Translating an inspired idea into a robust business plan
005 Porter's Five Forces
The Five Forces were Porter’s conclusions on the reasons for differing levels of competition, and hence profitability, in differing industries. They are empirically derived, i.e. by observation of real companies in real markets, rather than the result of economic analysis. Porter’s Five Forces is a useful generic structure for thinking about the nature of industries. The definition of an industry is as follows: “The group of firms producing products that are close substitutes for each other” Michael Porter – Competitive Strategy
The understanding of the structure of an industry is the basis for the formulation of competitive strategy. The work of Porter provides an analytical framework for the analysis of the structural factors that condition competition within an industry and suggests several generic competitive strategies. Porter's 5 forces provide a framework for analysis of these structural factors.
An industry is not a closed system, competitors exit and enter, and suppliers and buyers have a major effect on the prospects and profitability of the industry. However, Porter points out that the structure of an industry will not change in the short term. Industry structure is something that irrespective of the general economic climate or short term fluctuations in demand fundamentally affects return on investment. Structural change is slow and often associated with political and labour conflict. Structural factors are often cited as holding back development and in some cases governments make funds available to mitigate social problems caused by structural change.
Threat of New Entrants
New entrants to an industry add capacity and if the capacity added is greater than growth in demand this will reduce profitability. The threat of new entrants is low in cases where:
industries are capital intensive
economies of scale are a key factor
access to resources is limited, e.g. mining concessions, limited radio spectrum, patents
access to distribution is problematic
buyer's switching costs are high
New entrants may not seek to replicate the value chain of existing firms, but focus on certain activities where barriers to entry are lower. For example, a firm may enter the market for a product, but subcontract the manufacturing to a low cost produced and concentrate on R&D, sales and marketing, and distribution. A business that has achieved economies of scale in one industry may be able to apply these economies in another industry. An example would be an electricity retail distributor who also starts to retail gas and telephone services, thus leveraging existing meter reading staff and billing systems.
The objective of competitive strategy should be to deter new entrants if this is possible. Where scale economies are important, pricing is a key weapon. However, when pricing become predatory regulators tend to step in to protect new entrants. In general, governments seek to foster competition and step in where structural factors prevent competition from emerging. An example is the ice cream industry where certain manufactures supplied freezers to retailers and prevented their use for other brands. Government intervention removed this barrier to entry. Incumbents must judge carefully how to use structural factors as a barrier to entry; used without political awareness, strategies that seek to prevent new entrants may backfire.
Bargaining Power of Buyers
The prices you can obtain have the single biggest impact on the profitability of your business. In most cases buyers shop around for best prices and thus exert downward pressure on prices. There are a number of factors which increase the power buyers:
Switching costs are low, which tends to be the case with commodity products. Therefore the extent to which products can be differentiated will have direct impact on prices. This is particularly true for consumer products where branding is a key differentiator.
Buyers are large compared with the supplying industry. For example, farmers selling to few vast supermarkets suffer from this.
In business to business markets buyers have the option of producing the product in-house, i.e. extend their value chain backwards. Not only is this a credible threat, but it also increase the buyers’ knowledge of the suppliers’ costs. Knowledge of suppliers' costs considerably increases the bargaining position of buyers.
The Threat of Substitutes
Substitute products are products that perform the same function or satisfy the same need as an existing product. The threat from substitute products is particularly severe if the substitute product is cheaper or more cost effective. Whole industries have been wiped out by substitutes, for example in Europe the replacement of silk by viscose rayon.
In the telecoms industry mobile networks have overtaken fixed networks and now multiple wireless access technologies compete with GSM /UMTS access. UMA technology and VoIP is likely to disrupt the traditional vertically integrated telecoms operator model. A strategy to deal with competition from substitutes is to start making or supplying also the substitute.
A substitute may only threaten part of the value chain, i.e. actually making the product, but logistics, retailing and branding remain unaffected. Such strategy is an option when dealing with manufactured products, but can also work in the service sector. For example, on short intercity routes the German airline Lufthansa offers a domestic "flight" that is actually a train journey or a bus trip.
The definition of a substitute product can be drawn rather wide and includes directly competing products and fairly unrelated products. Disposable incomes are finite and all companies that sell products and services to consumers compete for the same limited pot of money. To deal with this, competitors in an industry may decide to pursue jointly a generic advertising campaign, for example an advertising campaign for French wine in general rather for any particular brand.
Bargaining Power of Suppliers
The balance of power between suppliers and the supplied industry is a function of the relative fragmentation. For example, in an industry with many small suppliers and few large buyers, the bargaining power of suppliers will be weak. The latter point particularly applies to labour. This is why many companies try to limit the power of trade unions and try to avoid collective bargaining. In industries where inputs are commoditised and where there is ample availability of substitutes, provided switching costs are reasonable, the ability of suppliers to raise prices is limited.
Certain strategies, such as just-in-time manufacturing, or even just holding low stocks, increase dependency on suppliers. A strategy to reduce the bargaining power of suppliers is to maintain a diverse base of suppliers. This means suppliers should not be squeezed too much, recognising that the relationship between the industry and its suppliers is symbiotic.
The operational expenditure of your profit and loss account should be presented in a sufficient level of detail to identify major expenditure categories. The bargaining power of suppliers for these services or goods should be addressed in detail, and ideally there should be an analysis of the trend in pricing.
Rivalry Among Existing Firms
The intensity of competition, or rivalry, will have a significant impact on the ability to generate adequate margins. The intensity of rivalry or competition among firms competing in the same industry varies depending upon a number of factors:
Industries with one dominant firm tend to be more stable than fragmented industries where one competitor may try to achieve dominance. The degree of concentration or the extent to which the industry is monopolistic is an important aspect on how competitors are likely to behave. For example, in an oligopolistic situation, such as telecoms networks, price wars should be avoided. While avoiding price fixing, competitors can send out pricing signals to move towards a new level of lower or higher prices.
If an industry stops growing, for any competitor the only way of growing is by taking market share, i.e. competition will intensify until some competitors exit or consolidation takes place. In the case of commodity markets, i.e. undifferentiated products such as grain or computer RAM, competition focuses on price, which is particularly damaging to all manufacturers. Where there is scope for differentiation, price competition will be lower.
In markets where products or services are perishable, competition becomes more intense when sales have to be made. An example is last minute summer holiday bookings.