In 1979, Michael Porter, a Harvard Business School professor, identified five forces you can use to assess competition within your industry. These five forces are a supplier’s bargaining power, customer’s bargaining power, degree of competitive rivalry, threat of substitute products and the threat of new entrants to your target market. A five forces analysis is useful for assessing your competitive position and for making decisions about whether a new business idea or a new product has any profit potential.
Supplier bargaining power refers to how much control your suppliers have over the amount you pay for raw materials and finished goods. The number of suppliers from which you have to choose, whether the products or services they offer are essential or discretionary, the expense involved in locating and switching to another supplier and the size of the suppliers business all work together to determine how easy it is for a supplier to increase prices.
Customer bargaining power refers to whether it’s your business or the customer who ultimately controls your pricing structure. Factors include the number of customers in your target market, the importance of each one, how many alternatives customers have and how easy it is for them to switch to a competitor. The more power customers have, the more they can influence and drive prices downward and, in the end, the more they can affect your profit ratios.
A competitive rivalry analysis determines whether your business has -- or needs to work harder to develop -- a competitive edge. If your target market includes numerous competitors, all offering similar products and services, suppliers and buyers have no real incentive to purchase from your business exclusively, unless you introduce competitive price reductions. As a result, competitive rivalry is high. In contrast, if no other business can duplicate what you do or sell what you sell, customer loyalty increases and competitive rivalry decreases.
A substitute is something that meets the same need and is of similar quality to your product. A high substitution threat links directly to the number of credible, available substitutes from which customers have to choose. The higher the threat, the more this generally limits the price your business can charge.
The easier it is for a new business to enter your industry or for an existing business to supply new products and services to your target market -- and compete effectively -- the greater the new entry threat. For this reason, businesses in industries with strong entry barriers such as high capital requirements or many federal and state compliance regulations, as well as those having a well-established brand or proprietary manufacturing processes enjoy fewer new entry threats.