Porter's Five Forces: Revealing What Business Competition Really Is

Michael Porter’s five forces are a fundamental tool for anyone trying to understand the competitive landscape of an industry. Porter outlined five forces at play in any given market: internal competition, potential for new entrants, negotiating power of suppliers, negotiating power of customers, and the ability of customers to find substitutes. Think of it as another tool in your shed for devising a sound strategy — next to SWOT, PEST, ETPS, and so on. The strength of Porter’s model is the focus on the internal dynamics of companies, whereas methods like SWOT tend to be vague.

Porter’s article in 1979 started with: “The essence of strategy formulation is coping with competition.” It was then followed up: “Yet it is easy to view competition too narrowly and too pessimistically.” Thus he formed five forces to accommodate his thinking and help narrow-minded leaders of tomorrow. The first force is what we usually mean when we refer to “business competition”. Think Pepsi versus Coke for soft drinks, IOS versus Android for smartphone operating systems, Nike versus Adidas for sneakers, and Audi versus BMW for moderately-priced sports cars. Consumers literally split into different “camps” — Windows versus MacOS users, Netflix versus Hulu subscribers.

So it’s easy to see why we get pent up primarily on Porter’s first force: rivalry. We see it and experience it first-hand. The price wars, high-priced marketing gimmicks, and races for tiny technological steps are no secret. There are numerous competitors, each fighting fiercely for scraps of market share as you read this. The battle is more ferocious where the industry is declining — think global print and newspapers — because the pie is shrinking and firms want a larger slice for themselves. There is even more bloodshed when the products or services are similar — this is why Apple’s products are standout because they have built a strong brand with a loyal customer base. And the wars rarely end when you consider something which is difficult to exit — emotionally, by contract, or financially. Take, for example, the airline industry. How quickly can you shut down your airline in comparison to a coffee shop chain?

Porter’s second force is the potential for new entrants. If the market is easy to enter, each firm typically has low profit margins and a tiny slice of the market. Think the local restaurant sector. It’s relatively easy to enter: the upfront investment is low, and the legislative steps are surmountable for most people. This also means, however, that restaurants often don’t stay open for long, since the environment is hypercompetitive and new restaurants open shop constantly. This force is governed by scale: where you need to produce a lot of something to compete with your rival’s price. It also depends on product differentiation: where existing firms have strong brand identities (e.g. Apple, Inc.), it’s hard for new entrants to gain market share. Certainly the capital requirement: high startup costs deter new entrants, as is the case in the car manufacturing business.

The third force is supplier power. The more exclusive the product the supplier is providing, the more powerful they become. That is, when they are the only source of something important that a firm needs, they can charge premiums. The supplier can even reduce quality with little fear of losing business. There’s simply nobody to replace them if they provide a unique product which it is difficult to find a substitute for. Plus, if it’s costly for a firm to find and switch to another supplier, they have even more power.

Customers have power as well. When they have more strength, businesses are pressured into providing better products or services for lower prices. This is dependent on: the number of buyers (the fewer, the more powerful), the purchase size (why buying in bulk gets you better terms and discounts), the switching cost (where it’s easy to switch providers, companies have to offer competitive terms to keep up), price sensitivity (the more cost-conscious customers are, the lower the prices brands have to charge to attract them), and access to information (if customers are savvy and know the rival next door, businesses are forced to provide better prices). Porter also outlined a fifth, separate force: the presence of substitutes for a product or service. That force works because customers are willing to go elsewhere if it’s easy to switch to a substitute for better performance or a lower cost — think cable television to Netflix.

Real-life example of Porter’s five forces — the smartphone industry:

• Threat Of New Entrants (first force): high capital requirements and established brands (e.g. Apple Inc., Samsung Electronics) create a significant barrier to entry for new businesses.

• Bargaining Power of Buyers (second force): highly informed and price sensitive customers have more sway over the prices that businesses can charge for their products or services.

• Bargaining Power of Suppliers (third force): if there is a limited number of suppliers or if the product or service is unique, they get significant negotiation leverage, as is the case for components like processors and display panels.

• Threat of Substitutes (fourth force): where there is little threat of a substitute being chosen, the customer is forced to stay with one provider, such as the presence of tablets but the clear dominance of smartphones as the central device for communication.

• Competitive Rivalry (fifth force): industries marked with intense competition, constant innovation, and marketing battles are more fierce and harder to enter — not to mention compete in — for new firms.

How to use Porter’s five forces as a mental model (as outlined by Porter himself): (1) where are you fighting? — clearly describe the industry to focus your analysis; (2) who are you fighting? — specify and group the major actors in your sector into categories; (3) what are your strengths? — evaluate your firm and the industry its in to determine the better and worse paths you may take based on your strengths, according to the five forces above; (4) take the bird’s eye view — examine the overall industry, particularly the factors that influence how profitable it is; (5) apply the five forces — once you have done the above, Porter advises a detailed analysis of the five competitive forces, their positive and negative effects on your company, and planning for any possible changes in these forces in the future; (6) what do you influence? — pinpoint aspects of the industry that your firm has at least some control over, such as marketing and unique product development; (7) synthesize — combine your findings and formulate an overall business strategy (e.g. if the threat of entrants is high, build a loyal customer base with superior service).