Porter's 5 Forces
INTRODUCTIONPorter's five forces is an analytical framework created by Michael E. Porter in 1979, a distinguished Harvard Business School professor. It is a popular tool for a company to understand their business competitive environment. Normally firms are inward focused on how they can be more competitive, for example, cost cutting or increasing productivity of current resources is often viewed as a way for a firm to become more competitive. However, this excludes external factors that influence or threaten a firm's competitive industry position.
Porter espouses that firms need awareness of external factors that can impact their competitiveness. The model examines five forces that can impact competitiveness in the wider business ecosystem. When applied, the model can be used to identify strengths and weaknesses of its products and strategy within the broader business environment. The model analysis allows a firm to understand the threats to its business and develop strategies to remain competitive.
HISTORYThe model was published in Michael E. Porter's book, Competitive Strategy: Techniques for Analyzing Industries and Competitors in 1979. It's a simple model, but recently there's been some criticism that this is an outdated model and does not reflect current technological change. In my opinion it is still an effective model to understand a firm's competitive position as compared to its industry peers. This article is quite brief but hopefully provides an introduction to this framework and links that provide further detail. Porter also published several books on competitive strategy and are worth a read (note: some of them are quite lengthy).
DEFINITIONS
- Suppliers - suppliers can affect a firm's competitiveness by driving up the cost of
good or services they provide; the inputs. One factor is the number of suppliers that can
provide similar inputs. The more suppliers there are providing the same product, the more
competitive the supplier market is and the weaker the supplier is in negotiating a higher
cost of goods. A supplier also has less price leverage if the switching costs to another
supplier are low. For example, a buyer with an integrated inventory demand system
with its supplier may find it difficult to re-integrate it's inventory system with
another supplier; the cost of re-integrating system may outweigh the cost of the savings,
or the client may not have the in-house skills to do that.
Some suppliers achieve "client stickiness" by making it costly to switch
to another supplier.
I worked for a Bank whereby we would integrate client's accounts payable and receivables into our banking systems. The client would have to create a file format that the Bank would accept. Clients would have to build a translator from the output of their systems into a standard format the Bank could accept. The cost of re-mapping input to outputs and the integration of system between bank and client over secure/reliable networks was costly. The client could switch to any other bank but the switching costs were high and client "stickiness" was the outcome.
Likewise if there are very few suppliers, the buyer may not have have much leverage in keeping its suppliers from increasing costs by threatening to switch supplier. For example, in aerospace there are only a couple of supplier of avionics systems for commercial aircraft, Honeywell being one of them. A manufacturer such as Bombardier will not have as much leverage to lower avionics costs as would Boeing or Airbus. Bombardier does not have the aircraft manufacturing volume of the bigger airplane manufacturers. Their volumes are too low and so is their power to negotiate better avionics pricing. On the other hand, Honeywell can raise its prices as there are few alternative suppliers.
- Buyers / Clients - have some leverage on the price it buys its goods. If a firm relies on a handful of buyers for its business, then the buyers have more leverage to pressure the firm to negotiate prices. However, a firm that has a large number of buyers/clients can hold its prices or stop doing business with a buyer if the buyer demands lower prices. The loss of one buyer would likely not impact the firm's profitability. For example, a client looking for a mobile service plan will not have any leverage to demand a lower monthly plan price if dealing withe one of the major Telecom providers. However, a small Telecom provider may be willing to offer a better price to build-up its client base.
- New Entrants - impact a firm's power. If a competitor can establish a market
foothold quickly at less cost in its industry it can become a powerful competitor to an incumbent firm.
A firm is protected from new entrants if the industry has high entry barriers. Barriers could be
high capital costs, a regulatory environment, intellectual property (licensing) or lack of
required human resources with specialized skills. For example, in Canadian banking there are
high barriers to entry for any new banks. These are federal government regulatory and capital barriers that
make it challenging for new entrants.
Industries, such as banking, have strong barriers that keep new entrants at bay. Therefore the firm can charge a premium for its services (think of credit cards) since there are few competitors in its market segment. Sometimes new innovations disrupt entire industries. Anyone establishing a Taxi business normally needs to buy a costly license from the province. Uber massively disrupted the Taxi business as a new entrant by usurping the traditional Taxi model ( full time employment versus a gig business) and its licensing requirements.
