What are Porter’s 5 forces?
Porter’s 5 forces is a strategic model that allows you to identify, analyse and evaluate the main sources of competition in your industry. Essentially, it is a tool that helps you understand where your products or services stand in relation to your competitors at any given time.
It can give you valuable insights into the attractiveness of a market and inform your strategic decisions about how you position your products or services. The model is attributed to Harvard Business School professor Michael E Porter, who developed it in 1979. Porter’s work was groundbreaking at the time, and it is remains one of the most prominent market analysis tools to this day. The 5 forces of Porter’s model are:
- Competitive rivalry;
- Bargaining power of suppliers;
- Bargaining power of buyers (customers);
- Threat of substitution;
- Threat of new entrants.
How the model can help you
Porter’s 5 forces model is a powerful tool that can be useful for managers in various ways, including:
- It helps you to perform an insightful competitor analysis;
- You can grow your business and increase your market share by identifying and influencing the forces that you can control;
- You can identify ways to increase your profitability;
- It allows you to analyse changes in the market dynamics of your industry;
- It allows you to identify and develop strategies to combat the competitive forces in your industry.
Breakdown of Porter’s 5 forces
Below is a detailed overview of Porter’s 5 forces. You can use this information to assess the competitive position of your organisation in relation to the rest of your industry.
1. Competitive rivalry
The first force focuses on your competitors: how many there are, their individual strengths and weaknesses, and also how the quality and price of their products stack up against yours. You can get this information from an industry analysis or benchmark report.
Companies compete with each other in a variety of ways, including offering price discounts, introducing new products, improving existing products and services and launching marketing campaigns. The following factors can influence the intensity of competition in an industry:
- The number of competitors: When there are many competitors of roughly equal size and power, competition tends to be fiercer.
- High exit barriers: When it is difficult or expensive for a company to leave an industry, they decide to stay despite the market prospects being unappealing.
- Similar offerings: When companies offer very similar products or services, customers can easily switch, leading to more intense competition.
Strong competition among companies can lead to product innovation as companies try to gain a competitive advantage but can also drive down profitability when companies engage in price wars in an attempt to attract more customers.
2. Bargaining power of suppliers
Industries rely on suppliers for essential inputs – whether they be components, materials or services. If a supplier has strong bargaining power, it can choose to increase the prices for its products or services and lower the quality. When an industry has a small number of suppliers servicing a large number of companies, those suppliers are powerful because the companies are heavily reliant on them. Other factors that increase supplier power include:
- The number of industries a supplier serves: If a supplier serves multiple industries, it is less dependent on a single market.
- The uniqueness of the products or services it offers: For example, if a supplier offers patented products, companies may not be able to source the products from another supplier.
- How easily the products or services can be substituted: If a business can easily find a comparable product elsewhere, this reduces the supplier’s power.
- The cost of switching: Companies have a disincentive to change suppliers if the cost of switching is too high.
3. Bargaining power of buyers
Similar to suppliers, buyers (your customers) have more power when there are fewer of them and lots of sellers to choose from. If this is the case, losing even one customer could hit your bottom line hard. When buyers have strong bargaining power, they can demand lower prices, better service or higher quality. Some other factors that contribute to stronger buyer power include:
- The similarity of products in an industry: When buyers can get a comparable product elsewhere, it is easy to switch.
- Low cost of switching: Again, this makes it easier for buyers to take their business elsewhere.
- Purchasing volumes: Buyers have more power when they purchase in large quantities relative to the size of the seller.
- How easily the product can be produced: The buyer could threaten to start producing the product themselves.
If your business has low bargaining power relative to buyers, implementing a strong UX strategy could help by delivering unique value to customers and differentiating your business from your competitors.
4. Threat of substitution
A substitute product or service is one that meets customers’ needs by different means. Some examples of substitutions include:
- A smartphone can be used as a camera;
- Aluminium can be used instead of plastic;
- Video conferencing can be used instead of air travel.
So, while it’s important to monitor competitors who produce comparable products, you should also be aware of adjacent technologies that could disrupt your entire industry. If there are different products or services in other industries that can meet your customers’ needs just as well as your offerings, this will limit how high you can set your prices.
Identifying the substitution threat level is not always easy. For example, few taxi companies predicted that smartphones would pose a threat to their industry by creating a platform for the emergence of their biggest competitors – rideshare companies. However, consider whether there are many products or services that could perform a similar function to those that your business offers. If there are, the threat of substitution is high.
5. Threat of new entrants
New entrants are companies that enter the market and offer competing products and services for the first time. These new players can offer valuable new alternatives not currently available in your industry, put downward pressure on prices and reduce the market share of other firms in your industry. If it’s likely that new companies will enter the market, the threat of new entrants is high. Defending against newcomers can be expensive, so markets with a high barrier to entry are considered more attractive as the threat of new entrants is lower. Some of the main barriers to entry include:
- Supply-side economies of scale: Low cost per unit and high-volume production means that new entrants have to enter on a large scale or at a cost disadvantage.
- Network effect: A network of large and loyal customers forces newcomers to work hard to gain market share because customers will be reluctant to buy from a new company.
- Customer switching costs: The barrier to entry is higher if customers have to pay a high price to switch suppliers.
- Capital requirement: It is more difficult for newcomers to enter a market if it requires a large initial financial investment. However, if industry returns are high, investors may be prepared to loan new entrants the required capital, lowering the barrier to entry.
How to apply a 5 forces analysis
Now that you have an understanding of the forces that shape competition in your industry, it’s time to apply this knowledge and develop a competitive strategy. Having a competitive strategy in place can contribute considerably to the profitability and success of your organisation. Porter put forward three generic strategies that you can use to put your organisation in a strong competitive position. They are cost leadership, differentiation and focusing on a niche. Here is an overview of each of these strategies:
Cost leadership
The goal of this strategy is to target a broad market by becoming the lowest-cost producer in your industry. There are a variety of different sources of cost advantage depending on the industry. For example, a real estate agent could decide to offer a flat fee commission on property sales to undercut competitors and attract more customers.
Generally, this strategy involves cutting costs by offering a no-frills service. Look for ways that you can optimise your operating costs, for example, by using cheaper products or services, removing unnecessary products or processes and streamlining or outsourcing some processes. By adopting a cost leadership strategy, you can become an above average performer in your industry and maintain healthy profits.
Differentiation
This strategy is about finding ways to be unique. Firstly, identify the things that are important to your customers, and then find ways to uniquely position your business to meet those needs. For example, you could offer distinctive product features, provide higher quality products or services, exceptional customer service or new technology.
To successfully pursue this strategy, the company must have customers who are loyal to its brand. A major difference between this strategy and the cost leadership strategy is that offering unique products allows you to charge a higher price than your competitors.
Focus
Finally, to pursue a focus strategy, identify a segment or groups of segments in your industry – a niche – and focus on serving this niche better than your competitors. The focus strategy can be further broken down into:
- Focused cost leadership: become the lowest-cost producer in your niche.
- Focused differentiation: provide your segment of the market with unique, specialised products or services.
To make this strategy work, it’s important to have a deep understanding of your customers and identify ways that you can serve them more effectively than your competitors.
Key takeaways
Porter’s 5 forces model is a strategic framework first developed in 1979. It has since become one of the most popular and widely adopted strategy tools that organisations use to analyse the competitive forces in their industry. A key strength of the model is that it encourages you to consider not only your direct competitors, but also the broader environment – the power of different players in the market and the threats posed by new entrants and potential substitution. Understanding Porter’s 5 forces can help you to develop a more targeted strategy and place your organisation in a stronger competitive position.
