Developed by Harvard Business School professor Michael E. Porter in the late 1970s, Porter's Five Forces model is a competitive analysis framework that businesses of any size can use during their market research. Porter's Five Forces model is also generic enough to apply to different industries, and can help you develop your business strategy and competitive strategy.
Each of the Five Forces focuses on a particular way to measure competition. In turn, this information can be used to create realistic expectations about profitability, sales forecasts, marketing and budgeting.
Overview of Porter's Five Forces
The Five Forces model serves as a guideline for evaluating the competitiveness of an industry. Analyzing each of Porter's Five Forces before launching a new business or expanding into a new market can help entrepreneurs and business owners determine the potential profitability of their venture. Although this may seem like a stretch because Porter's model primarily focuses on competitive forces instead of budgets, an industry's competitive environment directly affects how a new business can price its products and still attract customers.
Therefore, as you and your team evaluate your industry in terms of the Five Forces, the question you always need to ask is, "Does this information imply that our business will be highly profitable?" The greater the competition, the less profit your business will enjoy simply because consumers' purchases will be spread out among many different brands. If fewer brands exist in the first place, the buyers' money will be spent in a more concentrated way.
1. Threat of New Entrants in the Market
If new businesses can easily enter the market, then the competition of that market is high. Many businesses, both established and new, compete for a share of the profits in the market.
On the other hand, if potential entrants face high barriers in the market, that particular industry will be less competitive because fewer businesses will be grappling for their market share. Although you might consider it a good thing to be able to easily enter a new market, the high level of competition will ultimately affect your profitability unless you're able to stand out as a high-quality, experienced or niche brand.
An example of an industry with a high threat of entrants is a dog-walking business. It's relatively easy to set up this kind of business, but there are a limited number of people who are interested in using a dog-walking service. With a static number of consumers and increased providers, the local dog-walking industry could become very competitive, and some of the walkers could lower their prices in an effort to stand out. In turn, this could compel you to lower your prices in order to not lose clients.
On the other hand, it's much harder to enter the smartphone market. The global recognition of top industry brands like Apple and Samsung serves as a barrier to entry for new businesses, as does the cost of producing a smartphone. Some of the technology might also be protected by patents. The low threat of entry for this industry keeps it less competitive, and the potential profitability for existing companies remains high.
Examples of Barriers to Entry
Evaluating the first force in Porter's Five Forces analysis requires an understanding of common barriers to entry. Of course, the other Five Forces all point out factors that might give you pause, such as a high degree of rivalry and a large quantity of substitute products. However, if competition was low and you felt confident that you could succeed, how easily could you enter an industry in terms of logistics?
In short, the more work and money that has to go into a new business, the harder it is to enter an industry. Is special training or a license required to operate a particular business? Do you need to become well versed in government rules and regulations? Would you be selling just one product or many, and would all of them need attention and development?
Sometimes, the industry know-how or "secret sauce" is kept under wraps and isn't readily available or accessible. Industries that operate on the economies of scale principle are difficult to enter competitively without sufficient startup funds. A business that requires a specific location in order to be successful needs more logistical planning than a business that can thrive on any street corner or without a physical location.
2. Threat of Substitute Products or Services
The next factor to consider when using Michael Porter's Five Forces to analyze a market's competitiveness is whether consumers can easily switch to another product or service. For example, consumers who are thirsty after exercise could choose from sports-drink brands like Gatorade or Powerade. However, substitute products include Vitaminwater, Crystal Light, plain water, iced tea, soft drinks or juices. Every single one of these brands is competing to quench your thirst, even though they do not all fit into the same category.
A low threat of substitute products can occur with highly niche products. For example, if you want to purchase baby formula, you can only choose from the various brands of baby formula. Other beverages do not pose a threat of substitution because infants can't consume them. Still, consumers can easily substitute one brand of formula for another.
What about your industry? How easy would it be for a consumer to choose a product not only from a direct competitor but also in a totally different category? If the threat of substitute products or services is high, then your potential profitability is low. If you offer a truly niche solution, then other products are unlikely to hone in on your customers and profits.
3. Degree of Rivalry Among Competitors
An industry's degree of competitive rivalry can also influence the profit opportunities of potential entrants. Think about whether the industry is dominated by one or two brands. Investigate the stock shares or estimated value of the top companies in the industry. Are they niche companies or generalized companies that happen to also sell the products you want to sell?
