What is the Porter's Five Forces model

Industry structure analysis (Five Forces) according to Porter

Porter's Five Forces are the classic in strategic management. Usually, however, the model is applied very superficially and its potential is therefore not exhausted. In this article, we therefore not only go into the basic model, but also show how it can be used in a well-founded manner.

 

The industry structure analysis is used to determine the attractiveness of an industry. For this purpose, the five components of the industry structure ("Five Forces") are analyzed and evaluated: the bargaining power of the suppliers, the bargaining power of the customers, the threat from new competitors, the threat from replacement products and the intensity of competition in the industry.

The industry structure model offers an analysis grid with which the structure of an industry and the competitive situation can be systematically examined. From the development of the competitive situation in an industry, it can be deduced whether this is attractive for the company, i.e. whether it enables long-term profitable development.

The basis of Porter's model is the approach of industrial economics. He assumes that the attractiveness of an industry for a company operating in it is determined by the market structure, as this influences the behavior of market participants. To determine the industry's attractiveness, the following five components of the industry structure, the so-called "Five Forces", must be examined:

  • Bargaining power of suppliers
  • Bargaining power of customers
  • New Competitor Threat
  • Threat from substitute products
  • Intensity of competition in the industry

Each of the five components is to be assessed for the present as well as for the future, e.g. on the basis of a utility value analysis. An evaluation can look like this:

The five components are described in detail below.

Bargaining power of suppliers

The bargaining power of the suppliers determines how much they can assert their interests in a business relationship with the company. A high bargaining power on the part of suppliers will usually mean that they can either charge higher prices or deliver poorer quality at the same price. Since this has a negative effect on the company's profit potential, the lower the bargaining power of the suppliers, the more attractive an industry is.

Indicators that suppliers have a high level of negotiating power

  • High differentiation in the products of the suppliers, e.g. if the supplier himself has a strong brand
  • Little presence of substitutes
  • High conversion costs for the customer in the event of a change of supplier
  • Little importance of the respective purchase for the supplier, i.e. the purchase volume with a supplier only makes up a small part of his total turnover
  • Purchasing is of great cost to the company: Either the costs make up a large proportion of the company's total purchasing costs, or the primary material has a major influence on the cost position or differentiation options
  • High concentration of suppliers: An oligopolistic (or even monopoly) market structure among suppliers leaves the company little opportunity to resort to alternative suppliers and makes it easier for suppliers to enforce high prices
  • Low risk of backward integration: the company cannot credibly threaten to manufacture the corresponding preliminary products itself (at least less credibly than the supplier can threaten forward integration)

Bargaining power of customers

As with suppliers, the bargaining power of the buyers determines how much they can assert their interests in a business relationship with the company. A high level of bargaining power on the part of customers will usually mean that they can either ask for lower prices or obtain better quality at the same price. Such behavior has a negative effect on the company's profit prospects, which is why an industry is all the more attractive, the less bargaining power the customers have.

Indicators that customers have high bargaining power

  • Little differentiation between the company's products and those of its competitors, e.g. in the case of bulk goods
  • Low conversion costs for the customer in the event of a change of supplier
  • High availability of substitutes: Substitutes are available or customers have sufficient knowledge of alternative suppliers or primary materials
  • The respective sales are very important for the company, i.e. the purchasing volume of a customer makes up a large proportion of the company's total turnover
  • Little influence of the product on the cost position or differentiation possibilities of the customers
  • High customer concentration: An oligopolistic (or even monopolistic) market structure among customers leaves the company few alternative sales opportunities and makes it easier for customers to enforce low prices.
  • High risk of backward integration: the customer can credibly threaten to manufacture the corresponding products himself

New Competitor Threat

The entry of new competitors into the market usually leads to increased price pressure. The ratio of supply to demand will become less favorable, in order to use their capacities to the full and to win customers, the new competitors will contribute to a drop in prices, which will reduce the attractiveness of the industry. The risk of new competitors entering the market depends on the level of the market entry barriers. Higher barriers mean a more protected position for the existing competitors and thus increase the industry's attractiveness.

