In the 1970s, Harvard economist Michael Porter created the gold
standard for how strategy is created and analyzed today. Referred to as Porter’s
Five Forces, this method analyzes the industry and competitive environment in
which a firm operates. When developed correctly, the framework paints a picture
of the current environment in which the firm competes, allowing the firm to see
the big picture and, in turn, develop long-term strategies for the company that
will lead to effective decision making and sustainability. Porter believes that
an industry’s potential profitability can be expressed as a function of these
five forces and that one can therefore determine the potential success of a
firm in that industry. Porter’s Five Forces provide a model for reviewing the
outside environment portion of the strategy bridge and for determining the
attractiveness of a particular activity at a particular moment in time. This
model can be used on any firm of any size in any location in any industry and
can be utilized regularly to keep a constant eye on the market, the direction
of the market, and the competitors coming and going within that market.
The essential elements of Porter’s analytical framework are:
1.
Barriers to entry.
2.
Threats of substitute products or services.
3.
Bargaining power of suppliers.
4.
Bargaining power of consumers/buyers.
5.
Rivalry among competitors.
Barriers to Entry:
Barriers to entry refers to forces that defer companies from entering
a particular market. In general terms, one will hear such references as
“The barriers to entry in the telecommunications market are
extremely high” or “The barriers to entry in the ice cream industry appear to
be quite low.” Barriers to entry are just as important for firms that are
incumbent in an industry as well as to the newcomers because of the threat of
new entrants.
The barriers generally observed by Porter include economies of
scale, product differentiation, capital requirements, cost disadvantage
independent of size, access to distribution channels, and government policies
(regulation).
Economies of Scale.
These refer to the ability of a firm to mass produce a product and
therefore to sell to the customer at a lower price. A competitor that does not
have the luxury or means to mass produce would thus not be able to compete on
price, but rather be forced to find another way to differentiate itself from
the competition to the consumer.
Product Differentiation.
This is the method or tactics used by a firm to give its product a
more recognized value than the competitors’ products. Brand identity is a
powerful tool in creating value and there- fore makes it difficult for a new
entrant into the market to gain customer loyalty. For example, the leaders in
the toothpaste market are Colgate and Crest. Customers tend to be loyal to
their toothpaste brands, and it would require heavy expenditures to draw
customers away from either of those brands. In addition to brand identity,
advertising, first mover advantage (being first in an industry), and differences
in products also foster loyalty to products and can easily make entering a
market highly expensive.
Capital Requirements.
These refer to the amount of money and investment necessary to
enter a market. Not only does this reference the product differentiation and
brand loyalty mentioned earlier, but it is also extremely important in an
industry in which the infra- structure to produce the product requires large
amounts of financial resources. Both telecommunications and aviation are
examples of industries that require investment in machinery, technology, and so
on.
Cost Disadvantage Independent of Size.
Some industries have a high learning curve, whether that is
scientific, technological, or experiential. In other cases, companies in a
particular industry may have access to raw materials, lower prices, advantage
based on history or relationships, favorable locations, or even the benefit of
government subsidies. All of these factors can affect the ability for an
up-and-comer to set up business, get access to capital, and even be profitable.
Access to Distribution Channels.
Incumbents in an industry have relationships that may have been
functioning profitably for all parties for years. New entrants to that industry
have the challenge of creating new relationships or even new and creative
methods of distribution just to get their products to market and in front of
the consumer. This may mean using price breaks, innovative marketing, and
creative product differentiation. For a service industry, this may refer to
selling relationships or even a location of the service or place in society.
For example, some law firms build relationships with clients and partners that
are a result of years of networking and relationships. Business between the organizations
goes back generations and new law firms in the field must be creative in
reaching the clients.
Government Policies (Regulations).
The government has power over industries in the form of licenses,
limits on access to raw materials,
taxation, and even environmental regulation and standards.
Threat of Substitute Products or Services
A substitute to a product or service can be any other product or
ser- vice that serves a similar function. Too often, firms underestimate the
competitor by not realizing that the product the competitor sells may be a
substitute for its own product or service. Many failed ventures during the
dot-com bubble had the misconceived notion that “we have no competition,” when,
in fact, there are always products or services that compete for a consumer or
customer’s budget. The key to a substitute is that although it may not be the
same product or service and although the competing products or services don’t
function in the same manner, the competing products meet the same customer
need. For example, sugar prices cannot go too high or sugar substitutes such as
fructose or corn syrup can be used in various consumable products (beverages,
etc.). Other industries also have indirect substitutes such as preventative
care and the pharmaceutical industry.
Bargaining
Power of Suppliers
By controlling the quality or quantity of a product or service a
firm needs to conduct its business, or by affecting the price, a supplier can
have power over the firm and impact its ability to enter or function in a new
market. The ultimate power of a supplier comes down to the characteristics of
the supplier group and the relative importance of sales. According to Porter, a
supplier group is powerful—it can affect a firm and possess control over the
firm—if and when:
? There are fewer suppliers
than buyers.
? Its product is unique or
differentiated.
? The buyer group is fairly
small.
? It has created high
switching costs. Switching costs are incurred when a customer switches from one
supplier/product/service to another. For example, when switching from one
deodorant to another, the consumer may not experience a switching cost.
However, for a company to switch from one office software provider to another,
the costs may involve human resources, time, training, and so on.
? The supplier can integrate
forward or take on the function of its customers; for example, a tire
manufacturer may open its own retail stores to sell and install its tires.
Bargaining Power of Consumers/Buyers
Just as the supplier has power in the competition and market wars,
the customer has power. Customers can force down prices, demand more service or
better quality, and even pit competitors against one another.As with most situations, when buyers form groups, they become pow-
erful and will remain powerful if and when:
?
They purchase in volume. A prime example is Wal-Mart or Costco. Not
only can the customer purchase in volume, but Wal-Mart can purchase in large
volume from the supplier, forcing down prices for the end consumer.
?
The product is undifferentiated and the alternatives for the buyer
increase.
?
The product that they purchase forms a component of the product
they produce.
?
Switching costs are low.
?
They can purchase up front.
?
They can integrate backward.
Rivalry among Competitors
All four of the aforementioned parts—barriers to entry, the threat
of substitutes, and the bargaining power of suppliers and buyers—create rivalry
among competitors. Analyzing all of these areas provides a plat- form for
studying the competition in the firm’s market space.
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