For example, the pet-supply industry is dominated by just a few chain brands, like PetSmart and Petco. Competing with these two stores on a national or global scale would be challenging, but perhaps there's still room for local, boutique or highly niche pet stores to thrive. Often, when an industry is dominated by global brands, the local market is still viable. Restaurants are another excellent example of this concept.
On the other hand, consider the makeup industry. Yes, some brands like Maybelline are globally recognized, but so are dozens of others like MAC, Revlon, Clinique and Estée Lauder. Compared to other industries, the degree of rivalry for makeup brands is lower. A lower degree of rivalry means it would be easier to convert customers to your brand, as they're more likely to shop around.
4. Bargaining Power of Buyers
Buyers who have a high degree of bargaining power can increase competition among brands and reduce overall profitability. This is especially true if one or two large entities make most of the purchases or if a significant segment of the population has a shift in consciousness that causes them to demand an increase in quality.
For example, as more and more buyers look for organic products, demand and supply increase, and the price levels for organics decreases. Whereas organic foods used to be sold exclusively in niche health-food stores, mainstream grocery stores now carry a selection as well. Their entrance to the market increased the competitiveness of the industry.
The bargaining power of customers can be used in myriad ways. Customers always have a reason for abandoning your brand and turning their attention toward a competitor, and sometimes it's about quality, sustainability or even social responsibility more so than price. The way buyers wield their money can cause businesses to try to catch up to the new competition. If you enter the market at the right time with an in-demand idea, you can cash in on the bargaining power of buyers, but you should expect competition to increase over time.
5. Bargaining Power of Suppliers
Sometimes, suppliers hold more bargaining power than buyers. If your business model means that you purchase items from suppliers and then modify them or resell them to consumers, your profits could be at the mercy of the suppliers. For example, if you purchase rare leathers to craft into purses, shoes or belts, your suppliers have high bargaining power. You do not have many other options for purchasing these raw materials because they are rare.
Therefore, if your suppliers decide to increase their prices — or there is a decrease in the number of suppliers — you can either eat the cost or pass it on to your buyers by compensating with higher prices. Price sensitivity can be a heavy burden to be subject to. Does your market demand support a price increase? Can your buyers afford your products?
If your competitors can still source rare leather at a lower price, they can keep their ultimate sales prices lower, and you may lose customers to them. Thus, the bargaining power of suppliers can create more of a competitive environment within an industry. Note that suppliers' bargaining power is not just limited to price but also affects the quality and availability of the goods.
Applying Porter's Model
Ideally, you'll have a chance to use Porter's Five Forces model before you launch your business. It's a powerful tool to use as part of your market research, in which you gather information about the industry and competitors in order to decide whether your business idea is viable and profitable.
If the Five Forces demonstrate low competition and high potential for profit, you could easily gain a competitive advantage in the industry. However, if the Five Forces point toward high competition and decreased potential for profitability, you'll need to have a strategic business plan that gives you the best shot at success. This could include narrowing your niche, trying a local market, having an effective pricing strategy or attempting to create market demand with a high-profile advertising campaign.
Consider pairing your analysis of Porter's Five Forces model with a SWOT analysis in order to determine if your business is poised to tackle any barriers to entry or other competitive hurdles.
Helpful Research Resources
Don't just go with your gut or what you imagine to be true about your industry when performing an industry analysis with Porter's Five Forces. Gather some data to help you make a decision. You can pay for ready-made market research reports or look at free data from the government, including the Small Business Administration.
Check out the stock market to find the major players in an industry. If only a few exist, then rivalry is high. Take a look at competitors' reviews on social media, the Better Business Bureau or the brands' own websites to check for buyers' bargaining power. Are customers unhappy, demanding changes or threatening to use substitute products or brands?
Be creative but always legal in looking up information about the market and your competitors. You may be surprised at how much data is publicly available.
- AccountingTools: Threat of Substitutes
- Business News Daily: How Porter's Five Forces Can Help Small Businesses Analyze the Competition
- The Strategic CFO: Threat of New Entrants (One of Porter’s Five Forces)
- MaRS: Bargaining Power of Buyers: Porter’s Five Forces Analysis
- Corporate Finance Institute: Bargaining Power of Suppliers