You have a great idea, and you want to start a business. You feel you have developed a great product or service for consumers to consider in the market. You believe that you can establish a great profit margin with your product or service and have a huge return on investments (ROI). Unless your product or service is the only one of its kind and doesn’t exist anywhere in the world, you should consider understanding Porter’s Five Forces Model prior to introducing your product to the market.
Dr. Michael Porter a Professor at Harvard Business School created the framework and concept known as “Porter’s Five Forces Model”. According to Dr. Michael Porter, “There are five competitive forces that shape strategy in an industry. Awareness of the five forces can help a company understand the structure of its industry and stake out a position that is more profitable and less vulnerable to attack.” The five forces that determine the competitive intensity of an industry are:
1. Threat of Entry
2. The Power of Suppliers
3. The Power of Buyers
4. Threat of Substitutes
5. Rivalry Amongst Existing Competitors
These five forces are critical for new business owners and entrepreneurs to understand prior to introducing their products or services into the market or entering into a specific industry. In this article I am going to provide a simplified explanation of the five forces in order for new business owners and entrepreneurs to understand their purpose.
Threat of Entry
– Every industry serves a limited market. Companies within a specific industry compete for a substantial share of that market. What happen when a new company enters the industry? The new company consumes a portion of the market. Pre-existing companies lose a portion of their customers and with that a portion of their revenue. If too many companies enter into the industry it affects the ability for companies to gain a significant share of the market. As the amount of suppliers in the industry increases it affects the overall demand for the products or services the companies are offering which affects offering price. “The threat of entry, therefore, puts a cap on the profitt potential of an industry. When the threat is high, incumbents must hold down their prices or boost investment to deter new competitors (Porter, 1979).” In order to protect the industry from new entries, pre-existing companies create barriers to prevent new companies from entering into the industry. Without going into detail, Dr. Michael Porter advises there are seven major sources incumbent companies use as advantages to entry barriers: Supply-side economies of scales, Demand-side benefits of scale, Customer switching costs, Capital requirements, Incumbency advantages independent of size, Unequal access to distribution channels, and Restrictive government policy.
The Power of Suppliers
– Suppliers are companies that create special supplies, raw material, personnel, or specialized equipment to service companies within specific industries. The power of a supplier depends on its size and financial strength. A supplier that service a variety of industries or offer a unique product or service that is not offered elsewhere could be extremely powerful especially when it comes to cost. A strong supplier can drive up cost and make it difficult for companies to increase their profit margin or pass those costs to its customers. “Powerful suppliers, including suppliers of labor, can squeeze profitability out of an industry that is unable to pass on cost increases in its own prices (Porter, 1979).
The Power of Buyers
– “Buyers are powerful if they have negotiating leverage relative to industry participants, especially if they are price sensitive, using their clout primarily to pressure price reductions (Porter, 1979).” Powerful buyers that purchase large amounts of goods or services from an industry could influence pricing in that particular industry. The powerful buyer could threaten to buy from a company’s competitor if it feels the company’s pricing is too high. Powerful buyers could also demand higher quality or increased service which may have the opposite affects and increase cost for the company it is purchasing from. It is extremely important as a new business owner or entrepreneur to create a product or service that is attractive to multiple buyers. Having a healthy portfolio of buyers with equal buying power would help alleviate having one buyer having to much influence.
Threat of Substitutes
– “When the threat of substitutes is high, industry profitability suffers. Substitute products or services limit an industry’s profit potential by placing a ceiling on prices… Substitutes not only limit profits in normal times, they also reduce the bonanza an industry can reap in good times (Porter, 1979).” The most important point a business owner or entrepreneur should understand about the threat of substitutes in an industry is how it affects demand and pricing. Substitute goods provide the consumer with an alternative from the preferred either directly or indirectly. Cross-elasticity of demand refers to the sensitivity in the amount demanded for one product or good to the price change of another product or good. In order to keep this simplified, if the consumer is highly sensitive to changes in price of a preferred good the demand for that good will decrease, while the demand for the substitute good will have a higher increase. “If an industry does not distance itself from substitutes through product performance, marketing, or other means, it will suffer in terms of profitability- and often growth potential (Porter, 1979).”
Rivalry Amongst Existing Competitors
– “High rivalry limits the profitability of an industry. The degree to which rivalry drives down an industry’s profit potential depends, first, on the intensity with which companies compete and, second, on the basis on which they compete (Porter, 1979).” Business owners and entrepreneurs should carefully study and analyze the number of companies within the industry in which they want to operate within, and how intense the rivalry is amongst those companies. Fierce rivalry within a saturated industry could wreak havoc on the profitability of that industry. Companies within an industry that is equal in stature and competing on the basis of price make it extremely difficult for that industry to be profitable. An example, companies that offer similar or identical products and services will often lower their prices on their products or services to gain a competitive advantage. As a new business owner or entrepreneur entering into a saturated industry having a price war makes it extremely difficult to make a profit, especially if the pre-existing companies have the advantage of economies of scale.
According to Porter, there are many factors that drive the intensity of rivalry and the basis in which companies compete. Business owners and entrepreneurs should conduct further research on Porter’s Five Forces Model to gain a deeper understanding of those contributing factors. In conclusion according to Porter, “Understanding the forces that shape industry competition is the starting point for developing strategy. Every company should already know what the average profitability of its industry is and how that has been changing over time. The five forces reveal why industry profitability is what it is. Only then can a company incorporate industry conditions into strategy.”
Porter, M. E. “How Competitive Forces Shape Strategy.” Harvard Business Review 57, no. 2 (March-April 1979): 137-145.
HarvardBusiness. “The Five Competitive Forces That Shape Strategy.” YouTube, YouTube, 30 June 2008, http://www.youtube.com/watch?v=mYF2_FBCvXw.