In the contemporary business world, strategic competitiveness has become a top priority for business leaders. Companies are keen on developing strong competitive advantages over their rivals to stay upbeat in the enormously growing competitive landscape. For that, what companies need to do effectively is to analyze the microenvironment or the competitor environment of the industry.
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This analysis will help companies efficiently assess their competitive position in the industry contingent on which they can develop new strategies to thrive amid the competition. To substantiate, the evaluation of the competitive environment will give companies effective insights into the state of rivalry, vulnerabilities of substitutes, and threats that prevail for companies in the industry.
However, the effectiveness of this competitor analysis will largely depend on the model of analysis being applied. While there could be different approaches to conducting microenvironment analysis to understand the competitive structure of an industry.
What is Porter's Five Force Model?
The Porter Five Forces Model offers the most elaborate scope of understanding all the intricacies of an industry's competitive environment.Porter's Five Forces Model, devised by Michael E. Porter, is a strategic framework that assesses an industry's competitive landscape. The model examines five key forces—threat of new entrants, bargaining power of buyers and suppliers, competitive rivalry, and threat of substitutes. By analyzing these forces, businesses can identify the attractiveness and profitability of an industry and make informed strategic decisions to gain a competitive advantage. But how does one create a worthwhile Porter Five Forces Analysis and what is the right approach to conducting it?
This comprehensive guide provides you with all the knowledge that you need to understand what Michael Porter's Five Forces Model is, its implications, and its application. To begin with, what we need to look at are the five key factors that the model describes as the five most important forces determining the success of a company in a competitive environment. The subsequent section talks about what are Porter’s five forces and how each of these forces can affect a business.
Delineation Of the Five Factors Explained By The Model
The Threat of New Entrants
In the context of the competitive environment of any industry, the threat that existing companies can have from new industry players is a vital factor for companies to consider. The threat of new entrants in any industry is determined by analyzing the barriers linked to the entry of new industry players.
Why companies need to look at the threat of new entrants is simply because of the fact that new companies in an industry can potentially affect the market share of the existing firms. Needless to say, new entrants will come to the scene with clear objectives of acquiring a strong customer base and hence, steal from the market share of existing companies. Besides, the entry of new companies in any industry also implies that the production capacity in the industry will see an upward trend hence, disrupting the balance between demand and supply. Moreover, new entrants would also mean that the consumers in the industry will have more choices.
Having said that, new companies in the industry will create a certain sense of urgency among the existing companies to boost efficiency and brace for greater competition in the market. These implications very well explain why ascertaining the threat of new entrants is so important for a company’s analysts to evaluate with respect to strategic planning.
Determinants Of The Magnitude of Threat of New Entrants
When do you think the threat of new entrants in a microenvironment is high? What are the key factors that determine whether the threat of new entrants is high or low? These sub-factors are listed below.
- Barriers to entry: If the barriers are not very complex or not way too much for new entrants such that they find them overwhelming, the threat of new entrants is high
- Customer switching costs: If the customer switching cost is low, the threat of new entrants will be high as customers can easily switch to the new entrants in the industry. However, if the switching costs are high, the threat is low.
- Government regulations: If there is a large number of restrictive regulations and norms set by the government, the threat of new entrants will be low. However, when there are little or no restrictions, the threat of new entrants is high.
- Possibility of retaliation: The threat will be low when current companies in the industry are more likely to retaliate against the new dimension of the competition initiated by new entrants. On the contrary, when there is little expectation of collective retaliation by existing companies, the threat of new entrants is high.
Bargaining Power of Buyers
Modern consumers are more aware than ever before and have the privilege to choose between different brands while making any sort of purchase. For companies, with respect to the analysis of the microenvironment, gauging the bargaining power of buyers in the industry is very imperative.
To elucidate, when the bargaining power of consumers is high, they can force companies in the industry to bring about some major transitions. Strong buyer communities can influence the prices as well the standards of quality offered by the enterprises in the industry. To explain, if we look at it from the perspective of consumers, they want the best possible quality at the least possible price.
Therefore, when the bargaining power of consumers is very high, they are likely to exert influence on the companies to improve quality, optimize service metrics, or reduce prices. The high bargaining power of consumers will directly imply that companies will have to readjust their strategies and operational tactics to deliver on the expectations of the buyers. In such a scenario, the profitability or revenue of a company may be negatively affected in the bid to retain customers.
Determinants of The Bargaining Power of Buyers
Probing further, it is also essential to identify the factors that influence the bargaining power of the buyers. These factors are listed below.
