Understand a business

If you want to know about an industry maybe you are a student, or somebody thinking about starting a business or even someone already working in the industry and want to deepen your understanding, what will you do?

Speak to few people to get their perspective, well that’s a start; but depending just on that will limit your view to the understanding of people you have spoken to.

We need a systemic way to understand the industry. How do we do it?

Thankfully Michel E Porter known as the best strategic thinker of the world has a framework to share called Porter’s five forces.

Porter’s five forces is an analytical framework to evaluate the profit potential and level of competition in any industry. It is especially useful when starting a new business or when entering a new industry sector.

If you look at a house blueprint —its structure immediately gives you important information about the house, what will be its shape and how it creates living space?

The structure is made up of elements common to all houses:

1.      The foundation

2.      The walls

3.      The roof

Porter's five forces framework does the same to get you important information about an industry by looking at its structure.

The particular configuration of Porter’s five forces tells you immediately how the industry “works,” how it creates and shares value.

These five forces are

1.      The bargaining power of customers 

2.      The bargaining power of suppliers,

3.      The threat of substitutes, and

4.      The threat of new entrants

5.      The intensity of rivalry among existing competitors,

Five forces analysis answers the key question, what’s going on out there in your industry? Before we understand these five forces a little bit about why a business exists.

What do you think? Business for profit exists to make a profit by providing a service or a product that its customers value.No profit no business. And what is Profit? It is what you get to keep after deducting the cost from the Price or earnings.

Profit = Price – Cost

Costs include all of the resources used in competing, including the cost of capital. Prices reflect what customers are willing to pay as they weigh their alternatives.

Now that you understand profit it is easy to see how these five forces impact this equation and determine the profitability of any industry or company.

First force: The bargaining power of customers 

If your company has powerful customers, they will use their clout to force prices down. They may also demand that the company put more value into the product or service.

This is very common in Business to Business setups when a big corporate or industrial buyer has the clout to push your prices down and you tend to accommodate it for the size of the order.

However, the same company selling their product to the retail customers will charge a much better price and profitability because each customer individual customer represents a very tiny part of the business and can’t impact the prices on their own.

Second force: The bargaining power of suppliers

If your company has powerful suppliers, they will use their negotiating leverage to charge higher prices or to insist on more favorable terms lowering the company’s profitability. Makers of personal computers (PCs) have long struggled with the market power of both Microsoft and Intel. These are hardly any alternates to these suppliers so that charge a premium while any PCs or laptops are as good as the other one and can be replaced.

If you noticed in both these forces of Buyers and Suppliers there are few factors which increase their power and hence lower the profitability of an industry or company:

1.      How big they are vs a fragmented set of multiple entities,

2.      How many alternates are there – fewer alternates for you as a company more is your dependency and hence less profitability and

3.      How differentiated the product is- more generic the product less is your profitability as a company.

The third force: The threat of substitutes 

Substitutes are products or services that meet the same basic need as the industry’s product in a different way—put a cap on industry profitability. It is not a direct competition but an offering that can be used to solve the same customer problem.

Consider flying from Delhi to Jaipur but then the rail journey is super comfortable and considerably cheaper. And since the road is also quite good so buyers also choose to hire a cab for the same journey. So more substitutes available for a product or service profitability tend to go down.

Fourth force: The threat of new entrants

Entry barriers protect an industry or company from newcomers who would add new capacity and seek to gain market share. Higher profits attract the attention of new players to jump into the fray but once the market is crowded everybody struggles for profits as buyers have multiple alternatives for similar products.

When are entry barriers high?

1.      Capital intensive industries like infra and pharma have high entry barriers.

2.      Companies with huge scale economies like Walmart which can procure stuff at very cheap price from their supplier’s vs the competition

3.      Companies with network effects like Facebook were because of the presence of all your friends on one platform make it difficult to shift to a new platform.

Fifth force: The intensity of rivalry among existing competitors 

The industry where rivalry among the competitors is intense, profitability will be lower. Price competition is the worst form of rivalry for companies. It usually happens because the product offered is very similar and also if the product is perishable and will result in a loss if not sold. The airline and hotel industry has a high impact on this force pushing the profitability down.

When Netflix started in India it charged a premium price but soon the market was crowded by similar quality streaming services like Amazon Prime, Youtube, Disney plus, and dozens of regional and mostly free services. Result Netflix had to introduce a cheaper and mobile-only plan for India limiting its profitability per subscriber.

These are the five forces that impact the profitability of any business

The five forces framework applies in all industries for the simple reason that it encompasses relationships fundamental to all commerce: those between buyers and sellers, between sellers and suppliers, between rival sellers, and between supply and demand. Think about it. This covers all of the bases. The five forces are universal and fundamental.

Memorizing the five forces won’t make you a better business thinker. What matters that you grasp the deeper point which is: there are a limited number of structural forces at work in every industry that impacts profitability in a predictable way.

A good five forces analysis allows you to see through the complexity of competition, and it opens the way to a host of possible actions you can take to improve performance.

As an example, Apple was successful to create a strong market for its Mac books despite the powerful alliance of Microsoft and Intel. It did this by making an extremely well-designed machine developing its own software and processors and made it a matter of pride to own one. This it did despite fierce competition and powerful suppliers and buyers who had cheaper choices available by making these forces work for them.

**PS: The piece is a part of the strategy series aiming to make the subject more accessible for everybody. If you found this useful share it with someone who might benefit from the same.

Here are the first two parts of the strategy series:

1) How Apple came back from dead

2) What is Strategy?