This paper is a summary of Michael E Porter article on The Five Competitive Forces That Shape Strategy. On the time his article was published by Harvard Business Review in 1979, Michael was a young economist and an associate professor at the same time. Despite being his first article, it revolutionalized the strategy field. Porters five forces have been responsible for shaping the business practice as well as academic research. In his article, Porter clarifies the common misunderstandings, offers practical guidance and illustrates the deeper perspective of the strategy in today's world.
The primary goal of the strategy is to enable the strategist to understand and learn how to cope with competition. The major problem with managers is their definition of competition which is very superficial. They tend to think of competition on the basis of industry rivals which is wrong because this is just one of the five forces as defined by Porter. The five forces include:
Bargaining power of suppliers.
Threat of new entrants.
Bargaining power of buyers.
Threat of substitute products or services.
Rivalry among existing competitors.
These five forces affect all industries despite their different natures. The more intense the forces, the lesser the profits; the opposite is true. The industries affected by the intensity of the forces and hence little returns are the likes of airlines, hotels and textiles whereas the forces are benign in software, toiletries and soft drinks industries. It is for this reason that a good understanding of these competitive forces is important for a business to be profitable and to position it strategically.
The intensity and magnitude of these forces vary from industry to industry. For instance, in commercial airlines the dominant force is industry rivalry that exists between Airbus and Boeing and the bargaining power that each offers its clients. Meanwhile, other forces such as threat of substitutes, entry and power of suppliers are less significant. Another instance is the movie industry whereby substitute forms of entertainment pose a great competition and might affect the profitability of the same if not kept in check. Safe to say, the profitability of an industry is determined by the strongest competitive force. The weaker forces have little or no impact at all and their effects may not be so obvious.
We will now focus and evaluate each competitive force individually.
Threat of Entry
When an industry is faced with new entrants, they pose a threat in the sense that they will bring a new capacity to produced goods or services. This means that they will too have a desire of gaining the market share and one way of doing so is providing a cheaper alternative to the consumers who will most times fall for that. This will in turn put pressure on prices, costs and investment rates to the other companies in order to compete. The threat of entry cannot afford to be overlooked as it directly dictates the profit potential of an industry; especially ones that are not used to any sort of industry related competition. Industries tend to lower their prices and boost their investments upon new entrants threat.
However, there are seven major barriers to entry:
Supply-side economies of scale - This occurs whereby lower production costs per unit are enjoyed by firms that produce goods/services at larger volumes. This means for a new entrant to be successful, she has to join the industry on a large scale which is hard.
Demand-side benefits of scale - This has a lot to do with branding and customer loyalty to a company. Where customers are so loyal to one company in an industry, entrants are generally discouraged and less inclined to put up competition for fear of failing.
Customer switching costs These are the costs incurred by a consumer upon changing the initial company. Generally, consumers avoid these costs and for that reason they will stick to the same old company instead of venturing into a new one. This discourages new entrants.
Capital requirements Investing in a new industry requires lots of starting capital that the entrants may not be able to raise and this hinders them from investing in such.
Incumbency advantages independent of size An existing company will always have the upper hand against entrants and existing advantages that may not be so obvious and although entrants may try to bypass such, it will take them a lot of time and funds.
Unequal access to distribution channels Existing companies have sure distribution channels that the entrant must displace to earn a spot in the market and this is not always an easy thing.
Restrictive government policy The government can directly hinder the entrants into an industry through set policies.
The Power of Suppliers
Powerful suppliers can directly affect the profitability of an industry. They can do this by limiting quality, charging higher prices or shifting production costs. An industry that is not able to put up with such changes imposed by the powerful suppliers risks low profits on its investment.
The Power of Buyers
Meanwhile, powerful customers can also change the game in the industry. They have the ability of forcing down prices, demanding more quality as well as more service and this increases the selling cost per unit or shifting from one industry to another. Therefore, since they are powerful and profitable customers, no company would want to lose them. The respective industries are forced to give in to their demands in an attempt to keep them.
The Threat of Substitutes
A substitute gives a customer another alternative that may not be the same as yours but has similar functions that may not be so obvious. As earlier stated, a good example of a substitute is the Play Station which can affect the movie industry. Although the two are not exactly the same, they are both forms of entertainment and depending on the target consumers; they may actually choose Play Station over movies especially the teenagers and young adults. Substitutes are be easy to overlook since they may appear as not so obvious form of competition and give you the sense that they are different from the industrys product.
The substitutes threat is high especially when: the offers are attractive and affordable and the buyers cost of switching is minimal.
Rivalry among Existing Competitors
This is the main force of competition under which all other forces lie. Rivalry could be as a result of: discounts, product quality, customer loyalty, service improvements among others. This rivalry is intensified in the cases where the competitors are numerous, slow growth of industry, high exit barriers and high production capacities.
Although the five competitive forces that shape strategy are applicable to all sorts of industries, it is important to determine which forces greatly affect your industry and which ones can be overlooked to maximize on the profitability of the investment.
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