Published On:Tuesday 27 December 2011
Posted by Muhammad Atif Saeed
Strategy: Porter's Five Forces Model: analysing industry structure
Defining an industry
An industry is a group of firms that market products which are close substitutes for each other (e.g. the car industry, the travel industry).
Some industries are more profitable than others. Why? The answer lies in understanding the dynamics of competitive structure in an industry.
The most influential analytical model for assessing the nature of competition in an industry is Michael Porter's Five Forces Model, which is described below:
Porter explains that there are five forces that determine industry attractiveness and long-run industry profitability. These five "competitive forces" are
- The threat of entry of new competitors (new entrants)
- The threat of substitutes
- The bargaining power of buyers
- The bargaining power of suppliers
- The degree of rivalry between existing competitors
- The threat of substitutes
- The bargaining power of buyers
- The bargaining power of suppliers
- The degree of rivalry between existing competitors
Threat of New Entrants
New entrants to an industry can raise the level of competition, thereby reducing its attractiveness. The threat of new entrants largely depends on the barriers to entry. High entry barriers exist in some industries (e.g. shipbuilding) whereas other industries are very easy to enter (e.g. estate agency, restaurants). Key barriers to entry include
- Economies of scale
- Capital / investment requirements
- Customer switching costs
- Access to industry distribution channels
- The likelihood of retaliation from existing industry players.
- Capital / investment requirements
- Customer switching costs
- Access to industry distribution channels
- The likelihood of retaliation from existing industry players.
Threat of Substitutes
The presence of substitute products can lower industry attractiveness and profitability because they limit price levels. The threat of substitute products depends on:
- Buyers' willingness to substitute
- The relative price and performance of substitutes
- The costs of switching to substitutes
- The relative price and performance of substitutes
- The costs of switching to substitutes
Bargaining Power of Suppliers
Suppliers are the businesses that supply materials & other products into the industry.
The cost of items bought from suppliers (e.g. raw materials, components) can have a significant impact on a company's profitability. If suppliers have high bargaining power over a company, then in theory the company's industry is less attractive. The bargaining power of suppliers will be high when:
- There are many buyers and few dominant suppliers
- There are undifferentiated, highly valued products
- Suppliers threaten to integrate forward into the industry (e.g. brand manufacturers threatening to set up their own retail outlets)
- Buyers do not threaten to integrate backwards into supply
- The industry is not a key customer group to the suppliers
- There are undifferentiated, highly valued products
- Suppliers threaten to integrate forward into the industry (e.g. brand manufacturers threatening to set up their own retail outlets)
- Buyers do not threaten to integrate backwards into supply
- The industry is not a key customer group to the suppliers
Bargaining Power of Buyers
Buyers are the people / organisations who create demand in an industry
The bargaining power of buyers is greater when
- There are few dominant buyers and many sellers in the industry
- Products are standardised
- Buyers threaten to integrate backward into the industry
- Suppliers do not threaten to integrate forward into the buyer's industry
- The industry is not a key supplying group for buyers
- Products are standardised
- Buyers threaten to integrate backward into the industry
- Suppliers do not threaten to integrate forward into the buyer's industry
- The industry is not a key supplying group for buyers
Intensity of Rivalry
The intensity of rivalry between competitors in an industry will depend on:
- The structure of competition - for example, rivalry is more intense where there are many small or equally sized competitors; rivalry is less when an industry has a clear market leader
- The structure of industry costs - for example, industries with high fixed costs encourage competitors to fill unused capacity by price cutting
- Degree of differentiation - industries where products are commodities (e.g. steel, coal) have greater rivalry; industries where competitors can differentiate their products have less rivalry
- Switching costs - rivalry is reduced where buyers have high switching costs - i.e. there is a significant cost associated with the decision to buy a product from an alternative supplier
- Strategic objectives - when competitors are pursuing aggressive growth strategies, rivalry is more intense. Where competitors are "milking" profits in a mature industry, the degree of rivalry is less
- Exit barriers - when barriers to leaving an industry are high (e.g. the cost of closing down factories) - then competitors tend to exhibit greater rivalry.
