Porters 5 Forces and VRIO Analysis
Porter's Five Forces of Competitive Position Analysis were developed in 1979 by Michael E Porter of Harvard Business School as a simple framework for assessing and evaluating the competitive strength and position of a business organisation.
This theory is based on the concept that there are five forces that determine the competitive intensity and attractiveness of a market. Porter’s five forces help to identify where power lies in a business situation. This is useful both in understanding the strength of an organisation’s current competitive position, and the strength of a position that an organisation may look to move into.
Strategic analysts often use Porter’s five forces to understand whether new products or services are potentially profitable. By understanding where power lies, the theory can also be used to identify areas of strength, to improve weaknesses and to avoid mistakes.
Porter’s five forces of competitive position analysis:
The five forces are:
1. Supplier power. An assessment of how easy it is for suppliers to drive up prices. This is driven by the: number of suppliers of each essential input; uniqueness of their product or service; relative size and strength of the supplier; and cost of switching from one supplier to another.
2. Buyer power. An assessment of how easy it is for buyers to drive prices down. This is driven by the: number of buyers in the market; importance of each individual buyer to the organisation; and cost to the buyer of switching from one supplier to another. If a business has just a few powerful buyers, they are often able to dictate terms.
3. Competitive rivalry. The main driver is the number and capability of competitors in the market. Many competitors, offering undifferentiated products and services, will reduce market attractiveness.
4. Threat of substitution. Where close substitute products exist in a market, it increases the likelihood of customers switching to alternatives in response to price increases. This reduces both the power of suppliers and the attractiveness of the market.
5. Threat of new entry. Profitable markets attract new entrants, which erodes profitability. Unless incumbents have strong and durable barriers to entry, for example, patents, economies of scale, capital requirements or government policies, then profitability will decline to a competitive rate.
Arguably, regulation, taxation and trade policies make government a sixth force for many industries.
What benefits does Porter’s Five Forces analysis provide?
Five forces analysis helps organisations to understand the factors affecting profitability in a specific industry, and can help to inform decisions relating to: whether to enter a specific industry; whether to increase capacity in a specific industry; and developing competitive strategies.
In practice:
Porter's Five Forces of Competitive Position Analysis
Analysis of the Indian business environment
In the June 2010 issue of Financial Management magazine, the Five Forces model was applied to the emerging Indian business environment in comparison with more developed markets. The analysis found that factors such as state protectionism and a lack of infrastructure are greater barriers to entry in India than they are in more developed nations, where market forces are more powerful.
The analysis highlighted many issues affecting competition in emerging economies and compared them to those that are more prevalent in more developed markets.
One factor that could play a crucial role in India is public opinion, which exerts a considerable influence on the government. A good example of this is a campaign by local retailers against Walmart, who feel that the arrival of the US retail giant could put them out of business. Walmart has made huge investments in India, but is having to find ways around stringent regulations that prevent it from doing things as basic as putting its brand name on stores.
VRIO framework is the tool used to analyze firm’s internal resources and capabilities to find out if they can be a source of sustained competitive advantage.
Understanding the tool
In order to understand the sources of competitive advantage firms are using many tools to analyze their external (Porter’s 5 Forces, PEST analysis) and internal (Value Chain analysis, BCG Matrix) environments. One of such tools that analyze firm’s internal resources is VRIO analysis. The tool was originally developed by Barney, J. B. (1991) in his work ‘Firm Resources and Sustained Competitive Advantage’, where the author identified four attributes that firm’s resources must possess in order to become a source of sustained competitive advantage. According to him, the resources must be valuable, rare, imperfectly imitable and non-substitutable. His original framework was called VRIN. In 1995, in his later work ‘Looking Inside for Competitive Advantage’ Barney has introduced VRIO framework, which was the improvement of VRIN model. VRIO analysis stands for four questions that ask if a resource is: valuable? rare? costly to imitate? And is a firm organized to capture the value of the resources? A resource or capability that meets all four requirements can bring sustained competitive advantage for the company.
Valuable
The first question of the framework asks if a resource adds value by enabling a firm to exploit opportunities or defend against threats. If the answer is yes, then a resource is considered valuable. Resources are also valuable if they help organizations to increase the perceived customer value. This is done by increasing differentiation or/and decreasing the price of the product. The resources that cannot meet this condition, lead to competitive disadvantage. It is important to continually review the value of the resources because constantly changing internal or external conditions can make them less valuable or useless at all.
