All business management consultants and strategy professors are indebted to Michael Porter. The three analytical tools he developed and which are now among the most famous in management: The model of the five forces of competition, the value chain and the diamond. This work is closely linked to strategy.
Michael Porter’s Five Forces of competition work has become a classic, as inseparable from strategy as the 4Ps of marketing, the NPV of finance, or pure and perfect competition of economics.
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Understanding the Five Forces of competition Model
The model of Mr. Porter’s five forces of competition appears for the first time in 1979 in the article of the Harvard business review, its principle consists in broadening the notion of competition by taking into account within an industry of goods or services, all the forces likely to influence the ability of the firms involved to generate a profit.
Porter’s Five Forces Model is a market analysis technique that takes into account the five dimensions on which the company can act in order to optimize its competitive advantage: competitor rivalry; the threat of new entrants; the threat of substitute products; the bargaining power of customers; the bargaining power of suppliers
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The Five Forces model is a strategic analysis that allows companies to understand the competitive environment in which they operate. It helps to identify the forces that affect the profitability and attractiveness of a given industry. By examining these strengths, companies can develop strategies to maximize their competitive position.
Porter’s Five Forces Explained
The bargaining power of customers
It represents their ability to negotiate price, level of quality, associated services, etc. This force has a direct impact on the average profitability of an industry since it influences revenue or product costs. A group of customers is all the more powerful when:
- They are concentrated or buy significant quantities
- The product does not greatly influence the quality of its own product or service
- The products they buy are standardized
- Its profits are low, which encourages it to reduce its purchasing costs
- He is likely to integrate upstream to manufacture the product himself
The bargaining power of suppliers
It corresponds to their ability to influence the industry, in terms of price and quality of the products or services they provide. Indeed, a very powerful supplier will be able to impose higher prices if demand is only weakly elastic to price. Their bargaining power is all the greater when:
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- Switching costs are high or prohibitive
- There is no substitute product
- The supplier industry is concentrated
- They represent an important part of the company’s purchases
The threat of new entrants
It is determined by the size of the barriers to entry into the industry. Indeed, the markets present a number of obstacles that do not facilitate the entry of a new company. Here is a list of the main types of barriers to entry that may exist:
- Economies of scale that require either acting on a large scale upfront or incurring a cost disadvantage
- Product differentiation and therefore the heavy marketing investments that will be required to undermine customer loyalty
- Capital requirements especially if they are spent on non-recoverable expenses (ex: launch advertising and R&D)
- Access to distribution channels
- Size-independent cost disadvantages that may result from the effect of experience, proprietary technologies, access to scarce or limited resources, favorable locations, etc.
The threat of substitute products or services
It is linked to the fact that a consumer need can be satisfied by several solutions (products or services). The threat posed by this force is all the greater because:
- Transfer costs borne by customers are low
- The price/performance ratio is similar
The struggle between current competitors
It corresponds to all maneuvers that influence the profit of industry players such as price reductions, product launches or intensive advertising. This force is all the more powerful because:
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- There are many competitors
- Sector growth is weak
- Fixed costs are high
- Barriers to exit are high
The more intense these forces are, the more the profit potential for the firms present in the industry is limited. Conversely, if these forces are weak, the industry offers High profitability for competitors.
The central question then consists in measuring the five forces using in particular classic concepts in industrial economics such as the experience curve, barriers to entry and exit, vertical integration or the maturity curve.
In addition, by seeking to analyze the structures of industries through the model of the five forces of competition, Michael Porter defined other concepts that have become classics in strategy: generic strategies and strategic groups.
Five Forces Model Real Usage Examples
Porter’s Five Forces model has been used successfully by many companies to inform strategic decisions and anticipate competitive dynamics. Here are some concrete examples of companies that have benefited from the application of this model:
Example 1: The Mobile Phone Industry
The mobile phone industry is a perfect example of the impact of the Five Forces model. With the emergence of messaging apps and social media, the threat of substitute products has increased dramatically. Companies in the sector have had to innovate quickly to respond to this threat. Smartphones have been developed to provide a richer user experience and additional features, reducing the pressure of substitute products.
Example 2: The Airline Industry
In the airline industry, airlines face strong competitive intensity. The Five Forces model has helped these companies assess the impact of existing competitors, potential new entrants and the bargaining power of customers. Airlines have developed loyalty programs to attract and retain customers, while exploring differentiation strategies such as in-flight entertainment services and enhanced comfort options.
Example 3: The Pharmaceutical Industry
In the pharmaceutical industry, the Five Forces model has been used to assess the bargaining power of raw material suppliers and the bargaining power of customers, including regulators and insurance companies.
Pharmaceutical companies have used this information to strengthen their relationships with suppliers and ensure that their products meet current standards and regulations.
In addition, they have developed strategic partnerships to extend their reach in the market.
Example 4: The Fast Food Industry
The fast food industry has seen constant upheaval due to changing consumer preferences. Using the Five Forces model, fast food chains analyzed the threat of substitute products, including healthier alternatives and home cooking options.
To respond to this threat, they have introduced more varied and health-oriented menu options, while offering delivery services to adapt to new consumer habits.
Advantages and Limitations of the Five Forces Model
Porter’s Five Forces model is widely recognized for its usefulness in competitive analysis and strategy formulation. However, it has both advantages and limitations that are important to consider.
Advantages of the Five Forces Model
- Understanding Competitive Dynamics: The model enables companies to understand the forces that influence the competitiveness of their industry. By identifying these strengths, they can develop strategies to position themselves optimally.
- Focus on Key Drivers: The model highlights the key factors that have a direct impact on the profitability and viability of a business. This helps decision makers focus on the most critical areas.
- Identification of Threats and Opportunities: By assessing competitive forces, companies can identify potential threats and strategic opportunities. This makes it easier to develop plans to mitigate threats and exploit opportunities.
- Developing Defensive and Offensive Strategies: Companies can develop defensive strategies to protect against negative forces, as well as offensive strategies to exploit competitive weaknesses.
- Decision Support: The model provides a structured framework for evaluating competitive factors, which facilitates informed decision-making in product development, pricing, marketing, and more.
Limitations of the Five Forces Model
- Excessive Simplicity: While its simplicity is an advantage, the model can also be considered too simplistic to capture the complexity of competitive interactions in some industries.
- Lack of Context: The model does not take into account contextual aspects specific to a company or an industry. The dynamics can vary greatly depending on the situation.
- Industry Focus: The model focuses primarily on forces external to the industry, neglecting internal aspects such as resources, capabilities, and company culture.
- Lack of Consideration of Rapid Changes: The model may be less effective for rapidly changing industries, where competitive forces may change rapidly.
- Data Dependency: To apply the model, accurate data is needed. In some industries, access to this data may be restricted.
Conclusion
In conclusion, Porter’s Five Forces model remains a valuable tool for analyzing the competitive environment. It offers a holistic perspective on the forces that shape an industry and helps companies develop relevant strategies to thrive in a competitive environment.