The Five Competitive

Forces That Shape

Strategy
There are many factors to consider when creating a business. One of the most
important is the competitiveness of the industry. Michael E. Porter, a Harvard
professor known as a leader in competitive and strategic management, created a
well-known model for determining the profitability of an industry. The framework
is known as Porter's Five Forces and is based on the competitive forces that
influence an industry the most. These five forces include:

1. Competitive rivalry
2. Threat of new entrants
3. Bargaining power of suppliers
4. Bargaining power of customers
5. Threat of substitute products

the job of the strategist is to understand and cope with competition .,Competition for
profits goes beyond established industry rivals .The extended rivalry that results from all five
forces defines an industry’s structure and shapes the nature of competitive interaction
within an industry .As different from one another as industries might appear on the surface,
the underlying drivers of profitability are the same.

If the forces are intense, as they are in such industries as airlines, textiles, and hotels, al-
most no company earns attractive returns on investment. If the forces are benign, as they
are in industries such as software, soft drinks, and toiletries, many companies are profitable.

The forces are decided by industry structure so that to understand the competitive forces,
and their underlying causes, reveals the roots of an industry’s current profitability while
providing a framework for anticipating and influencing competition over time is
important. Understanding industry structure is also essential to effective strategic
positioning.
 SHAPING STRATEGY

The strongest competitive force or forces determine the profitability of an industry and be-
come the most important to strategy formulation. The most salient force, however, is not
always obvious. For example, even though rivalry is often fierce in commodity industries, it
may not be the factor limiting profitability. In such a situation, coping with the substitute
product be-comes the number one strategic priority.

The threat of entry, therefore, puts a cap on the profit potential of an industry. When the
threat is high, incumbents must hold down their prices or boost investment to deter new
competitors. In specialty coffee retailing, for example, relatively low entry barriers mean
that Starbucks must invest aggressively in modernizing stores and menus.

Threat of New Entry is One of the forces that shape

strategy
The threat of entry puts a cap on the profit potential of an industry. When the threat is high,
incumbents must hold down their prices or boost investment to deter new competitors. In specialty
coffee retailing, for example, relatively low entry barriers mean that Starbucks must invest
aggressively in modernizing stores and menus.Newentrants to an industry puts
pressure on the costs and rate of investment necessary to
compete. The threat of entry in an industry depends on the height of entry barriers that are
present and on the reaction entrants can expect from incumbents. If entry barriers are low and
new-comers expect little retaliation from the entrenched competitors, the threat of entry is high
and industry profitability is moderated. It is the threat of entry, not whether entry actually occurs,
that holds down profitability.

Barrier To Entry
Entry barriers are advantages that incumbents have relative to new entrants. There are seven major
sources.
Supply side economies of scale
these economies arise when firms that produce at larger volumes enjoy lower costs
per unit because they can spread fixed costs over more units, employ more efficient
technology, or command better terms from suppliers. Supply-side scale economies
deter entry by forcing the aspiring entrant. Deter entry by forcing
entrants to either come into industry on a large scale which
requires dislodging competitors or to accept a cost
advantage.For lawn care companies like Scotts Miracle-Gro, the most important
scale economies are found in the supply chain and media advertising. In small-
package delivery, economies of scale arise in national logistical systems and
information technology.
Demand side benefits of scale:
also known as network effects, arise in industries where a buyer’s willingness to pay
for a company’s product increases with the number of other buyers who also
patronize the company. For example, online auction participants are attracted to
eBay because it offers the most potential trading partners. Discourage entry
by limiting the willingness of customers to buy from a new
corner by reducing the price new comer can command.

Customer switching cost:

Switching costsare fixed costs that buyers face when they change suppliers. Such
costs may arise becausea buyer who switches vendors must, for exam-ple, alter
product specifications, retrain em-ployees to use a new product, or modify pro-
cesses or information systems.The larger the switching cost the
harder it will be for entrant to gain customer.
Capital requirement:
Need to invest large financial resources in order to compete
can deter new entrants. Capital may be necessary not only for fixed facilities
but also to extend customer credit. build inventories, and fund start-up losses. The
barrier is particularly great if the capital is required for unrecoverable and harder to
finance expenditures. EG:For aspiring air carriers ,for instance, financing is available
to purchase expensive aircraft because of their high resale value, one reason why
there have been numerous new airlines in almost every region.
Incumbency advantages:
Incumbents may have cost or quality which results in how
to produce more efficiently not available to potential rival
entrants. Target and Wal Mart, for example, have located stores in free-standing
sites rather than regional shoppingcenters where established department
storeswere well entrenched.
Unequal access to distribution channel:
The new entrants must secure distribution of its product.
The more limited distribution channels are, the tougher entry
it will be. A new food item, for example, must displace others from the
supermarket shelf via price breaks, promotions, intense selling efforts, or some other
means. Sometimes access to distribution is so high a barrier that new entrants must
bypass distribution channels altogether or create their own.

