The Purpose of Five Forces AnalysisUnderstanding the dynamics that shape how much profit potential exists within an industry is key to knowing how likely a particular firm is to succeed within the industry. There are five key forces that determine the profitability of a particular industry. Taken together, all five forces indicate the attractiveness of an industry. Attractive industries—those with favorable conditions—are more likely to experience higher profitability. Show
Table 3.8 Porter’s Five Forces
Visit the executive suite of any company and the chances are very high that the chief executive officer and her vice presidents are relying on Five Forces Analysis to understand their industry. Introduced more than thirty years ago by Professor Michael Porter of the Harvard Business School, Five Forces Analysis has long been and remains perhaps the most popular analytical tool in the business world (Table 3.8). Figure 3.10: Porter’s Five ForcesThe purpose of Five Forces Analysis is to identify how much profit potential exists in an industry. To do so, Five Forces Analysis considers the interactions among the competitors in an industry, potential new entrants to the industry, substitutes for the industry’s offerings, suppliers to the industry, and the industry’s buyers (Porter, 1979). If none of these five forces works to undermine profits in the industry, then the profit potential is very strong. If all the forces work to undermine profits, then the profit potential is very weak. Most industries lie somewhere in between these extremes. This could involve, for example, all five forces providing firms with modest help or two forces encouraging profits while the other three undermine profits. Once executives determine how much profit potential exists in an industry, they can then decide what strategic moves to make to be successful. If the situation looks bleak, for example, one possible move is to exit the industry. The Rivalry among Competitors in an IndustryThe competitors in an industry are firms that produce similar products or services. Competitors use a variety of moves such as advertising, new offerings, and price cuts to try to outmaneuver one another to retain existing buyers and to attract new ones. Because competitors seek to serve the same general set of buyers, rivalry can become intense (Table 3.9). Subway faces fierce competition within the restaurant business, for example. This is illustrated by a quote from the man who built McDonald’s into a worldwide icon. Former CEO Ray Kroc allegedly once claimed that “if any of my competitors were drowning, I’d stick a hose in their mouth.” While this sentiment was (hopefully) just a figure of speech, the announcement in March 2011 that Subway had surpassed McDonald’s in terms of numbers of stores, this intense rivalry has led to Subway having 10,000 more stores world-wide than McDonald’s in 2020. High levels of rivalry tend to reduce the profit potential of an industry. A number of characteristics that affect the intensity of the rivalry among competitors are illustrated below. Table 3.9 Rivalry
Understanding the intensity of rivalry among an industry’s competitors is important because the degree of intensity helps shape the industry’s profit potential. Of particular concern is whether firms in an industry compete based on price. When competition is bitter and cutthroat, the prices competitors charge—and their profit margins—tend to go down. If, on the other hand, competitors avoid bitter rivalry, then price wars can be avoided and profit potential increases. Every industry is unique to some degree, but there are some general characteristics that help to predict the likelihood that fierce rivalry will erupt. Rivalry tends to be fierce, for example, to the extent that the growth rate of demand for the industry’s offerings is low (because a lack of new customers forces firms to compete more for existing customers), fixed costs in the industry are high (because firms will fight to have enough customers to cover these costs), competitors are not differentiated from one another (because this forces firms to compete based on price rather than based on the uniqueness of their offerings), and exit barriers in the industry are high (because firms do not have the option of leaving the industry gracefully). Exit barriers can include emotional barriers, such as the bad publicity associated with massive layoffs, or more objective reasons to stay in an industry, such as a desire to recoup considerable costs that might have been previously spent to enter and compete. Industry concentration is an important aspect of competition in many industries. Industry concentration is the extent to which a small number of firms dominate an industry (Table 3.10). Among circuses, for example, the four largest companies collectively own 89% of the market. Meanwhile, these companies tend to keep their competition rather polite. Their advertising does not lampoon one another, and they do not put on shows in the same city at the same time. This does not guarantee that the circus industry will be profitable; there are four other forces to consider as well as the quality of each firm’s strategy. But low levels of rivalry certainly help build the profit potential of the industry. In contrast, the restaurant industry is fragmented, meaning that the largest rivals control just a small fraction of the business and that a large number of firms are important participants. Rivalry