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Porter 5 Forces Analysis

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A graphical representation of Porter's Five Forces

Porter's 5 forces analysis is a framework for the industry analysis and business strategy development developed by Michael E. Porter of Harvard Business School in 1979 . It uses concepts developed in Industrial Organization (IO) economics to derive 5 forces that determine the competitive intensity and therefore attractiveness of a market. Attractiveness in this context refers to the overall industry profitability. An "unattractive" industry is one where the combination of forces acts to drive down overall profitability. A very unattractive industry would be one approaching "pure competition". Porter referred to these forces as the micro environment, to contrast it with the more general term macro environment. They consist of those forces close to a company that affect its ability to serve its customers and make a profit. A change in any of the forces normally requires a company to re-assess the marketplace. The overall industry attractiveness does not imply that every firm in the industry will return the same profitability. Firms are able to apply their core competences, business model or network to achieve a profit above the industry average. A clear example of this is the airline industry. As an industry, profitability is low and yet individual companies, by applying unique business models have been able to make a return in excess of the industry average.

Strategy consultants occasionally use Porter's five forces framework when making a qualitative evaluation of a firm's strategic position. However, for most consultants, the framework is only a starting point or 'check-list' they might use. Like all general frameworks, an analysis that uses it to the exclusion of specifics about a particular situation is considered naive.

Porter's Five Forces include three forces from 'horizontal' competition: threat of substitute products, the threat of established rivals, and the threat of new entrants; and two forces from 'vertical' competition: the bargaining power of suppliers, bargaining power of customers.

According to Michael E. Porter, the five forces model should be used at the industry level; it is not designed to be used at the industry group or industry sector level. An industry is defined at a lower, more basic level: a market in which similar or closely related products and/or services are sold to buyers. Firms that compete in a single industry should develop, at a minimum, one five forces analysis for its industry. Porter makes clear that for diversified companies, the first fundamental issue in corporate strategy is the selection of industries (lines of business) in which the company should compete; and each line of business should develop its own, industry-specific, five forces analysis. The average Global 1,000 company competes in approximately 52 industries (lines of business).

Model/framework

The threat of substitute products
The existence of close substitute products increases the propensity of customers to switch to alternatives in response to price increases (high elasticity of demand).

buyer propensity to substitute
relative price performance of substitutes
buyer switching costs
perceived level of product differentiation

The threat of the entry of new competitors
Profitable markets that yield high returns will draw firms. This results in many new entrants, which will effectively decrease profitability. Unless the entry of new firms can be blocked by incumbents, the profit rate will fall towards a competitive level (perfect competition).

the existence of barriers to entry (patents, rights, etc.)
economies of product differences
brand equity
switching costs or sunk costs
capital requirements
access to distribution
absolute cost advantages
learning curve advantages
expected retaliation by incumbents
government policies

The intensity of competitive rivalry
For most industries, this is the major determinant of the competitiveness of the industry. Sometimes rivals compete aggressively and sometimes rivals compete in non-price dimensions such as innovation, marketing, etc.

number of competitors
rate of industry growth
intermittent industry overcapacity
exit barriers
diversity of competitors
informational complexity and asymmetry
fixed cost allocation per value added
level of advertising expense
Economies of scale
Sustainable competitive advantage through improvisation

The bargaining power of customers
Also described as the market of outputs. The ability of customers to put the firm under pressure and it also affects the customer's sensitivity to price changes.

buyer concentration to firm concentration ratio
bargaining leverage, particularly in industries with high fixed costs
buyer volume
buyer switching costs relative to firm switching costs
buyer information availability
ability to backward integrate
availability of existing substitute products
buyer price sensitivity
differential advantage (uniqueness) of industry products
RFM Analysis

The bargaining power of suppliers
Also described as market of inputs. Suppliers of raw materials, components, and services (such as expertise) to the firm can be a source of power over the firm. Suppliers may refuse to work with the firm, or e.g. charge excessively high prices for unique resources.

supplier switching costs relative to firm switching costs
degree of differentiation of inputs
presence of substitute inputs
supplier concentration to firm concentration ratio
threat of forward integration by suppliers relative to the threat of backward integration by firms
cost of inputs relative to selling price of the product.

This 5 forces analysis is just one part of the complete Porter strategic models. The other elements are the value chain and the generic strategies.

References

Brandenburger, A.M. and Nalebuff, B.J. (1995), "The Right Game: Use Game Theory to Shape Strategy", Harvard Business Review, Jul-Aug, pp.57-71
Coyne, K.P. and Sujit Balakrishnan (1996), "Bringing discipline to strategy", The McKinsey Quarterly, No.4
Grant, R.M. (2005), "Contemporary Strategy Analysis", Blackwell Publishing Ltd., Oxford (U.K.), 2005
Porter, M.E. (1979) "How competitive forces shape strategy", Harvard Business Review, March/April 1979.
Porter, M.E. (1980) "Competitive Strategy", The Free Press, New York, 1980.
Porter, M.E. (1985) "Competitive Advantage", The Free Press, New York, 1985.
Hunger, J. David & Wheelen, Thomas L. (2003) "Essentials of Strategic Management". New Jersey: Pearson Education Inc.
McGahan, A. (2004) "How Industries Evolve - Principles for Achieving and Sustaining Superior Performance". Harvard Business School Press, Boston, 2004

Six Forces Model

The Six Forces Model is a market opportunities analysis model, as an extension to Porter's Five Forces Model and is more robust than a standard SWOT analysis.

The following forces are identified:

Competition
New entrants
End users/Buyers
Suppliers
Substitutes
Complementary products/ The government/ The public

Criticisms of the 5 Force model

Porter's framework has been challenged by other academics and strategists such as Stewart Neill, also the likes of Kevin P. Coyne and Somu Subramaniam have stated that three dubious assumptions underlie the five forces:

That buyers, competitors, and suppliers are unrelated and do not interact and collude
That the source of value is structural advantage (creating barriers to entry)
That uncertainty is low, allowing participants in a market to plan for and respond to competitive behavior.

An important extension to Porter was found in the work of Brandenburger and Nalebuff in the mid-1990s. Using game theory, they added the concept of complementors (also called "the 6th force"), helping to explain the reasoning behind strategic alliances. The idea that complementors are the sixth force has often been credited to Andrew Grove, former CEO of Intel Corporation. According to most references, the sixth force is government or the public. Martyn Richard Jones, whilst consulting at Groupe Bull, developed an augmented 5 forces model in Scotland in 1993, it is based on Porter's model, and includes Government (national and regional) as well as Pressure Groups as the notional 6th force. This model was the result of work carried out as part of Group Bull's Knowledge Asset Management Organisation initiative.

It is also perhaps not feasible to evaluate the attractiveness of an industry independent of the resources a firm brings to that industry. It is thus argued that this theory be coupled with the Resource-Based View (RBV) in order for the firm to develop a much more sound strategy.