In 1979, Michael Eugene Porter, the Bishop William Lawrence University Professor, Harvard Business School, submitted an article on “How Competitive Forces Shape Strategy” that revolutionized the strategy field. In his article, Porter highlighted how the five forces of competition affect the profitability of organizations and hence, the industry. In this article, I present his thoughts in an easy-to-comprehend manner such that readers can understand and apply the concept while formulating their corporate strategy. Read about Michael E. Porter here.
(1) Customers: The customers who are relatively large, the buyers who purchase in large volumes and the buyers who are few, enjoy more bargaining/negotiating leverage as compared to the industry participants, especially when the industry is price sensitive. These customers can derive more value by forcing down prices, demanding better quality, thereby driving up the costs, at the expense of industry’s profitability. Bargaining power increases because of the following:
- Buyers are few: They tend to play one vendor against another for its own benefit.
- Large volume buyers: Buyers who purchase in large volumes find such advantage in high fixed costs and low margin industries like telecommunications equipments, chemicals, etc.
- Standardized products: When the industry products are standardized, the customers can find an equivalent product, thus giving them more negotiating leverage.
- Low switching cost.
- Backward integration, if customers find their vendors too profitable.
(2) Suppliers: Similar to customers, powerful suppliers can derive more value by charging higher prices, limiting their quality of services or shifting their costs to industry participants. Microsoft is one such example. It dictates the PC market, and eroded the profitability of the PC makers by raising the prices of the Operating System (OS). It is near monopoly in the OS market because of its concentration than the industry in which it operates. Fragmented PC market is another reason. Suppliers enjoy such bargaining powers when:
- the switching cost is high
- they do not depend heavily/entirely on one industry
- there is no substitute for them
- they can threaten forward integration
(3) Competitors: Rivalry among the players impacts the industry’s profitability through price discounting, new product launches, services offerings and advertisements. The degree to which it drives down the profitability depends on the intensity of the competition. The intensity is highest when:
- There are too many players, approximately equal in size, supplying almost same kind of offerings.
- Industry growth is slow.
- Exit barriers are high.
Rivalry solely on price is destructive to the profit margins.
(4) New Entrants: New bees bring new capacity and ideas to the industry. They can pose a threat when they aim to gain market share. They affect the industry players’ price, cost and rate of investment. This especially holds good for entrants diversifying from other markets. These new entrants can shake up the competition by leveraging their existing capabilities and cash flows. Very good examples are Apple (iTunes in the music industry), Pepsi (bottled industry) and Microsoft (internet browser industry). The threat of new entry limits the industry’s potential profitability.
Barriers to entry are the key to new entrants. These barriers can be supply and demand side of the game, capital requirements, switching cost, access to distribution channels, government regulations, to name a few.
(5) Substitutes perform same/similar function that an existing industry product does, but by different means. For example, e-mail is a substitute of express mail. Substitutes are always present, but they can easily be overlooked. They can impact the profitability by putting a cap on it and increase the threat to a great extent when:
- the price-performance trade-off of the substitute is better and attractive, and
- the switching cost to a substitute is low.