What Are Porter's Five Forces?
Michael Porter's five-force strategic analysis model, introduced in a 1979 article published in the Harvard Business Review, remains a fundamental tool for strategic analysts plotting the competitive landscape of an industry.1 In a bid to mirror the complexity real strategists would face while keeping their strategic analysis manageable, Porter set out five forces at play in a given industry: internal competition, the potential for new entrants, the negotiating power of suppliers, the negotiating power of customers, and the ability of customers to find substitutes. Below, we take you through each of Porter's five forces, detail the significant critiques of his approach, and show how to apply the model to specific markets.


 

When to use Porter's Five Forces

Business owners, managers and marketers use Porter's Five Forces to determine whether their company or product can be profitable. It's a particularly useful tool when launching a new business or entering a new industry.They analyze the industry and compare their business to similar, existing ones to understand where their company ranks. The tool helps them identify whether they will be profitable and to what extent. Companies also use it to determine what factors in the industry might affect their success.Porter's Five Forces can help a business:

• Learn what industry they need to target.

• Determine which industries give the best or least chances of success.

• Understand the demand for their product.

• Recognize their risks.

• Recognize their opportunities.

• Learn how profits get distributed within an industry.

• Analyze industry trends.

• Predict future trends.

Companies can apply Porter's Five Forces to local, national and international markets. By performing this analysis regularly, they can change their strategies to fit the current competitive environment and potentially increase profits.Related: What Is a Five Forces Analysis?

Five Forces factors

Porter's Five Forces consists of five "factors" of competition that businesses apply to their own products and situations. These factors can reduce or improve one's profitability in an industry. If each one is high, the company has less chance of profitability. If each force is low, the company is likely to earn more money. The Five Forces factors include:

1. Industry competition

This factor considers the number of competitors in the market and how strong they are. It also compares the quality of each competitor's products and services.Competition is high when an industry has many companies of similar size and power. Customers can change from one company to another at little cost. Therefore, in a competitive market, businesses are more likely to launch aggressive advertising and marketing campaigns and lower their prices to attract customers. These strategies can reduce a company's profits.Competition in an industry is low if few companies are offering the same products. They have more opportunities to grow and be profitable. Things that can affect competitive rivalry include:

• Number of competitors

• Variety of competitors

• Differences in products

• Differences in quality

• Industry balance

• Industry growth

• Customer loyalty to existing brands

• Barriers (high costs) to exit the industry

Related: What Is a Competitive Analysis?

2. The threat of new entrants

This factor considers how easily competitors can enter the market. As more companies join an industry, existing businesses risk losing some of their customers and profits. The threat of new entrants is high if companies can enter the market easily and at little cost or if your company's idea or technology is not patented or protected.Things that can make it more difficult for competitors to become established include:

• Government regulations

• Customer loyalty to existing brands

• High costs of entry

• Limited access to distribution

• Technologies needed

• Experience needed

• Economies of scale

Related: A Complete Guide To Economies of Scale

3. The threat of substitute products

This factor considers how easily customers can switch between similar products or services. If many products fill customers' same needs, those products become interchangeable. Companies lose a share of the market's profits when customers use products interchangeably. Profits also decrease if companies begin lowering their prices to try to compete with substitute products. If a product or service is so easy to make that many substitute products exist, companies also risk customers doing it themselves.Things that can affect substitute products' potential threats to a company include:

• The number of substitute products

• The quality of substitute products

• The price of substitute products

• The customer's likelihood to switch between products

• Customers' perceived difference between products

• The competition's aggressiveness

• The competition's profits

Related: What Is a Competitive Market? (Definition and How It Works)

4. Bargaining power of buyers

This factor considers how price changes affect customers' buying decisions and their ability to lower market prices. Buyers have greater bargaining power when their numbers are small but the amount of substitute products is high. As a result, they can cause prices to lower and company profits to shrink. Buyers have less bargaining power when they buy in small amounts and have few alternative product options.Things that can affect how much power buyers have over a company's pricing include:

• The number of customers

• How much product each customer is buying

• The buyer's ability to substitute products

• The buyer's sensitivity to price

• The buyer's access to information (such as on the internet) so they can compare products and prices

Read more: The Bargaining Power of Buyers: Definition and Analysis

5. Bargaining power of suppliers

This factor considers the number of suppliers a company has access to and how easily suppliers can increase their prices or reduce their product quality. The more suppliers a company has to choose from, the easier it is to switch to one that costs less or produces a higher-quality product. If few suppliers offer the products a company needs, they have more power and can charge more for their services. The company's profits can decline as a result.Things that can affect a supplier's power over company profits include:

• The number of suppliers

• The size of the suppliers

• A company's ability to find substitute suppliers

• The uniqueness of the supplier's product

• The quality of the supplier's product

• The strength of the supplier's distribution channels

• The volume of product needed

• The cost of switching suppliers

• The industry's importance to the supplier's business

Related: Supply Chain Management: What It Is and How It Works

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Porter's Five Forces examples

Here are two examples of how companies might use Porter's Five Forces to assess their opportunities and profitability:

Example 1

In this example, Argento, an existing apparel company, is entering the athletic shoes and clothing market:

• Competitive rivalry: Several large, established companies already occupy the athletic apparel industry. They have big budgets and lots of resources to maintain their share of the market. Argento's products are not yet patented, so these companies or others could potentially copy them. Competitive rivalry for Argento is high.

• Threat of new entrants: Entering the athletic apparel market requires a large investment for production, advertising and branding. However, existing large apparel companies could decide to enter the athletic market. The threat of new entrants is medium to low.

• Threat of substitute products: While companies could copy Argento's unpatented products, the demand for athletic wear high and continuing to grow. The threat of substitute products is low.

• Bargaining power of buyers: Argento's buyers include both end-users and wholesale. Wholesale customers have enough bargaining power to substitute Argento's products with those of lower-priced competitors. End-users, however, are loyal to Argento's brand. The collective bargaining power of buyers is medium.

• Bargaining power of suppliers: The athletic apparel industry has a large and varied supplier base. Further, Argento has many options because it manufactures its products using different companies in multiple countries. The bargaining power of suppliers is low.

Based on this analysis, Argento has a good chance of being profitable in the athletic apparel industry and now knows it needs to focus its money and efforts on patenting and marketing to more end-users.

Example 2

Global Ebank is a digital alternative to traditional banking:

• Competitive rivalry: Global Ebank currently has four main competitors in the digital banking space. However, its website traffic ranks second among those companies even though all of them have similar backlink numbers to their sites. Competitive rivalry for Argento is medium.

• Threat of new entrants: Many companies are trying to enter the digital banking market. However, government regulations and online banking laws are major barriers against new entrants. It is difficult for companies to be recognized as trusted online banking sites. The threat of new entrants is low.

• Threat of substitute products: Global Ebank must compete with substitute products not only from its online competitors but also from traditional banks. The threat of substitute products is medium to high.

• Bargaining power of buyers: Global Ebank has a large and diverse worldwide customer base. Because it operates online, it is easily accessible to anyone. The bargaining power of buyers is low.

• Bargaining power of suppliers: Global Ebank works with a large payment technology company to provide its services. This company also provides similar services to Global Ebank's competitors. It can decide how much it wants to charge Global Ebank and, in turn, affect profitability. The bargaining power of suppliers is high.

To maximize its profits, Global Ebank now knows it must invest in more unique products and services and compare suppliers.