What are Porter’s Five Forces?

Part of my role is to speak with businesses and understand what challenges they face. A standard part of setting up a business that can help with this is a SWOT analysis. SWOT analyses are a great tool, however, something that I’ve found really useful is Porter’s Five Forces. I found it to be a more comprehensive way of analysing the competition of a business. It draws on economics and the perfect competition and that of the imperfect competition found in the real world.

Professor Michael Porter who developed the five forces analysis is the most cited author in business and economics. He developed the Five Forces Model to help analyse a business in greater depth than the more widely used SWOT analysis. The Five Forces model analysis looks at the full business environment and not just the business. This gives the business a greater understanding as it looks in more detail at the opportunities and threats element of SWOT.

The Five Forces

The five forces Porter includes in his analysis comprise competition in the business sector, threats from new entrants into your business sector, the respective power of customers and suppliers and the threat of substitution of products and services from outside the business sector.

1. Competition in the business sector

Where new entrants pose an external risk to businesses, they also face competition from other established firms within the business sector. Generally, the number and capability of competitors is the main factor in determining the level of competition within a sector, but even excluding outright collusion, companies may adhere to informal codes of conduct that inhibit competition which is often viewed as anti-competitive.

Aspects that increase competition:

• A large number of businesses in the sector
• Low customer loyalty
• Slow market growth
• High fixed costs
• Barriers to exit

2. Potential of new entrants into your business sector

When a business has no competition, they can charge a high price for their product within reason. As more and more businesses enter the market, profits drop until joining the business sector is no longer appealing to new businesses looking to open. Barriers to entry also discourage new competition and monopolies can develop if they become sufficiently high.

Aspects that increase barriers to entry:

• Capital investment to start-up
• Specialist knowledge and expertise
• Economies of scale
• Key intellectual property
• Regulation

3. Power of customers

A business that has only one customer or just a few strong customers, these buyers have a significant impact on how the business operates. If a customer changes its specifications this can have an adverse effect on its suppliers i.e., Iceland decides to go palm oil-free, all its supplier must change their ingredients or stop supplying. The closer the buyer is to the supplier, the more power the customer has and can push for long credit terms or lower prices etc, which adversely affects the supplier.

Aspects to consider:

• Essentialness of product or service to the customer
• Price sensitivity to the customer
• Cost of switching to a new supplier to the customer
• The information available to customers
• The total size of the supply market

4. Power of suppliers

Suppliers in the business sector will be customers in another, so similar factors are at play (number of suppliers, cost of switching) but from a different perspective. An additional factor to consider is the specialisation of the supplier’s product, that is, whether they face threats of substitution.

Aspects to consider:

• Employee stability
• The ability of the customers to move production internally
• Strength of distribution channels
• Existence of commodity products or services
• Influence of supplied item on the cost

5. Threat of substitute or replacement products or services

Replacement products or services are not simply a different brand (BA vs. Virgin), but an alternative product or service altogether (flights vs. car vs. train). These alternatives aren’t competitors, but they do threaten to substitute and reduce customer demand. The demand elasticity of a product or service can be a good alternative for how vulnerable it is to substitution.

Aspects to consider:

• Relative prices of potential substitutes
• Cost of switching
• Customer loyalty or inertia
• Ease of switching
• Relative performance of potential substitutes

Summary

Although looking at the Five Forces model may seem complicated, in practice, it’s quite a straightforward process. It gives the benefit of truly understanding the market that you operate in. In a world where information accumulation and data analysis is becoming more essential, Porter’s Five Forces model is a great way for a business to develop a more thorough business strategy which can then increase your competitive advantage.

To that end, Porter identified three generic strategies that can be implemented in any business.

Cost leadership

Increase profits by reducing costs while charging average prices, or to increase your market share by reducing the price while retaining profits.

Differentiation

To implement this strategy, your company's products and services need to be significantly better than the businesses you compete with, improving their competitiveness and value to the customer. Implementing this necessitates thorough research and development, plus effective marketing and sales.

Focus

Successful implementation entails the company selecting niche markets in which to sell their goods. It requires an intense understanding of the marketplace, its sellers, buyers and competitors. 

More information on these strategies can be found in Porter's 1985 book, Competitive Advantage (Free Press).