Chapter 1 - Business Strategy
IN THIS LESSON
Self-Assessment – Porter’s Five Forces Analysis: Understanding the Competitive Landscape
Understand the Forces Affecting Profitability in Your Industry – Porter’s Five Forces
As you ramp up your start-up company in a market that you find attractive, you will increasingly become a more effective CEO when you better understand the competitive forces that are at work in your specific industry. These competitive forces will affect how much money you will make. The good news is that a standardized, structured way for you to understand these forces exists. It’s called Porter’s Five Forces.
Originally developed by Harvard University professor Michael Porter four decades ago, Porter’s Five Forces model helps you better understand the forces – in other words, the dynamics, or factors — that shape your industry, your competition, and the market in which you are selling or will sell.
It’s a business strategy tool that provides a framework to enable you to gain key insights. Porter’s Five Forces will help you understand your company’s current competitive position and give you useful information for moving into a stronger position over time.
Some experts have described Porter’s Five Forces as helping you determine where the “power” resides. Who has the most power in your industry – competitors, customers, suppliers, vendors? Strong power can result in price pressure and the degree and speed of substitution – all affecting you and your business.
To be a successful entrepreneur, you need to understand the competitive environment, identify your company’s favourable position within the context of the five forces, and take advantage of it. At the same time, you can help yourself by facing the reality of forces presenting challenges to your business to make profitability tougher to achieve and, thereby, give you an opportunity to avoid making mistakes.
The Five Forces in Porter’s model are:
[1] Supplier power
The first four forces result in the fifth force
[5] Competitive rivalry
[2] Buyer power
[3] Threat of substitution
[4] Threat of new entry
Let’s take a look at each one in more depth. At the end, you can do this analysis for your business, using a blank template that we provide.
1. Supplier power
The power of suppliers is largely determined by how easily suppliers can raise prices, as well as how much you need them. Their power – whether low or high – will affect your profitability. When many suppliers exist in your industry, then you have expedient alternatives where you can go if one supplier increases prices and tries to affect your profits in an effort to improve their own profits. This puts you in a strong position. However, when there are fewer suppliers, you are in a weaker position because you are more reliant on this small number of suppliers. They can charge you more, obviously affecting your financials. Action for You: To understand this force, you need to assess how many suppliers and potential suppliers you have, and how special or unique each supplier’s offering is. You should also determine up-front the cost of switching from one supplier to another.
2. Buyer power
The power of buyers is rated on how strong they are to dictate terms to you, especially pricing. When you sell to only a few customers who want to wheel and deal in negotiations, those buyers have more power because they can drive your prices down. Clearly, you are beholden to them. However, if you are selling to many customers, the power of your company increases. If one customer demands lower prices that would hurt your revenues, you can walk away from them and focus on the customers who are committed to you and are buying your product or service. Action for You: A first step is for you to size the market by assessing how many potential customers exist in your target market. Is it dozens or hundreds or thousands? You can write out a profile of the type of customer you are targeting and then do research on how many of those exist.
You should understand the cost of a customer switching from your product to a competitor’s product. This will tell you whether a customer is likely to switch quickly, or if they standardize on your product or service, they may be less likely to switch, albeit they may still negotiate hard on terms.
3. Threat of substitution
To understand your market, you need to grasp how likely is it for your customers to substitute your product with the product (or service) of another company. Let’s say you started a software business, providing enterprise monitoring tools. If you are providing an on-premises monitoring tool, but there are a dozen cloud-based monitoring tools out there on the market with similar functionality but at a lower cost and less complexity, you are at greater risk of losing business. In this scenario, you’d find yourself with lack of competitive differentiation, which would affect your profitability. Substitutes are not direct competitors; they are just alternatives. For example, ADP is a payroll processor. A substitute is a company that offers software that allows a company to process its own payroll. Action for You: You need to think about whether a substitution is too easy and/or low cost for a customer to make.
4. Threat of new entry
The ability of other companies to enter your industry will impact your position in the market. The threat of new competitors entering the market is a force that cannot be taken lightly. Think about how easy it would be for competitors to come into the market, especially when you start making money. Experts refer to the ease or difficulty of entering a market as “barriers.” Are the barriers to entering your market high (difficulty) or low (ease)? If the barriers to entry are low because it takes small amounts of money and little effort to enter your market, then competitors will be able to enter it rapidly and challenge your position in the market. However, if the barriers are high because it takes loads of money, effort, and expertise, then your company is more likely to benefit from a strong position, which would likely preserve your profitability in a more sustained manner. Action for You: You should work to understand the barriers to entry, shaping the threat to entry. If you invest large amounts of money into a venture that has low barriers to entry, you will need to adjust your expectations for profits.
5. Competitive rivalry
By doing the above four forces, you gain insight into competitive rivalry. In other words, the force of Competitive Rivalry is the result of the other four forces. With this force, you assess how many competitors your business has – and who are they. You evaluate the strength of your rivals and how your company’s offerings compare and contrast with the offerings of your competitors. When you determine that competitive rivalry is low, you are more likely to be more profitable because no other company can deliver to the marketplace what your company can deliver. Your business will have more strength. However, when competition is intense, your business will be more susceptible to the price reductions that competitors do. You do not want to be caught off-guard. Competitors will often get more aggressive in marketing as well.
In an industry with many competitors, you will also find that customers and suppliers will be quicker to walk away from your company if they are not getting what they want. It’s a question of leverage. Who has more leverage in the business negotiation? Also, how much risk can you take? You may have a great product, but if competitors can undercut you on price for a comparable product, and customers can easily go elsewhere for a similar solution, then this “force” may be working against you and can put you at a disadvantage.
Action for You: Before draining your financial resources, you may need to reassess and retool your strategy in light of this force.
EXAMPLE
Below is an example of using Porter’s Five Forces to evaluate Boeing’s Commercial Airlines business:
ADDITIONAL TIPS
An early stage of an industry that is starting to take shape is likely to be turbulent.
If there are at least three competitors in the emerging industry, Porter’s Five Forces can be extremely useful, as you measure your company’s own competitive position and aim to improve it over time.
In a more established industry, information about the competitive landscape is usually more readily available.
Five Forces Example using Boeing:
Porters Five Forces – Boeing Example.pptx