- The volume of buyers: The bargaining power of buyers is high when there are a few buyers and hence, customer retention becomes very important for businesses at all costs. To explain, when the number of buyers is less and each buyer accounts for a large share of purchases, the bargaining power of buyers is pretty high.
- Consumer switching costs: Consumer switching costs are inversely proportional to the bargaining power of buyers. The switching costs of customers are low when they have many companies to choose from, products in the industry do not have much price variations, and substitutes are easily available to them.
- Standardization of commodities: The bargaining power of buyers is quite high when the products or services are standardized. This is because when there is high standardization, buyers have many substitutes to choose from. For instance, in the grocery industry or consumer goods industries, the commodities are standardized.
- The threat of backward integration: When buyers have a reasonable influence to pose the threat of backward integration into the industry, the bargaining power is considerably high. To elaborate, backward integration is the process wherein a company buys a supplier of raw materials or other supplies needed for the production of the end product.
Bargaining Power of Suppliers
Next, having assessed the bargaining power of the buyers in the industry, it is equally imperative to evaluate the bargaining power of the industry’s suppliers. When if we delve deeper into the competitive environment in any industry, gauging the bargaining power of suppliers becomes essential.
To explain, suppliers can potentially influence the prices and the quality of goods and services in an industry. Moreover, suppliers can also manipulate the supply chain and expose an industry to supply chain crises to make companies agree to their demands. Hence, the kind of pressure that suppliers can actually exert on companies can have drastic repercussions on the companies’ profitability and revenue generation.
Determinants of The Bargaining Power of Suppliers
Moving forward, there are certain key determinants that provide an overview of the extent of bargaining power that suppliers have in an industry. These factors are listed below.
- Suppliers' reliance on the industry: The bargaining power of suppliers is subject to the kind of dependence they have on the industry. If the industry is the sole source of revenue generation for suppliers, suppliers will have little power, and companies will have greater bargaining power.
- Companies’ switching costs: If companies can easily switch between suppliers without having to incur high switching costs is also a key factor to determine suppliers’ power. Therefore, if the cost of switching is low for companies, the bargaining power of suppliers will be low and vice versa.
- Product differentiation: It is also to be considered if the products or supplies offered by suppliers are highly differentiated or not. If suppliers are supplying many products of different kinds, they will have greater bargaining power. However, if the supplier is only supplying one or two basic materials, the bargaining power of the supplier will be much lower than that of the company.
- Availability of substitutes: In case substitute vendors or suppliers are easily available to the companies in the industry, the suppliers’ influence will be very low. On the other hand, the bargaining power of suppliers will be high if there are only a few suppliers and replacements are not easy to find.
- The threat of forward integration: The bargaining power of suppliers is high when they can potentially force forward integration into the industry. Forward integration is when companies aim at advancing further in the supply chain to boost operational efficiency. For that, they acquire the companies in the next phases of the supply chain to eliminate third-party suppliers or dependence.
Threat of Substitutes
The competitive environment in an industry also needs to be looked at in terms of how convenient it is for buyers to switch between products. For instance, if we look at the beverage industry, consumers of carbonated drinks can easily substitute them with organic fruit drinks. Therefore, it becomes essential for any company to understand if their products have close and readily available substitutes or not. In case there is a high threat of substitutes, companies might have to bring modifications to their product portfolio or alter the composition of their products. Besides, companies may also be forced to drastically reduce the price of their products.
The greater the threat of substitutes, the more competitive the industry. The presence of a large number of substitutes available with great ease to the buyers will also push companies to improve their quality, introduce different channels of distribution and invest more in product marketing. Consequently, the profitability of companies in the industry will be impacted.
Determinants of The Magnitude Of The Threat of Substitutes
There are a few key influences that affect the possibilities of product substitution. These determining influences are enlisted below.
- Price of substitutes: The price of the substitute will play a key role in ascertaining the likelihood of substitution. If substitutes are available at lower prices to the consumers, the threat of substitution may be very high.
- Quality of substitutes: Next, the quality or performance of substitutes will also be a salient factor with respect to the vulnerability of substitution. If substitutes offer better or more improvised quality at a similar price, consumers will indeed be attracted to the idea of substitution.
- Customer switching costs: When substitutes are easily available and the switching costs of consumers are low, the threat of substitutes will be high. For instance, if we look at the quick-service restaurant industry, the cost of switching is very low and customers can easily switch from one QSR brand to the other. This explains why the threat of substitutes is enormously high in the QSR industry.
Degree of Rivalry
Ultimately, the last on the list of Porter's Five Forces is the degree of rivalry that is prevalent between the existing players in the industry. In fact, the degree of rivalry between existing competitors gives a realistic and practical overview of the competitive environment in the industry.
