Before we decide on a strategy, we need to take a step back and look at our industry. Why does my industry look the way it does today? What forces beyond competition shape my industry? Where can I find a position amongst my competitors that is profitable and difficult to replicate? Porter’s 5 Forces is a straightforward model that, if followed, can answer these questions. This article aims to succinctly define these 5 Forces as well as the factors that determine their strength – you’ll also find a downloadable template that will help you complete your own assessment of how Porter’s 5 Forces impact your own organization. Lastly, there are actionable next steps that can help you define your strategy and find a profitable position in your industry.
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Porter’s 5 Forces
Threat of New Entrants
When an industry starts becoming profitable, it will entice new entrants. If the barriers to entry are low, new entrants can easily capture market share and threaten profitability. New entrants undercut prices and offer valuable alternatives to what your industry currently provides. On the other hand, if barriers to entry are high, it’s much harder for new entrants to threaten your industry’s profitability.
Some of the key factors that can influence barriers to entry are economies of scale and customer loyalty. Established companies already have the infrastructure in place to offer products or services at a lower per unit cost than would a new entrant. The amount of time and money it would take for a new entrant to achieve a similar per unit cost without sacrificing quality is a huge deterrent. Beyond that, if strong customer loyalty is prevalent in a particular industry, it’s going to be difficult for new entrants to convert those customers.
- How expensive would it be and how long would it take to achieve the economies of scale necessary to compete in your industry?
- Is there strong customer loyalty in your industry? Would it be difficult for a new entrant to woo customers away from your products or services?
- Are there any additional barriers to entry a new entrant could encounter (e.g. regulation, intellectual property, access to distribution channels, etc.)?
Suppliers offer your industry the needed inputs to operate (e.g. components, materials, and services). When the bargaining power of suppliers is high, there’s a strong chance your suppliers could raise prices or reduce quality without retaliation. In situations where there are plenty of competent suppliers to choose from, it’s likely their bargaining power is low and you’ll have no issue changing suppliers if you need to. If you don’t have the option to choose between multiple suppliers or the cost of switching suppliers is high, the suppliers will have stronger bargaining power.
- Who are your key suppliers?
- How many competent suppliers does your company have to choose from?
- How difficult or expensive would it be to change suppliers?
In Porter’s 5 Forces model, buyers are your customers. At the expense of industry profitability, buyers can force prices down, pit rivals against each other, and demand higher quality or service. Buyers have power when they are few in number and have many sellers to choose from. Beyond this, if a large portion of a seller’s revenue is determined by a handful of buyers, those buyers will have more leverage. Switching cost should also be considered when determining the buyers’ bargaining power.
- How many potential buyers are in your industry compared to the number of sellers?
- Does a handful of buyers make up the majority of your revenue?
- How easy would it be for your buyer to switch from one seller to another?
Threat of Substitutes
All firms in an industry are competing with other industries who make substitute products or services. If buyers can satisfy their needs with a different product or service from an alternative industry, that will put a lid on how high your industry can set its price. The more attractive a substitute, the firmer the lid on industry profits. If there are many substitutes that can perform a similar function as your product or service, then the threat of substitutes is high. If there are few substitutes that provide the same function as your product or service the threat is low.
- How many substitutes products/services are there your industry?
- How similar are those products/services from a functional standpoint?
- Are those products/services affordable?
- What differentiates your products/services from those substitutes?
Although rivals are subject to the same industry forces as yourself, the force of competitive rivalry is often the largest determinant of an attractive industry. In order to capture their share of the market, rivals will compete on price, quality, service, marketing spends, etc. Rivalry is strongest when your buyers have plenty of alternatives, there is little differentiation between rivals, and when industry growth is slowing. If the buyer can choose from multiple rivals, the buyer can start bidding wars and reduce profits. When there is little differentiation between rivals, your product or service will be perceived as a commodity and the buyer will purchase solely on price. If an industry’s growth is slowing, the existing firms will be in a fight to maintain their piece of market share.
- How many competitors are in your industry?
- What makes your product/service different from your rivals? Are there any barriers that would prevent your customers from switching providers? If so, what are they?
- Is your industry shrinking or growing?
What overall strategy should you pursue (Cost Leadership, Differentiation, or Focus)?
Using Porter’s 5 Forces, you should start to understand the forces that shape your industry, the next step is to identify how your company is going to compete. Ideally, we want to sit in a position where we can defend against the 5 Forces thereby maximizing our profit. The 3 generic strategies that help us find a defendable position are Cost Leadership, Differentiation, and Focus.
Cost leadership is a strategy which focuses on reducing the costs involved in providing a product or service. By running a lean operation, you’ll maintain healthy margins and profits.
A differentiation strategy focuses on providing a product or service that is perceived as being unique and hard to replicate. Buyers won’t find anything like your product or service in the market allowing you to charge a premium.
A focus strategy looks at serving a specific target market better than anyone else in this industry. By acquiring a deep understanding of your specific customer, you’ll be able to serve your customers more effectively and efficiently than the competitors who are working across the entire industry.
Don’t get stuck in the middle
Which strategy is your firm working towards? It’s not uncommon for firms to successfully pursue more than one strategy, especially if your industry is growing and profitable. However, as industries mature, the companies who are unclear about their strategy often see their profits dwindle. When companies fail to focus their efforts into any one of these 3 strategies they are, as Porter calls it, “stuck in the middle”. Companies who are stuck in the middle lack the investment and resolve needed to be a cost leader, the unique product offering to pursue differentiation, and the attention required to pursue focus… in the long run, it’s a losing strategy.
If you are stuck in the middle, it’s important to start aligning your company with one of these strategies. Not sure which strategy to pick? choose a strategy that is hardest to replicate and that is best suited for your company’s strengths. If you’re interested in easy to follow methods for identifying your strengths, check out our internal analysis article.
Interestingly, the idea of focusing on a strategy is omnipresent in the realm of strategic planning. Whether you’re reading Michael Porter’s Competitive Strategy, Stephen Covey’s 4 Disciplines of strategic execution (BHAG), or Jim Collins’ Good to Great (Hedgehog Concept), keeping an acute focus on one strategy is vital for success.
Keep your strategy focused
If you’re looking to focus your company on a specific strategy, you should adopt a simple yet powerful strategy method. Our FREE strategic planning course can help you with this. The course walks you through our proven method for crafting your strategy from the top down. To prevent being “stuck in the middle,” remember to keep your strategy front of mind as you work through the course. For example, if you’re looking to pursue a cost leadership position, make sure you create goals focused on cost reduction and growing market share. In order to protect yourself successfully against the forces that shape your industry, you’ll need to identify the strength of each force and the underlying reason for its strength. From there, create goals and procedures that, if achieved, place you in a position that protects you from whatever force you were looking to mitigate.
Lastly, know that you cannot do this alone. Change requires buy-in from your people. Aligning your strategy across your organization can be difficult – it’s even more difficult for everyone to keep strategy front of mind. Make sure you have the systems in place that can help to align and facilitate your strategy, such as strategic planning and execution software.
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Hopefully, this article gave you the steps necessary to protect against the competitive forces in your industry. Please leave your comments and thoughts below!