- Competitors - impact how a firm can have greater power and continue to charge premium
prices. When there are many competitors in the same industry with equivalent products it weakens
the ability of anyone firm to raise its prices as buyers can switch to a competitor. Likewise,
when there are few competitors, a firm can continue to charge buyers premium pricing for
their goods or services. Competitors can try to usurp each other by lowering their prices. This
often results in the firm lowering its price as well to prevent losing client. This can lead to
a "race to the bottom", a scenario whereby each firm lowers their price to gain clients
or keep clients; a price war.
The airline industry is a good example of this competitive environment. The product is common to all airlines, fly a passenger from point A to point B. There are differentiators such as premium service classes (First Class, Business, Coach, etc.) but the service to fly someone to a destination remains the same. One approach to reduce competition is through acquisitions of competitors. For example, Air Canada's acquisition of Air Transat is such an example. Air Canada, in previous years acquired Wardaid and Canadian Pacific airlines as well. Mergers and acquisitions in the razor thin profit margins of the airline industry are common. In the US, in 2013 US Air merged with American Airlines. The US market for airline M&A activity has been quite active, *click here*. You will likely have seen "seat sales" as airlines lower pricing to attract more clients and increase sales. Another way to retain clients and prevent them moving to competitors has been airline "reward" plans as an attempt to lock in traveler loyalty to an airline.
- Alternatives / Substitutes - the threat of alternative products or services can reduce the power of a firm's competitiveness in the market. This could be viable substitutes for a firm's products. For example, a bag of Starbucks coffee can be substituted for a bag of equally good no name brand coffee from a competitor. Another alternative to coffee may be clients switching to a newly introduced beverage. If the firm raises its prices, clients may switch to alternative products. Expensive coffee can drive a consumer to switch to tea, which has as much caffeine! In business school we were reminded that an alternative to the computer repair shop is the computer savy fourteen year old teenager down the street. It's important a firm understand what are the alternatives to a product or service.
- Workforce - is one of the factors that can also affect a firms competitiveness. This is NOT part of Porter's five forces but in my opinion, the firm's human resources can impact its competitiveness. Porter's five forces are outward looking, but there are internal firm factors that can also impact a firm's cost of producing goods. For example, a tight labor market, as experienced in 2021/2022, led to employees leaving firms for better opportunities elsewhere. The loss of knowledge can affect the operations of the firm as new hires may take time to familiarize themselves with the firm's processes and products. Losing key trained personnel to competitors is only one aspect, the other is the cost of labor. In tight labor markets, employees will demand higher salaries. This will increase the cost of producing goods. In response, the firm may have to raise the prices of its goods and in doing so may lose its competitive cost advantage.
There are three generic competitive strategies for coping with the five competitive forces. There are risks with each strategy. A firm without a strategy is said to be "stuck in the middle."
- Cost Leadership - is the ability for the firm to produce the product at the most competitive price. Cost leadership is difficult to sustain because a competitor may easily drop their costs to steal market share away. WalMart operates on this competitive model through two strategies; pressuring suppliers to lower their product costs and purchasing in large volumes to reduce unit cost, thereby reducing cost of goods to the consumer. See the FastCompany article on WalMart and the the pressure it exerts on its suppliers *click here*.
- Differentiation - is one strategy to keep prices high, by providing something that competitors are not providing or have no competencies to provide. This may be a level of significantly better service that clients are willing to pay a premium for.
- Focus - this strategy is to focus on a limited product offering and produce it efficiently. For example, Masonite manufactures door for office and residential use. When asked why they don't produce windows or other complementary products to doors, their reply is that they only produce doors! By focusing on one product they achieve product expertise and supply chain efficiencies (e.g. volume purchase of materials). Focus on one product or service and do it well!
This is a framework for understanding the industry forces affecting a firm's competitiveness. These five forces shape every industry and assists in determining a firm's strengths and weaknesses. This analysis allows firms to understand what levers they can use to refine their strategy that gives them a better market advantage.
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