Restrictive government policy:

Govt: policy can hinder new entry and directly limits or even
forecloses entry into industries by licensing requirements
and restrictions on foreign investment in Regulated industries like
liquor retailing, taxi services, and airlines.

An analysis of barriers to entry and expected retaliation is obviously

crucial for any company contemplating entry into a new industry. The
challenge is to find ways to surmount theentry barriers without nullifying,
throughheavy investment, the profitability of partici-pating in the industry.

The power of suppliers

Powerful suppliers capture more of the value for themselves by charging higher
prices, limiting quality or services, or shifting costs to industry participants.

A supplier group is powerful if:

—It is more concentrated than the industry it sells to

Eg.Microsoft’s near monopoly in operating systems, coupled with the fragmentation

of PC assemblers.

The supplier group does not depend heavily on the industry for its revenues. Suppli-
ers serving many industries will not hesitate to extract maximum profits from each
one.

Industry participants face switching costsin changing suppliers. For example,

shiftingsuppliers is difficult if companies have investedheavily in specialized ancillary
equipment or inlearning how to operate a supplier’s equipment.

Suppliers offer products that are differentiated. Pharmaceutical companies that offer
patented drugs with distinctive medical benefits have more power than drug
companies offering me-too or generic products.
There is no substitute for what the supplier group provides. Pilots’ unions, for exam-
ple, exercise considerable supplier power over airlines partly because there is no
good alternative to a well-trained pilot in the cockpit.

The supplier group can credibly threaten to integrate forward into the industry. In
that case, if industry participants make too much money relative to suppliers, they
will induce suppliers to enter the market.

Power of Buyer
Powerful customers—the flip side of powerful suppliers—can capture more value by
forcing down prices, demanding better quality or more service.

Buyers are power-ful if they have negotiating leverage relative to industry

participants, especially if they are price sensitive, using their clout primarily to
pressure price reductions.

A customer group has negotiating leverage if: There are few buyers. Large-volume
buyers are particularly powerful in industries with highfixed costs, such as
telecommunications equipment, offshore drilling, and bulk chemicals.

The industry’s products are standardizedor undifferentiated. If buyers believe they

can always find an equivalent product, they tend to play one vendor against another.

Buyers face few switching costs in changing vendors

Buyers can credibly threaten to integratebackward and produce the industry’s

productthemselves if vendors are too profitable.

A buyer group is price sensitive if:

represents a significant fraction of cost structure or procurement budget. Where the

product sold by an industry is a small fraction of buyers’ costs or expenditures,
buyers are usually less price sensitive.

If The quality is very much affected by the in-dustry’s product, buyers are generally
less price sensitive.
buyers focus onprice. Conversely, where an industry’s productor service can pay for
itself many times over byimproving performance or reducing labor, ma-terial, or
other costs, buyers are usually moreinterested in quality than in price. Examples in-
clude products and services like tax accountingor well logging that can save or
evenmake the buyer money.

Intermediate customers gain significant bargaining power when they can influence
the purchasing decisions of customers downstream. Consumer electronics retailers,
jewelry retailers, and agricultural-equipment distributors are examples of
distribution channels that exert a strong influence on end customers.

The threat of substitutes.

A substitute per-forms the same or a similar function as an in-dustry’s product by a

different means. Video-conferencing is a substitute for travel. Plastic isa substitute
for aluminum. E-mail is a substi-tute for express mail.

Sometimes, the threat ofsubstitution is downstream or indirect, when asubstitute

replaces a buyer industry’s product.For example, lawn-care products and servicesare
threatened when multifamily homes inurban areas substitute for single-family
homesin the suburbs.

Substitutes are always present, but they are easy to overlook because they may
appear tobe very different from the industry’s product:To someone searching for a
Father’s Day gift ,neckties and power tools may be substitutes by purchasing a used
product rather than a new one, or to do It yourself (bring the service or product in-
house).