in fragmented industries tends to become bitter and fierce. Quiznos, a chain of sub shops that is roughly 15% the size of Subway, has directed some of its advertising campaigns directly at Subway, including one depicting a fictional sub shop called “Wrong Way” that bore a strong resemblance to Subway. Within fragmented industries, it is almost inevitable that over time some firms will try to steal customers from other firms, such as by lowering prices, and that any competitive move by one firm will be matched by others. In the wake of Subway’s success in offering foot-long subs for $5, for example, Quiznos has matched Subway’s price. Such price jockeying is delightful to customers, of course, but it tends to reduce prices, and profit margins) within an industry. Indeed, Quiznos later escalated its attempt to attract budget-minded consumers by introducing a flatbread sandwich that cost only $2. Overall, when choosing strategic moves, Subway’s presence in a fragmented industry forces the firm to try to anticipate not only how fellow restaurant giants such as McDonald’s and Burger King will react but also how smaller sub shop chains like Quiznos and various regional and local players will respond. Industry concentration refers to the extent to which large firms dominate an industry. Buyers and suppliers generally have more bargaining power when they are from concentrated industries. This is because the firms that do business with them have fewer options when seeking buyers and suppliers. One popular way to measure industry concentration is via the percentage of total industry output that is produced by the four biggest competitors. Below are examples of industries that have high (80%-100%), medium (50%-79%), and low (below 50%) levels of concentration. Table 3.10 Industry Concentration
The Threat of Potential New Entrants to an IndustryCompeting within a highly profitable industry is desirable, but it can also attract unwanted attention from outside the industry. Potential new entrants to an industry are firms that do not currently compete in the industry but may in the future (Table 3.11). New entrants tend to reduce the profit potential of an industry by increasing its competitiveness. If, for example, an industry consisting of five firms is entered by two new firms, this means that seven rather than five firms are now trying to attract the same general pool of customers. Thus, executives need to analyze how likely it is that one or more new entrants will enter their industry as part of their effort to understand the profit potential that their industry offers. New entrants can join the fray within an industry in several different ways. New entrants can be start-up companies created by entrepreneurs, foreign firms that decide to enter a new geographic area, supplier firms that choose to enter their customers’ business, or buyer firms that choose to enter their suppliers’ business. The likelihood of these four paths being taken varies across industries. Restaurant firms such as Subway, for example, do not need to worry about their buyers entering the industry because they sell directly to individuals, not to firms. It is also unlikely that Subway’s suppliers, such as farmers, will make a big splash in the restaurant industry. Figure 3.11: The entry of chicken burger restaurant Oporto into the United States might hurt hamburger restaurants more than it hurts Subway and other sandwich makers.On the other hand, entrepreneurs launch new restaurant concepts every year, and one or more of these concepts may evolve into a fearsome competitor. Also, competitors based overseas sometimes enter Subway’s core US market. In February 2011, Australia-based Oporto opened its first US store in California (Odell, 2011). Oporto operates more than 130 chicken burger restaurants in its home country. But Oporto didn’t survive in the US, and closed its US stores in 2013. Every industry is unique to some degree, but some general characteristics help to predict the likelihood that new entrants will join an industry. New entry is less likely, for example, to the extent that existing competitors enjoy economies of scale (because new entrants struggle to match incumbents’ prices), capital requirements to enter the industry are high (because new entrants struggle to gather enough cash to get started), access to distribution channels is limited (because new entrants struggle to get their offerings to customers), governmental policy discourages new entry, differentiation among existing competitors is high (because each incumbent has a group of loyal customers that enjoy its unique features), switching costs are high (because this discourages customers from buying a new entrant’s offerings), expected retaliation from existing competitors is high, and cost advantages independent of size exist. The Great Wall of China effectively protected China against potential raiders for centuries. The metaphor of a high wall as a defense against potential entrants is a key element in Porter’s Five Forces model. Industries with higher barriers to entry are in a safer defensive position than industries with lower barriers. Below we describe several factors that make it difficult for would-be invaders to enter an industry. Table 3.11 New Entrants
