Porter’s Five Forces Analysis

Consultants usually follow a mix of few steps to arrive at a Consulting Methodology . In every methodology the first step involves, defining the problem the client has presented before us. Deep analysis of the case and to come up with questions to be analyzed in further steps.

Second comes, the task of structuring the problem because as consultants, one of our key responsibilities is communicating with clients in a clear, simple and logical manner. Frameworks help structure our analysis and answers in this way. One of such framework is Porter’s 5 Forces Model.

Porter’s Model is a tool to understand the client’s micro-environment by assessing the competition an organization faces. It encourages organizations to look at the wider industry context, both today and into the future. This model identifies and analyzes five competitive forces that shape every industry. Porter’s model can be applied to any aspect or department of the economy to understand the level of competition within the industry and enhance a company’s long-term profitability.

The Five Forces model is named after Harvard Business School professor, Michael E. Porter and was was first published in Harvard Business Review in 1979 and also published in Michael Porter’s book, “Competitive Strategy: Techniques for Analyzing Industries and Competitors” in 1980.

Porter’s five forces are:

1. Threat of new entrants
2. Bargaining power of suppliers
3. Bargaining power of buyers
4. Threat of substitutes
5. Intensity of competitive rivalry

Now, let us discuss in detail each of the five-structural force:

1)Threat of new entrants:

How easy is it for new business to set up shop?
The easier it is to get into the market, the weaker the company’s position will be as the new entrants in an industry bring new capacity and the desire to gain market share. The seriousness of the threat depends on the barriers to enter a certain industry. Examples of barriers to entry are the need for economies of scale, high customer loyalty for existing brands, large capital requirements (e.g. large investments in marketing or R&D), the need for cumulative experience, government policies, and limited access to distribution channels.
An industry with strong barriers to entry is ideal for existing companies within that industry since the company would be able to charge higher prices and negotiate better terms.

2)Bargaining power of suppliers:

How much power do suppliers have?
This force analyses how easily can suppliers for the company change prices of their inputs and if needed can the company can easily switch suppliers. So basically, it explains how much power and control a company’s supplier (also known as the market of inputs) has over the potential to raise its prices or to reduce the quality of purchased goods or services, which in turn would lower an industry’s profitability potential. The fewer the concentration of suppliers and the availability of substitute suppliers the more power they have.
As a result, the supplier has more power and can drive up input costs and push for other advantages in trade. On the other hand, the companies gain when there are a multitude of suppliers or there exists low switching costs between rival suppliers.

3)Bargaining power of buyers:

How much power do customers have?
The next factor addresses the ability of customers to go to competitors or otherwise force the firm to reduce their prices in some ways. The size of a company’s customer base can impact the company’s freedom to influence pricing and quality. It is calculated by ascertaining how many buyers or customers a company has, how significant each customer is, and how much it would cost a company to find new customers or markets for its output. A smaller and more powerful customer base means that each customer has more power to negotiate for lower prices and better deals.
Whereas, if company that has many independent customers, this will have an easier time charging higher prices to increase profitability. Companies can take measures to reduce buyer power by for example implementing loyalty programs or by differentiating their products and services.

4)Threat of substitutes:

How likely are customers to switch to an alternative?
The more substitutes available, the less power the firm has to increase their prices. When close substitutes are available, customers will have the option to forgo buying a company’s product, and a company’s power can be weakened. When a substitution for a company’s product or service that is currently on the market appears, it can be potentially damaging.
It is crucial the company to ensure their product or service maintains demand among customers in such cases. That way, even if a substitute appears at some point, customers will trust the quality of their product or service regardless. If the product or service substitution includes many similar features at a much lower price, buyers may be tempted to use an alternative. This is why it’s so important to understand your customer base from the grassroot level.

5)Intensity of competitive rivalry:

How many firms compete and how much is the market growing?
This last force of the Porter’s Five Forces examines the intensity of the current competition in the marketplace. It is determined by identifying the number of existing competitors and what each competitor is capable of doing. A good indicator of competitive rivalry is the concentration ratio of an industry. The lower this ration, the more intense rivalry will probably be and in such circumstances, competitors are likely to actively engage in advertising and price wars, which can hurt a business’s bottom line. In addition, rivalry will be more intense when barriers to exit are high, forcing companies to remain in the industry even though profit margins are declining.
Conversely, when competitive rivalry is low, a company has greater power to charge higher prices and set the terms of deals to achieve higher sales and profits. Cost leadership and product differentiation can be effective strategies for helping to alleviate the risks that your client may face in a highly competitive industry.

Conclusion:
According to Porter, “the collective strength of these forces determines the ultimate profit potential of an industry”. The number and power of a company’s competitive rivals, potential new market entrants, suppliers, customers, and substitute products influence a company’s profitability and this model can be used to guide business strategy to increase competitive advantage. The five forces are frequently used to measure competition intensity, attractiveness, and profitability of an industry or market.

Porter’s Model can be applied to clients of most sizes and industries. It is unlikely to be useful for clients who face little to no competition (e.g. monopolies or governments).There have been a few criticisms about the framework but there is no denying the fact that Porter’s 5 forces framework can help a business assess the actual picture of the industry and identify the opportunities and threats in an external environment.