When the threat of substitutes is high, indus-try profitability suffers. Substitute

products orservices limit an industry’s profit potential byplacing a ceiling on prices.

The threat of a substitute is high if:• It offers an attractive price-performancetrade-

off to the industry’s product.

Eg video rental outlets are struggling with theemergence of cable and satellite video-
on-de-mand services, online video rental services suchas Netflix, and the rise of
internet video siteslike Google’s YouTube.
The buyer’s cost of switching to the substitute is low. Example: Switching from a
proprietary, branded drug to a generic drug usually involves minimal costs, for
example, which is why the shift to generics

Rivalry among existing competitors.

Rivalryamong existing competitors takes many famil-iar forms, including price

discounting, newproduct introductions, advertising campaigns,and service
improvements. High rivalry limitsthe profitability of an industry.

The intensity of rivalry is greatest if:•Competitors are numerous or are roughlyequal

in size and power. In such situations, ri-vals find it hard to avoid poaching
business.Without an industry leader, practices desirablefor the industry as a whole
go unenforced.

Industry growth is slow. Slow growth pre-cipitates fights for market share.

Exit barriers are high. Exit barriers, the flipside of entry barriers, arise as highly
specialized assets or manage-ment’s devotion to a particular business.

Firms cannot read each other’s signals wellbecause of lack of familiarity with one
another,diverse approaches to competing, or differinggoals.

Price cuts are usually easy for competitors to see and match, makingsuccessive
rounds of retaliation likely. Sus-tained price competition also trains customersto pay
less attention to product features andservice.

Price competition is most liable to occur if:•Products or services of rivals are

nearlyidentical and there are few switching costs for buyers.

Eg ; Years of airlineprice wars reflect these circumstances

Fixed costs are high and marginal costs arelow. This creates intense pressure for
competi-tors to cut prices below their average costs,

Eg; Many basic-materials businesses, such as paper and aluminum, suffer from this
problem, especially if demand is not growing. So do delivery companies with fixed
networks of routes that must be served regardless of volume.

Capacity must be expanded in large increments to be efficient.

Eg The need for large capac-ity expansions, as in the polyvinyl chloride busi-ness,
disrupts the industry’s supply-demandbalance and often leads to long and
recurringperiods of overcapacity and price cutting.

The product is perishable. Perishabilitycreates a strong temptation to cut prices

andsell a product while it still has value.

the dimensions of rivalry iswhether rivals compete on the same dimen-sions. When
all or many competitors aim tomeet the same needs or compete on the
sameattributes

Zero Sum Competition

Here, one firm’s gain is often another’s loss,driving down profitability. While price
compe-tition runs a stronger risk than nonprice com-petition of becoming zero sum,

Rivalry can be positive sum, or actually in-crease the average profitability of an

industry,when each competitor aims to serve the needsof different customer
segments, with differentmixes of price, products, services, features, orbrand
identities.

The opportunity for positive-sum competition will begreater in industries serving

diverse customer groups.

Factors not forces

Industry structure, as manifested in thestrength of the five competitive forces, deter-

mines the industry’s long-run profit potentialbecause it determines how the
economicvalue created by the industry is divided—howmuch is retained by
companies in the industryversus bargained away by customers and sup-pliers,
limited by substitutes, or constrained bypotential new entrants.

Visible Industry Attributes

A common mistake is to assume that fast-growing industries are al-ways attractive.

Growth does tend to mute rivalry, because an expanding pie offers opportunities for
all competitors.

Without new entrants high growth rate is not guarantee profitability.

Eg:some fast-growth businesses,such as personal computers, have been amongthe
least profitable industries in recent years.

te chnology and innovation.

Advanced tech-nology or innovations are not by themselvesenough to make an

industry structurally attractive

Price-insensitive buy-ers, high switching costs, or high entry barriersarising from

scale economies are often farmore profitable than sexy industries, such assoftware
and internet technologies,.

Government is not best un-derstood as a sixth force because

governmentinvolvement is neither inherently good norbad for industry profitability.

The only way see the influence by clearly analysis

—how specific government policies affect the five competitive forces.

government policies favoring unions may raise supplier power and diminish profit
potential.

— Political power of Government can operates at multiple levels through many

different policies,

Complementary products and services.

Complements are products or services used to-gether with an industry’s product.

Comple-ments arise when the customer benefit of twoproducts combined is greater

than the sum ofeach product’s value in isolation. Computer hardware and software,
for instance, are valu-able together and worthless when separated.

the role of complements, espe-cially in high-technology industries where theyare

most obvious.