The Threat of Substitutes for an Industry’s OfferingsExecutives need to take stock not only of their direct competition but also of players in other industries that can steal their customers. Substitutes are offerings that differ from the goods and services provided by the competitors in an industry but that fill similar needs to what the industry offers (Table 3.12). How strong of a threat substitutes are depends on how effective substitutes are in serving an industry’s customers. At first glance, it could appear that the satellite television business is a tranquil one because there are only two significant competitors in the US: DIRECTV and DISH Network. These two industry giants, however, face a daunting challenge from substitutes. The closest substitute for satellite television is provided by cable television firms, such as Comcast and Charter Communications. DIRECTV and DISH Network also need to be wary of streaming video services, such as Netflix, and video rental services, such as Redbox. The availability of viable substitutes places stringent limits on what DIRECTV and DISH Network can charge for their services. If the satellite television firms raise their prices, customers will be tempted to obtain video programs from alternative sources. This limits the profit potential of the satellite television business. In other settings, viable substitutes are not available, and this helps an industry’s competitors enjoy profits. Like light bulbs, candles can provide lighting within a home. Few consumers, however, would be willing to use candles instead of light bulbs. Candles simply do not provide as much light as light bulbs. Also, the risk of starting a fire when using candles is far greater than the fire risk of using light bulbs. Because candles are a poor substitute, light bulb makers such as Sylvania and Phillips do not need to fear candle makers stealing their customers and undermining their profits. Figure 3.12: Few consumers would be willing to substitute candles for light bulbs.The dividing line between which firms are competitors and which firms offer substitutes is a challenging issue for executives. Most observers would agree that, from Subway’s perspective, sandwich maker Quiznos should be considered a competitor and that grocery stores such as Kroger offer a substitute for Subway’s offerings. But what about full-service restaurants, such as Ruth’s Chris Steak House, and “fast casual” outlets, such as Panera Bread? Whether firms such as these are considered competitors or substitutes depends on how the industry is defined. Under a broad definition—Subway competes in the restaurant business—Ruth’s Chris and Panera should be considered competitors. Under a narrower definition—Subway competes in the sandwich business—Panera is a competitor and Ruth’s Chris is a substitute. Under a very narrow definition—Subway competes in the sub sandwich business—both Ruth’s Chris and Panera provide substitute offerings. Thus clearly defining a firm’s industry is an important step for executives who are performing a Five Forces Analysis. A substitute teacher is a person who fills in for a teacher. Some substitute teachers are almost as good as the “real” teacher while others are woefully inadequate. In business, the competitors in an industry not only must watch each other, they must keep an eye on firms in other industries whose products or services can serve as effective substitutes for their offerings. In some cases, substitutes are so effective that they are said to “disrupt” the industry, meaning they kill most or all industry demand. Below we note a number of effective substitutes for particular industries. Table 3.12 Substitutes
The Power of Suppliers to an IndustrySuppliers provide inputs that the firms in an industry need to create the goods and services that they in turn sell to their buyers. A variety of supplies are important to companies, including raw materials, financial resources, and labor (Table 3.13). For restaurant firms such as Subway, key suppliers include such firms as Sysco that bring various foods to their doors, restaurant supply stores that sell kitchen equipment, and employees that provide labor. The relative bargaining power between an industry’s competitors and its suppliers help shape the profit potential of the industry. If suppliers have greater leverage over the competitors than the competitors have over the suppliers, then suppliers can increase their prices over time. This cuts into competitors’ profit margins and makes them less likely to be prosperous. On the other hand, if suppliers have less leverage over the competitors than the competitors have over the suppliers, then suppliers may be forced to lower their prices over time. This strengthens competitors’ profit margins and makes them more likely to be prosperous. Thus when analyzing the profit potential of their industry, executives must carefully consider whether suppliers have the ability to demand higher prices. Every industry is unique to some degree, but some general characteristics help to predict the likelihood that suppliers will be powerful relative to the firms to which they sell their goods and services. Suppliers tend to be powerful, for example, to the extent that the suppliers’ industry is dominated by a few companies, if it is more concentrated than the industry that it supplies and/or if there is no effective substitute for what the supplier group provides. These circumstances restrict industry competitors’ ability to shop around for better prices and put suppliers in a position of strength. Supplier power is also stronger to the extent that industry members rely heavily on