Porter's Five-Forces Model
Porter's Five-Forces Model
Porter's five-forces model is a strategy framework that provides corporations with clear analysis of their competitive strategies. The model was developed and advanced by Michael Porter, a renowned marketing strategist. Porter's five-forces model looks at the strength of five distinct competitive forces, which when taken together, determine long-term profitability and competition. Porter's work has had a greater influence on business strategy.
The five-forces model was developed in Porter's 1980 book, Competitive Strategy: Techniques for Analyzing Industries and Competitors. To Porter, the classic means of developing a strategy—a formula for competition, goals, and policies to achieve those goals—was antiquated and in need of revision. Porter was searching for a solution between the two schools of prevailing thought. One was centered on the Harvard Business School, and it urged firms to adjust to a unique set of changing circumstances. The other strategy, championed by the Boston Consulting Group, was based on the experience curve, whereby the more a company knows about the existing market, the more its strategy can be directed to increase its share of the market. Porter applied microeconomic principles to business strategy and analyzed the strategic requirements of industrial sectors, not just specific companies.
THE FIVE FORCES
The five forces are competitive factors, which determine industry competition and include: suppliers, rivalry within an industry, substitute products, customers or buyers, and new entrants (see Figure 1).
Although the strength of each force can vary from industry to industry, the forces, when considered together, determine long-term profitability within the specific industrial sector. The strength of each force is a separate function of the industry structure, which Porter defines as “the underlying economic and technical characteristics of an industry.” Collectively, the five forces affect prices, necessary investment for competitiveness, market share, potential profits, profit margins, and industry volume. The key to the success of an industry, and thus the key to the model, is analyzing the changing dynamics and continuous flux between and within the five forces. Porter's model depends on the concept of power within the relationships of the five forces.
Industry Competitors. Rivalries naturally develop between companies competing in the same market. Competitors use means such as advertising, introducing new products, more attractive customer service and warranties, and price competition to enhance their standing and market share in a specific industry. To Porter, the intensity of this rivalry is the result of factors like equally balanced companies, slow growth within an industry, high fixed costs, lack of product differentiation, overcapacity and price-cutting, diverse competitors, high-stakes investment, and the high risk of industry exit. There are also market entry barriers.
Pressure from Substitute Products. Substitute products are the natural result of industry competition, but they place a limit on profitability within the industry. A substitute product involves the search for a product that can do the same function as the product the industry already produces. Porter uses the example of security brokers, who increasingly face substitutes in the form of real estate, money-market funds, and insurance. Substitute products take on added importance as their availability increases.
Bargaining Power of Suppliers. Suppliers have a great deal of influence over an industry as they affect price increases and product quality. A supplier group exerts even more power over an industry if it is dominated by a few companies; there are no substitute products; the industry is not an important consumer for the suppliers; their product is essential to the industry; and forward integration potential of the supplier group exists. Labor supply can also influence the position of the suppliers. These factors are generally out of the control of the industry or company but strategy can alter the power of suppliers.
Bargaining Power of Buyers. The buyer's power is significant in that buyers can force prices down, demand higher quality products or services, and, in essence, play competitors against one another, all resulting in potential loss of industry profits. Buyers exercise more power when they are large-volume buyers, the product is a significant aspect of the buyer's costs or purchases, the products are standard within an industry, there are few changing or switching costs, the buyers earn low profits, potential for backward integration of the buyer group exists, the product is not essential to the buyer's product, and the buyer has full disclosure about supply, demand, prices, and costs. The bargaining position of buyers changes with time and a company's (and industry's) competitive strategy.
Potential Entrants. Threats of new entrants into an industry depend largely on barriers to entry. Porter identifies six major barriers to entry:
- Economies of scale, or decline in unit costs of the product, which force the entrant to enter on a large scale and risk a strong reaction from firms already in the industry, or accepting a disadvantage of costs if entering on a small scale.
- Product differentiation, or brand identification and customer loyalty.
- Capital requirements for entry; the investment of large capital, after all, presents a significant risk.
- Switching costs, or the cost the buyer has to absorb to switch from one supplier to another.
- Access to distribution channels. New entrants have to establish their distribution in a market with established distribution channels to secure a space for their product.