The value of acar, for example, is greater when the driver alsohas access to gasoline
stations, roadside assis-tance, and auto insurance.
The presence of complements can raise orlower barriers to entry. In application
software,for example, barriers to entry were loweredwhen producers of
complementary operatingsystem software, notably Microsoft, providedtool sets
making it easier to write applications.

The presence of complements can also affectthe threat of substitutes.

Forexample, Apple’s iTunes hastened the substitu-tion from CDs to digital music.

ndustry struc-ture proves to be relatively stable, and indus-try profitability

differences are remarkablypersistent over time in practice.

Shifts in structure may emanate from out-side an industry or from within. They
canboost the industry’s profit potential or reduceit. They may be caused by changes
in technol-ogy, changes in customer needs, or other events.

Shifting threat of new entry.

Changes to anyof the seven barriers described above can raiseor lower the threat of
new entry.

Strategic decisions of leading competitorsoften have a major impact on the threat of

en-try. Starting in the 1970s, for example, retailerssuch as Wal-Mart, Kmart, and Toys
“R” Usbegan to adopt new procurement, distribution,and inventory control
technologies with largefixed costs, including automated distributioncenters, bar
coding, and point-of-sale termi-nals. These investments increased the econo-mies of
scale and made it more difficult forsmall retailers to enter the business (and for ex-
isting small players to survive).

Changing supplier or buyer power. As thefactors underlying the power of

suppliers andbuyers change with time, their clout rises ordeclines.

Another example is travel agents, whodepend on airlines as a key supplier. When

theinternet allowed airlines to sell tickets directlyto customers, this significantly
increased theirpower to bargain down agents’ commissions.
advances in technology create new substitutes or shift price performance
comparisons in one direction or the other.

Trends in the availabil-ity or performance of complementary produc-ers also shift the

threat of substitutes.

New bases of rivalry. Rivalry often intensi-fies naturally over time. As an industry
ma-tures, growth slows. Competitors becomemore alike as industry conventions
emerge,technology diffuses, and consumer tastes con-verge.

EG:televisions, snowmobiles, and telecommunications equipment.

The nature of rivalry in an industry is al-tered by mergers and acquisitions that intro-
duce new capabilities and ways of competing.Or, technological innovation can
reshape ri-valry.

Implications for Strategy

The forces reveal the most significant aspects of the competitive environment. They also pro-vide a
baseline for sizing up a company’s strengths and weaknesses: Where does the company stand
versus buyers, suppliers, en-trants, rivals, and substitutes?

The forces reveal the most significant aspects of the competitive environment.

Provide a baseline for sizing up a company’s strengths and weaknesses(SWOT analysis)

Shaping Forces

Positioning the company. Strategy can beviewed as building defenses against the com-petitive
forces or finding a position in the in-dustry where the forces are weakest.Eg: The position of Paccar
in the mar-ket for heavy trucks. The heavy-truck industryis structurally challenging. Many buyers
oper-ate large fleets. with both the leverage and the motivation todrive down the price of one of
their largest purchases. Paccar, has chosen to focus on one group of customers: owner-operators—
drivers who own their trucks and contract directly with shippers or serve as sub-contractors to
larger trucking companies.They maintain the crucial considerations for an owner-operator. Paccar
illustrates the principles of position-ing a company within a given industry struc-ture. The firm has
found a portion of its indus-try. where the competitive forces are weaker—where it can avoid buyer
power and price-based rivalry. And it has tailored every singlep art of the value chain to cope well
with theforces in its segment. As a result, Paccar hasbeen profitable for 68 years straight and
hasearned a long-run return on equity above 20%

Exploiting industry change. Industry changes bring the opportunity to spot and claim prom-ising
new strategic positions

Apple with its iTunes music store with its iPod music player. By per-mitting the creation of a
powerful new gate-keeper, the major labels allowed industrystructure to shift against unauthorized
downloading the label.

When industry structure is in flux, new and promising competitive positions may appear.Structural
changes open up new needs andnew ways to serve existing needs. Smaller competitors in the
industry can capitalize on such changes, or the void may well be filled by new entrants

 Industrial structure can be shaped in two ways:

Redividing Profitability-to increase the share of profits to industry competitors.

A firm can lead its industry toward new ways of competing that alter thefive forces for the better. In
reshaping structure a company wants its competitors to follow so that the entire industry will be
transformed..