Its implication can be easily understood in the sense that a company’s profitability will be more vulnerable when there is a very high degree of rivalry in the industry. In the bid to fiercely compete with each other via aggressive marketing strategies or discount offers, the companies struggle to generate high profits.
Determinants of The Degree of Rivalry
Speaking of the factors that help in gauging the degree of rivalry in the industry, there is a need to comprehensively analyze each of them. The most influential determinants in this context are explained below.
- The balance between competitors: The degree of rivalry is high in two cases with respect to how competitors compare to each other. Firstly, the degree of rivalry is extremely high when there are many competitors functioning in the same industry. To exemplify, there are many competitors in the apparel industry and that explains why there is such fierce rivalry among apparel brands.
- Secondly, the degree of rivalry is extremely high even when there are only a few competitors but they are equally positioned. For instance, in the Indian market, there are only a few luxury passenger car brands competing. However, the likes of BMW, Mercedes, and Audi are almost equally positioned in terms of market share and that makes the rivalry very intense.
- Industry growth rate: Industry growth rate and future projections are also salient determinants in terms of assessing the degree of rivalry in an industry. It is noteworthy that the degree of rivalry is pretty intense in slow-growth markets. To explain, when the growth rate in an industry is miserably slow or not up to the mark, companies intensely compete with each other to acquire each other’s customers for a greater market share. To cite an example, the US aerospace and defense industry is expected to grow at a meager CAGR of 2.37 percent between 2022 and 2027 as per Mordor Intelligence. Since the growth rate of the industry is not promising, companies in the industry will be competing fiercely.
- Fixed costs and storage costs: Greater the fixed costs and storage costs in an industry the higher is the degree of rivalry. To explain, when these costs are high, companies aim at getting the maximum out of their production capacity and producing large volumes of goods. However, that leads to inventory management issues as stocks get piled up in the inventory. Thereafter, to manage inventory, companies sell products at discounted prices and hence the profitability remains low.
- Strategic stakes: The degree of rivalry is enormously high when the strategic stakes are too high for the existing enterprises in the industry. In simpler terms, the rivalry is fierce when it is paramount for the companies in the industry to perform exceptionally well to thrive in the market. At times, the very existence of an enterprise or its future can be at stake and then companies compete fiercely to do whatever it takes to sustain their business. For instance, after having to exit India, for Ford, the strategic stakes in other automotive markets are very high as it has lost a major market in India. Hence, Ford will look to give very tough competition to other automotive manufacturers in markets beyond India hence enhancing the rivalry in the global automotive industry.
- Exit barriers: A large number of exit barriers signifies that companies cannot easily exit the industry when they stop being profitable or face other issues. They will have to stay in the industry and keep competing because a large number of exit barriers may not allow them to walk out of the industry. Hence, in such scenarios, companies know that they cannot quit at will and they compete to remain competitive by going all guns blazing. Having said that, the higher the number of exit barriers the greater the degree of rivalry in the microenvironment.
- Product differentiation: Companies do not feel much pressure of rivalry in the industry when they have successfully developed differentiated products that perform well at satisfying consumers’ needs. However, when there is little differentiation or when products or services are pretty standardized, the degree of rivalry is high. For instance, insurance is a standardized service and all companies sell insurance plans with little or no differentiation. Hence, in the global insurance industry, there is intense competition.
- Switching costs: The rivalry is much fiercer when the switching costs are low. Companies know that customers can easily switch between products and brands and hence they always look to raise the bar of competitiveness to retain their customers as well as acquire new customers.
Now, you clearly understand what the Five Forces in the Porter’s Analysis Model actually are and what their implications are in terms of assessing and understanding the competitive environment. Having said that, you can now easily conduct Porter’s Five Forces Analysis to evaluate the microenvironment stating the competitive position. However, if you are looking to conduct an analysis of the macro-environment, conducting PESTLE analysis effectively would be the ideal strategic analysis approach and not Porter’s Five Forces.
Moving further, let us look at the steps that you need to apply while conducting the Porter’s Five Forces Analysis of any industry or for a real organization.
How To Do A Porter's Five Forces Analysis Of A Company
Define the Industry
Whenever you do the Porter’s Five Forces Analysis of a company, you first need to define the industry that the company falls in. For instance, if you are doing the analysis of BMW, you need to first clearly define the market. BMW is an automotive manufacturer falling into the luxury passenger vehicle industry.
Defining the industry correctly is essential for the purpose of the analysis as the correct identification of the industry is what is indispensable for further evaluating the microenvironment. In case the market or industry is not defined correctly, the analysis can lead to misleading conclusions.