- Cost disadvantages independent of scale, whereby established companies already have product technology, access to raw materials, favorable sites, advantages in the form of government subsidies, and experience.
BARRIERS TO ENTRY STRATEGY
The six factors identified by Porter can be narrowed down into two major categories of barriers to entry; market barriers to entry and mobility barriers to entry. Market barriers to entry are the structural characteristics of a market, which favor established firms to the disadvantage of new entrants in the market in such a way that established firms enjoy the flexibility of raising prices over costs without attracting new entrants. Mobility barriers shield a firm operating in one segment of the market from entry by other firms operating in different segments of the same market.
Armstrong and Kotler reckon that barriers to entry as a strategy does not occur naturally and has to be initiated by organizations through anticipatory approach. The major strategies of barriers to entry commonly employed by established firms include adoption of sunk costs, squeezing of new entrants, and raising the costs of competitors.
Sunk costs are one of the most effective barriers to entry strategies that a firm can adopt. This is done by locking itself into a market in such a way that new entrants find it difficult to initiate and enforce counter strategies that would kick the incumbent firm out of business. A firm sinks costs through commitment of substantial capital towards purchasing, expanding, and sustaining its investment resources such as plant, machinery, equipments, and acquisition of advanced technologies which enable the firm to draw the advantages of low pricing through economies of scale. Dell, a leading manufacturer of personal computers, is one of the best examples of companies that have successfully applied this strategy. Dell has been able to retain the lion's share of the personal computer market for many years despite the entry of Macintosh Computers and even the subsequent merger of Hewlett-Packard and Compaq Computers because of the low pricing advantage that it draws from the economies of scale of its vast resources.
Squeezing of new entrants and raising the costs of a competitor are closely related strategies, which focus on creation of a difficult market environment; this denies competitors the likelihood of achieving positive returns on their investments. These strategies of barrier to entry involve introduction of measures such as increased expenditures on advertising, heavy research and development, minimization of access to channels of distribution, patenting of innovations, lowering of prices, optimization of government subsidies, and development of cheaper alternative product ranges in the same market.
New entrants can also expect a barrier in the form of government policy through federal and state regulations and licensing. New firms can expect retaliation from existing companies and also face changing barriers related to technology, strategic planning within the industry, and manpower and expertise problems. The entry deterring price or the existence of a prevailing price structure presents an additional challenge to a firm entering an established industry.
Whereas established firms may find it easy to manipulate the different strategies of barriers to entry according to prevailing market conditions, new entrants always find it difficult to break these barriers and may even run the risks of incurring heavy losses during the efforts to establish favorable market share for their products. It is equally important for management of established firms to adopt a balanced approach when implementing market barrier techniques against competitors and imitators by ensuring that additional costs incurred are appropriately recovered through increased sales volumes.
In summary, Porter's five-forces model concentrates on five structural industry features that comprise the competitive environment, and hence profitability, of an industry. Applying the model means, to be profitable, the firm has to find and establish itself in an industry so that the company can react to the forces of competition in a favorable manner. For Porter, Competitive Strategy is not a book for academics but a blueprint for practitioners—a tool for managers to analyze competition in an industry in order to anticipate and prepare for changes in the industry, new competitors and market shifts, and to enhance their firm's overall industry standing.
Throughout the relevant sections of Competitive Strategy, Porter uses numerous industry examples to illustrate his theory. Although immediate praise for the book and the five-forces model was exhaustive, critiques of Porter have appeared in business literature. Porter's model does not, for example, consider nonmarket changes, such as events in
the political arena that impact an industry. Furthermore, Porter's model has come under fire for what critics see as his under-evaluation of government regulation and antitrust violations. Overall, criticisms of the model find their nexus in the lack of consideration by Porter of rapidly changing industry dynamics. In virtually all instances, critics also present alternatives to Porter's model.
Yet, in a Fortune interview in early 1999, Porter responded to the challenges, saying he welcomed the “fertile intellectual debate” that stemmed from his work. He admitted he had ignored writing about strategy in recent years but emphasized his desire to reenter the fray discussing his work and addressing questions about the model, its application, and the confusion about what really constitutes strategy. Porter's publications on competitive strategies span across all spheres of business as demonstrated by his 2006 book titled Redefining Health Care: Creating Value-Based Competition on Results.
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