Porter's Five Forces Analysis © Jeff Miles

Porter's Five Forces Analysis was developed by Michael Porter of Harvard Business School in 1979. He based his analysis on the idea that a company gets a competitive advantage if it gets a quicker return on investment than its competitors do.

This analysis uses Industrial Organization economics to select five forces to determine whether or not a particular market is attractive. These five forces affect a company's ability to serve its customers and make a profit. When there is a change in any one of the forces the business has to adjust and re-assess accordingly.

Five Forces Analysis focuses on a single business or market rather than on a particular product or group of products. Three of the forces are horizontal: threat of substitute products, threat of established rivals, and the threat of new competition. The other two are vertical: the power of buyers and the threat of entry.

Here are the five forces and a summary of each:

1. The threat of entry:

This examines the threat of potential competitors as well as existing competitors. The threat of new entrants is based on the market entry barriers. These barriers can take a variety of forms and exist to prevent a surge of new firms into an industry whenever profits rise above zero.  The most common forms of entry barriers (excluding legal and physical obstacles) are as follows:

• Economies of scale: for example, the benefits of bulk purchasing
• Cost of entry: for example, how much one would have to invest in new technology in order to compete
• Distribution channels: for example, competitors' ease of access
• Cost advantages that aren't related to the size of the company: for example, connections/contacts and expertise
• Government legislation: for example, new laws that might weaken a company’s competitive position
• Differentiation: for example, a certain brand that cannot be copied

 

2. The Power of Buyers:

Buyer power is one of the two horizontal forces. The most important factors that determine buyer power are the size and the concentration of customers. Buyer power is high when there are only a few large players in the market, such as large grocery store chains. It is also high if there are a large number of small suppliers supplying the large grocery store chains.

3. The Power of Suppliers:

This tends to be the opposite of the power of buyers. The switching costs are high (for example, switching from one software to another). The power of suppliers is also high where the brand is powerful (Microsoft, Mercedes, Pizza Hut, etc.).  If the customers are fragmented and not in clusters they will have little bargaining power (i.e. a gas station in a rural area).
 
4. The Threat of Substitutes:

The threat that substitute products pose depends on the price-to-performance ratios of the products or services. The threat of substitution is also affected by switching costs. In other words, the costs in areas such as redesigning and retraining that happen when a customer switches to a different type of product or service. It also involves:

• Product-for-product substitution (email replacing mail and fax) and substitution of need;
• Generic substitution;
• Substitution of products that people can do without (cigarettes, alcohol).

5. Degree of Competitive Rivalry:

The intensity of rivalry is probably the most obvious of the five forces. It helps determine to what degree the value will be affected by competition. The Porter's five forces analysis says that competition is only one of several factors that determine an industry's strength.

This force is always located at the center of the five forces chart.  It is bound to be high in those industries where there is a threat of substitute product and an existing concentration of suppliers and buyers in the market.