Rare
Resources that can only be acquired by one or very few companies are considered rare. Rare and valuable resources grant temporary competitive advantage. On the other hand, the situation when more than few companies have the same resource or uses the capability in the similar way, leads to competitive parity. This is because firms can use identical resources to implement the same strategies and no organization can achieve superior performance.
Even though competitive parity is not the desired position, a firm should not neglect the resources that are valuable but common. Losing valuable resources and capabilities would hurt an organization because they are essential for staying in the market.
Costly to Imitate
A resource is costly to imitate if other organizations that doesn’t have it can’t imitate, buy or substitute it at a reasonable price. Imitation can occur in two ways: by directly imitating (duplicating) the resource or providing the comparable product/service (substituting).
A firm that has valuable, rare and costly to imitate resources can (but not necessarily will) achieve sustained competitive advantage. Barney has identified three reasons why resources can be hard to imitate:
- Historical conditions. Resources that were developed due to historical events or over a long period usually are costly to imitate.
- Causal ambiguity. Companies can’t identify the particular resources that are the cause of competitive advantage.
- Social Complexity. The resources and capabilities that are based on company’s culture or interpersonal relationships.
Organized to Capture Value
The resources itself do not confer any advantage for a company if it’s not organized to capture the value from them. A firm must organize its management systems, processes, policies, organizational structure and culture to be able to fully realize the potential of its valuable, rare and costly to imitate resources and capabilities. Only then the companies can achieve sustained competitive advantage.
Using the tool
Step 1. Identify valuable, rare and costly to imitate resources
There are two types of resources: tangible and intangible. Tangible assets are physical things like land, buildings and machinery. Companies can easily by them in the market so tangible assets are rarely the source of competitive advantage. On the other hand, intangible assets, such as brand reputation, trademarks, intellectual property, unique training system or unique way of performing tasks, can’t be acquired so easily and offer the benefits of sustained competitive advantage. Therefore, to find valuable, rare and costly to imitate resources, you should first look at company’s intangible assets.
Finding valuable resources:
An easy way to identify such resources is to look at the value chain and SWOT analyses. Value chain analysis identifies the most valuable activities, which are the source of cost or differentiation advantage. By looking into the analysis, you can easily find the valuable resources or capabilities. In addition, SWOT analysis recognizes the strengths of the company that are used to exploit opportunities or defend against threats (which is exactly what a valuable resource does). If you still struggle finding valuable resources, you can identify them by asking the following questions:
- Which activities lower the cost of production without decreasing perceived customer value?
- Which activities increase product or service differentiation and perceived customer value?
- Have your company won an award or been recognized as the best in something? (most innovative, best employer, highest customer retention or best exporter)
- Do you have an access to scarce raw materials or hard to get in distribution channels?
- Do you have special relationship with your suppliers? Such as tightly integrated order and distribution system powered by unique software?
- Do you have employees with unique skills and capabilities?
- Do you have brand reputation for quality, innovation, customer service?
- Do you do perform any tasks better than your competitors do? (Benchmarking is useful here)
- Does your company hold any other strengths compared to rivals?
Finding rare resources:
- How many other companies own a resource or can perform capability in the same way in your industry?
- Can a resource be easily bought in the market by rivals?
- Can competitors obtain the resource or capability in the near future?
Finding costly to imitate resources:
- Do other companies can easily duplicate a resource?
- Can competitors easily develop a substitute resource?
- Do patents protect it?
- Is a resource or capability socially complex?
- Is it hard to identify the particular processes, tasks, or other factors that form the resource?
Step 2. Find out if your company is organized to exploit these resources
Following questions might be helpful:
- Does your company has an effective strategic management process in organization?
- Are there effective motivation and reward systems in place?
- Does your company’s culture reward innovative ideas?
- Is an organizational structure designed to use a resource?
- Are there excellent management and control systems?
Step 3. Protect the resources
When you identified a resource or capability that has all 4 VRIO attributes, you should protect it using all possible means. After all, it is the source of your sustained competitive advantage. The first thing you should do is to make the top management aware of such resource and suggest how it can be used to lower the costs or to differentiate the products and services. Then you should think of ideas how to make it more costly to imitate. If other companies won’t be able to imitate a resource at reasonable prices, it will stay rare for much longer.
Step 4. Constantly review VRIO resources and capabilities
The value of the resources changes over time and they must be reviewed constantly to find out if they are as valuable as they once were. Competitors are also keen to achieve the same competitive advantages so they’ll be keen to replicate the resources, which means that they will no longer be rare. Often, new VRIO resources or capabilities are developed inside an organization and by identifying them you can protect you sources of competitive advantage more easily.