To sustain profitable growth, organizations have to repeatedly assess competition. However, one of the key frameworks for analyzing competition and getting insights is Porter’s Five Forces.
The framework was developed in 1979 by Harvard professor Michael E. Porter. This framework helps businesses analyze their industry and create strong strategies. By looking at five key competitive forces, companies can tackle threats, spot opportunities, and develop unique value propositions.
What’s Porter’s Five Forces Framework?
The framework is a helpful tool businesses use to determine their competition level in any industry. Before this, companies were analyzing direct competitors and internal forces only to make their decisions.
However, Michael Porter changed that perspective by emphasizing the importance of looking at the whole industry. He highlighted how external forces can greatly affect a company’s profitability and market position.
Porter identified five key factors, or forces, that influence competition:
The Power of Suppliers
The Threat of New Entrants
The Power of Buyers
The Intensity of Rivalry Among Existing Competitors
The Threat of Substitute Services or Products
In other words, even if you feel confident about your current competitors.
Understanding Porter’s Five Forces
When Porter wrote his article, strategic analysis often focused on various models and acronyms (like SWOT, BCG Matrix, and PEST). These models mainly looked at the internal dynamics of individual companies.
While these models did consider the competitive environment, they often did so in a vague way. For example, the "threats" and "opportunities" in SWOT analysis were too broad for those dealing with specific industry challenges.
Porter’s 1979 article also challenged the theoretical models taught in major business schools. This is where future strategists learned about a "perfectly competitive" market. This model assumed that no single company could influence prices, which is far from reality in most industries.
Porter started his article with a straightforward statement. The statement was, that the essence of strategy formulation is coping with competition. However, it was his next point that had a bigger impact: "Yet it is easy to view competition too narrowly and too pessimistically."
Instead of just seeing competition as a rivalry among current competitors, Porter expanded the idea to include four other forces.
Five Elements of the Framework Explained
Here we have explained the five key elements of Porter's Framework:
1. Threat of New Entrants
Competition is known to intensify when an industry produces profits, and this has remained true with every industry. In a highly flexible environment, new competitors challenge the existing firms by capturing a part of the demand within a short time span. Thus, it is affecting the profitability of established players.
New entrants might lower prices and provide appealing alternatives to what your industry currently offers.
A good example of this is when Apple launched the iPod and entered the music distribution industry. Apple took market share from existing companies and completely changed how we listen to music and audio today.
On the flip side, if there are high barriers to entry, it becomes much harder for new companies to threaten the profitability of your industry.
According to Porter, seven main factors affect how high these entry barriers are:
Supply-side Economies of Scale
If companies need to produce a lot to keep costs low, new entrants may need to start big or risk being at a cost disadvantage.
Network Effect
As more people use a product, it becomes more valuable, making customers less likely to switch to a new competitor. A strong brand can really help here.
Switching Costs
If it is expensive or difficult for customers to change suppliers, it raises the barrier for new entrants.
Capital Requirement
New companies often need a lot of money to start. However, if the industry is very profitable, investors might be willing to provide that money.
Unfair Advantage
Established companies may have benefits that are hard for new entrants to replicate, like patents, exclusive materials, strong brand recognition, or prime locations.
Unequal Access to Distribution Channels
New competitors may find it difficult to get their products into existing sales channels. They might need to find new ways to sell, such as low-cost airlines selling tickets directly on their websites.
Government Policies
The government regulations that get imposed on industries can determine the extent of the ease with which one can penetrate an industry. These are licensing requirements which have relative barriers to industry entry and subsidies which have the relative barriers to entry reduced.
2. Competitive Rivals
Porter's first force is what we usually think of when we talk about business competition. For example, we see rivalries like Pepsi vs. Coca-Cola in soft drinks. There can be a lot more examples when it comes to industry rivals.
Some of these rivalries are so strong that people almost divide into groups based on their preferences. We can see like the ones who own an iPhone, prefer Netflix over Hulu or drive a Ford. So, it is no surprise that we often see business competition as a battle between rivals.
These rivalries can lead to things like expensive marketing campaigns and price wars. It is normal to see fierce races to make small improvements that give one company an edge over another. These tactics can push companies to create better products. However, they can also hurt profits and create instability in the market.
Several factors influence how intense the competition is in an industry:
The Number of Competitors
Industry Growth
Similarities in the services or products
Fixed costs
Exit barriers
3. Bargaining Power of Buyers
In Porter’s Five Forces model, buyers are your customers. When buyers have strong power, they can lower prices, demand better quality or service, and create competition among companies. These often happen at the expense of the industry’s profits.
This is especially true when the number of customers is small, but there are many sellers within the market. Further, if a firm is highly dependent on a few customers, the ones that generate most of the income, thus the customers can exert even more power.
The final component is the cost to buyers for switching to another supplier is another crucial element. It should also be noted that where the switching costs are low it is the buyer who wields the power.
With so many choices available, consumers can push for better prices, more sustainable practices, and higher quality. This puts a lot of stress on brands to keep improving their products and stay competitive.
4. Threat of Substitution
Every product or service has alternatives if they are identical copies or different solutions that achieve the same goal. Substitute products can hurt industry profits when they provide better value in terms of price, quality, or convenience.
Here are some key factors that drive the threat of substitutes:
Comparable Functionality
A substitute doesn't have to be a perfect replacement but it should provide the primary reason for which the customer buys that product, even if they do it in a different manner.
Aggressive Pricing:
In particular, if the substitutes are cheaper, then more often they will be able to attract customers focused on the purchase of a product at a low price.
Higher Utility
If substitutes perform better than traditional options in important areas like speed, customization, risk, or user experience, people are likely to switch, even if they are used to the old options.
Latent Alternatives
Sometimes, new technologies or changes in regulations can suddenly make unexpected solutions viable, shaking up the industry.
For instance, digital platforms like Spotify and Netflix have quickly replaced physical video and music rentals because they offer on-demand convenience and lower costs. Similarly, mobile messaging apps have started to take away users from email and SMS by providing more features for free.
5. Bargaining Power of Suppliers
Suppliers are those strategic business intermediaries that offer the business inputs required for the production of goods and services which include inputs such as components and materials. It is observed that when suppliers have high bargaining power, they are free to increase prices or even decrease the quality of the product they provide without actually facing any penalties necessary.
If you have several suppliers to choose from, their power is lower, making it easier for you to switch if necessary.
For example, in the automotive industry, Volkswagen Group has many suppliers worldwide. It limits those suppliers' bargaining power. VW also has backup suppliers for each part. This allows them to shift demand easily.
On the other hand, many suppliers make only specific parts and depend heavily on the automotive industry, putting them at a disadvantage compared to VW.
This is true if you have few options, no substitute, and high switch-over costs, the power shifts to the suppliers. In such situations, dependence may lock you out in bargaining interests with a single supplier.
Final Thoughts
Porter's five forces model helps companies analyze their competitive environment by looking at the five key areas listed above.
The Porter has updated his ideas over the years. Still, the core principles of his model are still relevant today. Companies don’t succeed or fail just based on their products. They are also competing within industries that have their own unique rules and forces at work.