Typical barriers to market entry are

  • Economies of scale: New competitors usually achieve a lower sales volume than established companies at the beginning and thus have a cost disadvantage if economies of scale play a role in the industry
  • Absolute cost advantages: learning curve based on protected products, protected cost-effective design, protected access to necessary inputs (e.g. raw materials)
  • Product differentiation often increases customer loyalty, which makes it more difficult for new competitors to acquire customers
  • Capital requirement: A high investment requirement, e.g. for research and development, production facilities, infrastructure or even for marketing, enables only financially strong companies to enter the market. In addition, the high investment requirement increases the risk of entering the market, which makes it less attractive
  • Conversion costs for customers when switching suppliers reduce their willingness to switch
  • Access to sales channels: If important sales channels are bound or occupied, a new competitor has poor sales opportunities
  • Expected reactions from established competitors
  • State influence: State restrictions, requirements and regulations as well as subsidies can make market entry more difficult or lead to disadvantages for new competitors

Threat from substitute products

Substitute products are understood to mean substitutes in the broader sense, i.e. products that meet similar customer needs, but are currently perceived differently by customers, address other customer groups or are sold in other regions. Such replacement products have a negative impact on the attractiveness of an industry, as customers could switch to these products if necessary.

Are factors influencing the threat from substitute products

  • Price / performance ratio of the replacement products compared to your own products
  • Conversion costs for the customer when switching to the supplier of a replacement product
  • Customer attitudes to the replacement products, e.g. whether customers perceive them as such at all

Intensity of competition in the industry

Finally, the fifth factor is the intensity of competition in the industry (referred to by Porter as rivalry among competitors) that has an impact on the attractiveness of the industry. A high level of competition manifests itself either as price competition (the competitors undercut each other in terms of prices) or as performance competition (the competitors outperform each other in terms of product quality and additional services and thereby increase costs). Both forms of competition have a negative effect on profit prospects and thus on the attractiveness of the market.

Important influencing factors on the degree of competitive intensity in the industry are

  • Number of competitors: A high number of competitors leads to high competitive pressure. According to macroeconomic theory, a large number of competitors results in production near marginal costs and low profits
  • Industry growth: In fast-growing industries, competition is often less than in slow-growing or even shrinking industries, since it is possible to expand your own sales without having to take market share from competitors
  • Overcapacities / utilization: If the capacities significantly exceed the demand, the providers will struggle to achieve a high utilization. This leads to price pressure and thus a decline in the attractiveness of the industry
  • Share of fixed costs in total costs: If the share of fixed costs is high, there is a strong incentive to achieve high utilization in order to cover at least part of the fixed costs. Due to the high supply pressure, the prices then often fall almost to the level of the variable costs
  • Exit barriers: In order to reduce excess capacities, it is often necessary for competitors to exit the market. However, this is made more difficult or delayed if high conversion or shutdown costs occur, the business field is important for the relevant competitors for strategic reasons (e.g. synergy effects with other business fields), or investments in the past lead to (irrational) ties to the business field ("Sunk costs")
  • Product differentiation: If the offers of the competitors differ significantly, the interchangeability of the products / services decreases, which also weakens the price pressure

The following diagram summarizes the five components of the industry structure.

Interview with Michael E. Porter

Michael E. Porter, the author of the approach himself, explains the system of the "5 Forces" and how it can be used in practice in an interview with Tom Stuart, the managing director of Harvard Business Review.

Porter: The Five Competitive Forces that Shape Strategy

The original article by Michael E. Porter that first explains the approach.

An Analysis of the Impact of the Internet on Competition in the Banking Industry, using Porter's Five Forces Model

The article provides an application example of industry structure analysis. It examines the influence of the Internet on competition in the banking sector.

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Author: Achim Sztuka