Five Forces Model - Michael Porter

This topic will add to your knowledge about the underlying sources of competitive pressure which further highlights the critical strengths and weaknesses of the company and clarifies the areas where strategic change may yield the highest payoff. It also highlights the major strengths and weaknesses of industry along with associated opportunities and threats. This model is based upon following five forces.

Fig: Five Forces model by Michael Porter

1. Bargaining power of suppliers

Suppliers can pose a great threat to bottom line i.e. profitability by threatening to raise prices or reduce the quality of purchased goods / services. So this force should be analysed in detail.

A supplier group is powerful if any of the following applies.

a) Unique product / service delivered by supplier.

b) Diversified sales bucket: If seller has large number of buyers and commands a dignified respect in the industry then bargaining power of buyers become less.

c) When supplier’s product is an important input to the buyer’s business.

2. Bargaining power of buyers

Buyers have huge potential and can influence the prices of industry in a big way. They can force down the prices and can dent your profit.

A buyer is powerful if the following circumstances hold true.

a) If large portion of saleable goods in industry is being purchased by single buyer e.g. government agencies, market leader who commands a monopoly in his industry.

b) If the products which are supplied are standard and undifferentiated. Buyer can switch from one company to other and bargain upon prices.

c) Possibility of backward integration: If buyer is financially strong and purchase of particular items accounts for huge percentage of costs then there is always a chance of losing buyer as option of backward integration is always open to them, hence seller loses his bargaining power.

d) Full information:  When the buyer has full information about market prices, supplier’s cost and actual product demand then bargaining power vests more upon buyers.

3. Threat of new entrants

This is again an important force as a new entrant to an industry brings new capacity and adds back to competition which further leads to price reduction which ends up with reduced profit margin. The threat of entry into an industry depends on barriers to entry that are present coupled with the instant reaction from existing Competitors in the industry. Barriers of entry can come through various sources such as:

a) Capital required: if the capital requirement is on higher side then barrier seems to be stronger for new entrants.

b) Economies of scale: It can pose a barrier to entry by forcing the new entrant to produce at large scale and risk strong reaction from existing firms or produce at small scale and accept cost ineffectiveness. Both options are undesirable.

c) Product differentiation: It creates a barrier by forcing new entrants to spend heavily on advertising activities to overcome existing customer loyalties. This barrier is more prevalent in baby care products.

d) Government policies: If there is some restriction from government regarding entry / exit into particular industry e.g. defence industry, gas and petrochemicals.

4. Threat of substitute goods or services

Substitutes limit the potential returns of an industry by placing a ceiling on the prices which can be charged comfortably in market. This not only limits the profit in normal course of business but also reduces the benefits which an industry can reap during boom times. So identify your substitutes carefully and make your strategies accordingly. Identifying these goods is a matter of searching for other products which can perform the same function as the product of the industry. E.g. Tea and Coffee, Diesel vs Petrol engines, rest you think upon.

5. Rivalry amongst existing competitors

It occurs because one or more competitors either feels the pressure or sees the opportunity to improve position. Competitive moves by nor firm have impact on competitors, hence may invite a counter move. This reminds of Newton third law i.e. to every action there is equal and opposite reaction. Moves upon moves sometime lead to price war and dents heavily in the profit margin of the firms in the industry. This rivalry is available in almost all industry. So this can’t be avoided.

Customers, suppliers, substitutes and potential entrants are all “Competitors” to firms in the industry and more or less prominent depending on the particular circumstances. Competition in the broader sense might be termed extended rivalry. All five forces collectively determine the intensity of industry competition and profitability. The collective strength of these forces determine the ultimate profit potential in the industry, where profitability potential is measured in terms of long run return on invested capital.