suppliers to be profitable, industry members face high costs when changing suppliers, and suppliers’ products are differentiated. Finally, suppliers possess power to the extent that they have the ability to become a new entrant to the industry if they wish. This is a strategy called forward vertical integration. Ford, for example, used a forward vertical integration strategy when it purchased rental car company and Ford customer, Hertz. A difficult financial situation forced Ford to sell Hertz for $5.6 billion 11 years later. But before rental car companies such as Avis and Thrifty drive too hard of a bargain when buying cars from an automaker, their executives should remember that automakers are much bigger firms than are rental car companies. The executives running the automaker might simply decide that they want to enjoy the rental car company’s profits themselves and acquire the firm. A number of characteristics that impact the power of suppliers to a given industry are illustrated below. Table 3.13 Power of Suppliers
Strategy at the MoviesFlash of Genius When dealing with a large company, a small supplier can get squashed like a bug on a windshield. That is what college professor and inventor Dr. Robert Kearns found out when he invented intermittent windshield wipers in the 1960s and attempted to supply them to Ford Motor Company. As depicted in the 2008 movie Flash of Genius, Kearns dreamed of manufacturing the wipers and selling them to Detroit automakers. Rather than buy the wipers from Kearns, Ford replicated the design. An angry Kearns then spent many years trying to hold the firm accountable for infringing on his patent. Kearns eventually won in court, but he paid a terrible personal price along the way, including a nervous breakdown and estrangement from his family. Kearns’s lengthy battle with Ford illustrates the concept of bargaining power that is central to Porter’s Five Forces model. Even though Kearns created an exceptional new product, he had little leverage when dealing with a massive, well-financed automobile manufacturer. What did Henry Ford II Steal from a common man | One man fought the might of Ford Motors and won! [01:52] This video is about Robert Kearns taking on Ford. You can view this video here: https://youtu.be/iroEVFDZOHI. The Power of an Industry’s BuyersBuyers purchase the goods and services that the firms in an industry produce (Table 3.14). For Panera Bread and other restaurants, buyers are individual people. In contrast, the buyers for some firms are other firms rather than end users. For Procter & Gamble, for example, buyers are retailers such as Walmart and Target who stock Procter & Gamble’s pharmaceuticals, hair care products, pet supplies, cleaning products, and other household goods on their shelves. Figure 3.13: College students’ lack of buyer power in the textbook industry has kept prices high for decades and created frustration for students.The relative bargaining power between an industry’s competitors and its buyers helps shape the profit potential of the industry. If buyers have greater leverage over the competitors than the competitors have over the buyers, then the competitors may be forced to lower their prices over time. This weakens competitors’ profit margins and makes them less likely to be prosperous. Walmart furnishes a good example. The mammoth retailer is notorious among manufacturers of goods for demanding lower and lower prices over time (Bianco & Zellner, 2003). In 2008, for example, the firm threatened to stop selling compact discs if record companies did not lower their prices. Walmart has the power to insist on price concessions because its sales volume is huge. Compact discs make up a small portion of Walmart’s overall sales, so exiting the market would not hurt Walmart. From the perspective of record companies, however, Walmart is their biggest buyer. If the record companies were to refuse to do business with Walmart, they would miss out on access to a large portion of consumers. On the other hand, if buyers have less leverage over the competitors than the competitors have over the buyers, then competitors can raise their prices and enjoy greater profits. This description fits the textbook industry quite well. College students are often dismayed to learn that an assigned textbook costs $150 or more. Historically, textbook publishers have been able to charge high prices because buyers had no leverage. A student enrolled in a class must purchase the specific book that the professor has selected. Used copies are sometimes a lower-cost option, but textbook publishers have cleverly worked to undermine the used textbook market by releasing new editions after very short periods of time. Of course, the presence of a very high profit industry is attractive to potential new entrants. Firms such as, the publisher of this book, have entered the textbook market with lower-priced offerings. Time will tell whether such offerings bring down textbook prices. Like any new entrant, upstarts in the textbook business must prove that they can execute their strategies before they can gain widespread acceptance. Overall, when analyzing the profit potential of their industry, executives must carefully consider whether buyers have the ability to demand lower prices. In the textbook market, buyers do not. Every industry is unique to some degree, but some general characteristics help to predict the likelihood that buyers will be powerful relative to