it purchases from the industry are standard or undifferentiated; it faces few switching costs; it earns low profits, and hence is highly price sensitive and less loyal to a firm; the buyers pose a credible threat of backward integration and can therefore demand bargaining concessions; the industry’s product is unimportant to the quality of the buyer’s products or services; the buyer is well informed; and lastly, the buyer can influence other buyer’s purchasing decisions.

A company can improve its strategic posture by finding buyers who posses the least power to influence their profitability adversely.

Threat of substitute products or services

Substitutes limit the potential returns of an industry by placing a ceiling on the prices firms in the industry can profitable charge. Substitutes not only limit profits in normal times but these can also reduce the rewards an industry can reap in boom times.

Identifying substitute products is a matter of searching for other products that can perform the same function as the product of the industry. Substitute products that deserve the most attention are those that are subject to trends improving their price-performance tradeoff with the industry’s product, or are produced by industries earning higher profits.

Rivalry among existing competitors

Rivalry among existing competitors takes the familiar form of "jockeying for position" or performing actions that aim to improve a player's competitive position in the industry--using tactics like price competition, advertising battles, product introductions, and increased customer service and warranties. This occurs because one or more competitors feel the pressure or see the opportunity to improve its position in the industry. Intense rivalry may result from numerous or equally balanced competitors, slow industry growth, high fixed or storage costs, lack of differentiation or switching costs, over capacity in the industry, and the diversity of competition. As such, the intensity of rivalry in industries are often described using industry classifications that range from "monopoly" (one player = no rivalry) to "perfect competition" (many players = intense rivalry).

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