Expanding overall profit-to increase the overall pool of economic value.

Expanding the overall profit pool createswin-win opportunities for multiple industryparticipants. It
can also reduce the risk of de-structive rivalry that arises when incumbents. The most successful
companies are those thatexpand the industry profit pool in ways thatallow them to share
disproportionately in thebenefits.

Defining the Relevant Industry

Defining the industry in which competition actually takes place is important for good in-dustry
analysis. The boundaries of an industry consist of two primary dimensions. First is the scope of
products or services. F or example, is motor oil used in cars part of the same industry as motor oil
used in heavy trucks and stationary engines, or are these different industries? The second
dimension is geographic scope. Most industries are present in many parts of the world. However, is
competition contained within each state, or is it national? Does com-petition take place within
regions such as Eu-rope or North America, or is there a single glo-bal industry.

Industry structure (buyer power, barriers to entry, and so forth) is substantially different. Automotive
oil is thus a distinct industry from oil for truck and station-ary engine uses. Industry profitability will
dif-fer in these two cases, and a lubricant com-pany will need a separate strategy for competing in
each area.

Typical Steps in Industry Analysis

• Define the relevant industry

• Identify the participants and segment them into groups

• Asses driver of competitive forces

• Determine overall industry structure

• Test the analysis for consistency

Analyze recent and likely future changes in each force, both positive and negative.Identify aspects of
industry structure that might be influenced by competitors, by new entrants, or by your company.

Differences in the five competitive forces also reveal the geographic scope of competi-tion. If an
industry has a similar structure in every country (rivals, buyers, and so on), the presumption is that
competition is global, and the five forces analyzed from a global perspec-tive will set average
profitability.

• Analyze recent and likely future changes of forces

• Positive /Negative in each force

• Industry aspects influenced by other forces

• Common Pitfalls

In conducting the analysis avoid common mistakes like Defining the industry too broadly or too
narrowly.

•Making lists instead of engaging in rigorous analysis.•Paying equal attention to all of the forces
rather than digging deeply into the most important ones.•Confusing effect (price sensitiv-ity) with
cause (buyer econom-ics).•Using static analysis that ignores industry trends.•Confusing cyclical or
transient changes with true structural changes.•Using the framework to declare an industry
attractive or unat-tractive rather than using it to guide strategic choice

Competition and ValueThe competitive forces reveal the drivers of in-dustry competition.
trategist whounderstands that competition extends well be-yond existing rivals will detect wider
competi-tive threats like
Tthinking comprehen-sively about an industry’s structure can un-cover opportunities: differences in
customers,suppliers, substitutes, potential entrants, andrivals that can become the basis for
distinctstrategies yielding superior performance.

Thinking Structurally about competition

In a world of more open competition and relentless change, it is more important than ever to think
structurally about competition

Understanding industry structure is equally important for investors as for managers.

Attraction to the industry

The five competitive forces reveal whether an industry is truly attractive, and they help investors
anticipate positive or negative shift and allows to take advantage of undue pessimism or optimism.

Executives and investors would both be focused on the same fundamentals that drive sustained
profitability. The conversation between investors and execu-tives would focus on the structural, not
the transient.

Creating value leads to the creation of profits. In his five forces framework, Porter argued that
competing for profits is a complex game and is a struggle involving multiple players, and not just
rivals, over who will capture the value an industry creates.

Who are these multiple players or forces? Porter’s five forces – the intensity of rivalry among
existing competitors, the bargaining power of buyers, the bargaining power of suppliers, the
threat of substitutes and the threat of new entrants – determine the structure of an industry.

The configuration of the five forces shows how a particular industry works and how it creates and shares
value. Each of the five forces has a clear, direct and predictable relationship to industry profitability.
Generally, the more powerful the force, the more pressure it will put on prices and costs or both, and
therefore, the less attractive the industry will be to its incumbents.

So how does the five forces framework help?

 The five forces framework has universal applicability because it captures the
relationships fundamental to all commercial activities – those between buyers and sellers,
between sellers and suppliers, between rival sellers and between supply and demand.
  A well done analysis of the five forces will help you determine the average profitability
of an industry through their impact on prices, costs and the investments required to
compete.
 Armed with this information, you can develop a strategy that will help you generate
profits that are better than the industry baseline.

For a better understanding of the five forces framework, you should read the two classic articles
below. Or you could read Joan Magretta’s outstanding book – Understanding Michael Porter –
that explains Porter’s ideas succinctly.