Assess The Threat of New Entrants
After you have recognized the industry corresponding to which the microenvironment analysis is to be conducted, as discussed above, the first step is to assess the threat of the new entrants. As explained above in detail, the extent to which new entrants can pose a threat to an existing firm in the industry is subject to entry barriers and customer switching costs.
For a large company that has been in the industry for many years, the threat from new companies or startups will be low. This is for the simple reason that it will require massive investments from the new entrants to level up with the R&D and expertise of large corporations. You need to analyze if the company you are analyzing is in any way vulnerable to losing its market share to new entrants.
Examine The Bargaining Power of Buyers
Next, you need to assess the buyers in the industry to evaluate their bargaining power. You need to first determine if there are many buyers in the industry or a few buyers only who account for the maximum share of purchases. Secondly, you need to examine if the switching cost of customers with respect to making the switch to other products or brands is high or low.
In this way, you can evaluate if the company has a greater influence on the customers or vice versa. The company’s profitability and future prospects of advancement will be much higher when the bargaining power of customers is less.
Evaluate The Bargaining Power of Suppliers
Having examined the bargaining power of buyers, the next step is to determine the bargaining power of suppliers. You need to research about the supplier networks in the industry and how much power or influence the suppliers actually have to exert pressure on companies. In case there are many suppliers in the industry, their bargaining power will be low and the companies will have easily available substitutes for supplies.
Assess The Threat of Substitutes
Moving forward, the next step is to evaluate the threat of substitutes. As explained in an elaborate manner above, you need to see if there are quality or efficiency issues in the industry that substitutes can easily make up for. If that is the case, the threat will be much higher. Also, you need to evaluate if the products are standardized or differentiated. In the case of standardized commodities like in the case of the grocery retail industry, the threat of substitution is very real.
Determine The Degree of Rivalry
Going into the last of the five dimensions of competitiveness as per Porter’s Five Forces Analysis, you need to ascertain the degree of rivalry among the existing firms in the industry. This is where you need to go in-depth and individually examine each determinant that influences the rivalry in the industry. We have already explained above how each determinant has an impact on the magnitude of rivalry.
Focus on Conclusions and Actions
For every assessment that you do with respect to Porter’s Five Forces, you need to ultimately present rational conclusions in the analysis. Besides, in addition to the conclusion, you should also focus on actions that the company should take to mitigate any identified threats.
The Concept Of Attractiveness And Profitability
Attractiveness and profitability are two crucial dimensions that can be assessed with the successful application of Porter’s Five Forces Analysis model. After you have conducted the analysis and have closely scrutinized the microenvironment as per the five forces, you can figure out if the industry is attractive or unattractive.
When is an Industry Considered Attractive?
- When the entry of new firms or budding enterprises is difficult
- The extent of rivalry is limited
- The bargaining power of suppliers and buyers is low
- The threat of substitutes is very little
In this case, the industry will be attractive in the sense that the scope of generating higher profits will be much greater. The industry will attract companies to perform better with the aim of generating higher profits. To cite an example, the pharmaceutical manufacturing industry is an attractive industry with only a few players as it involves large R&D expenditures. The CAGR of the pharmaceutical industry is quite promising as it is expected to grow at a CAGR of 11.3 percent.
When is an Industry Considered Unattractive?
- It is easy for new entrants to establish themselves in the industry
- The rivalry between the existing companies is enormously high
- Buyers and suppliers are strong in terms of their bargaining power
- Switching costs are low and alternatives are readily available
Contrary to attractive industries, these industries will have lower profitability and revenue generation prospects. The grocery retail industry is an example of an unattractive industry given how suppliers and buyers in the industry have greater bargaining power than the companies.
To encapsulate, the Porter’s Five Forces Model is one of the most effective analysis tools that can be used to effectively analyze the competitive environment in a given industry. Porter’s five forces analysis of a company will help the organization identify and assess competitive threats. Subsequently, the company can plan new strategies and refine operational capabilities to stay ahead of the competition and eliminate potential threats.
Are there any limitations or criticisms of Porter's Five Forces Analysis?
Some limitations include its static nature, lack of consideration for external factors, and potential oversimplification of complex industry dynamics. Additionally, it may not be suitable for rapidly changing industries or emerging markets.
Can Porter's Five Forces be used in conjunction with other strategic frameworks?
Yes, businesses often use Porter's Five Forces alongside other models, such as SWOT analysis, to gain a comprehensive understanding of their situation.
Can Porter's Five Forces Analysis be used to evaluate individual companies?
While it primarily focuses on industry dynamics, some aspects of the model can be adapted to assess a company's competitive position within its industry.