the firms from which they purchase goods and services. Buyers tend to be powerful, for example, to the extent that there are relatively few buyers compared with the number of firms that supply the industry, the industry’s goods or services are standardized or undifferentiated, buyers face little or no switching costs in changing vendors, the good or service purchased by the buyers represents a high percentage of the buyer’s costs, and the good or service is of limited importance to the quality or price of the buyer’s offerings. Finally, buyers possess power to the extent that they have the ability to become a new entrant to the industry if they wish. This strategy is called backward vertical integration. DIRECTV used to be an important customer of TiVo, the pioneer of digital video recorders. This situation changed, however, when executives at DIRECTV grew weary of their relationship with TiVo. DIRECTV then used a backward vertical integration strategy and started offering DIRECTV-branded digital video recorders. Profits that used to be enjoyed by TiVo were transferred at that point to DIRECTV. A number of characteristics that impact the power of buyers to a given industry are illustrated below. Table 3.14 Power of Buyers
Interpreting the Five ForcesWhen using Porter’s Five Forces tool, it is important to note the strength of each of the five forces that are analyzed. The forces are typically ranked as Strong/High, Moderate/Medium, or Weak/Low. If these competitive forces within an industry are high, then the profit potential in that industry is low. Strong forces indicate high competition for the profits within that industry, making it a less desirable industry to be in. Conversely, if the forces within an industry are generally weak, this indicates a stronger potential for profit and a desirable industry to be in. A mixture of strong and weak forces means there is profit potential, but there exist competitive forces within the industry that can dilute the profit potential. Upon doing Porter’s Five Forces Analysis, companies should make an informed decision on entering that market, and how they might compete, given the various strengths of the forces. The Limitations of Five Forces AnalysisFive Forces Analysis is useful, but it has some limitations too. The description of Five Forces Analysis provided by its creator, Michael Porter, seems to assume that competition is a zero-sum game, meaning that the amount of profit potential in an industry is fixed. One implication is that if a firm is to make more profit, it must take that profit from a rival, a supplier, or a buyer. In some settings, however, collaboration can create a larger pool of profit that benefits everyone involved in the collaboration. In general, collaboration is a possibility that Five Forces Analysis tends to downplay. The relationships among the rivals in an industry, for example, are depicted as adversarial. In reality, these relationships are sometimes adversarial and sometimes collaborative. General Motors and Toyota compete fiercely all around the world, for example, but they also have worked together in joint ventures. Similarly, Five Forces Analysis tends to portray a firm’s relationships with its suppliers and buyers as adversarial, but many firms find ways to collaborate with these parties for mutual benefit. Indeed, concepts such as just-in-time inventory systems depend heavily on a firm working as a partner with its suppliers and buyers. Section VideosPorter’s Five Forces [02:57] This video for the lesson explains the Porter’s Five Forces Model. You can view this video here: https://youtu.be/_IaBZmB09RE. Porter’s Five Forces (Tesla Example) [09:51] This video for the lesson works through the Porter’s Five Forces analysis using Tesla as an example. You can view this video here: https://youtu.be/5F0dI8zaotU. Key Takeaway
Exercises
ReferencesBianco, B., & Zellner, W. (2003, October). Is Wal-Mart too powerful? Bloomberg Businessweek. https://www.bloomberg.com/news/articles/2003-10-05/is-wal-mart-too-powerful Odell, K. (2011, February 22). Portuguese-influenced Australian chicken burger chain, Oporto, comes to SoCal. Eater LA. http://la.eater.com/archives/2011/02/22/portugueseinfluenced_australian_chicken_burger_chain_oporto_comes_to_socal.php Porter, M. E. (1979, March–April). How competitive forces shape strategy. Harvard Business Review, 137–156. Image CreditsFigure 3.10: Kindred Grey (2020). “Porter’s Five Forces.” CC BY-SA 4.0. Retrieved from https://commons.wikimedia.org/wiki/File:Porter%27s_Five_Forces.png. Figure 3.11: MDRX. “Oporto drive through menu in Sydney.” CC BY-SA 4.0. Cropped. Retrieved from https://upload.wikimedia.org/wikipedia/commons/3/3e/Oportodrivethrumenu.jpg. Figure 3.12: Sugeesh. “A candle lit inside an electric bulb.” Public Domain. Retrieved from https://commons.wikimedia.org/wiki/File:Candle_in_Incandescent_light_bulb.png. Figure 3.13: Grabowska, Karolina. “Person Holding Stack of Books.” Pexels License. Retrieved from https://www.pexels.com/photo/person-holding-stack-of-books-4218978. Video CreditsDesai, Y. (2017, August 22). What did Henry Ford II Steal from a common man | One man fought the might of Ford Motors and won! [Video] YouTube. https://youtu.be/iroEVFDZOHI. MindToolsVideos. (2018, January 9). Porter’s five forces [Video]. YouTube. https://youtu.be/_IaBZmB09RE. Learn to Invest. (2019, July 31). Porter’s 5 forces (Tesla example) [Video]. YouTube. https://youtu.be/5F0dI8zaotU. |