This article explains porter’s five forces model in a practical way. After reading you will understand the basics of this powerful strategy tool.
- Background Porter’s five forces model
- Porter’s five forces model / competitive forces model
- Supplier Power
- Buyer Power
- Threat of Substitutes
- Threats of new entrants on the market
- Competition in the business sector
Background Porter’s five forces model
Porter’s five forces model (competitive forces model) is a model that was developed by Michael Porter. The purpose of Porter’s five forces model is to determine the profit potential of a market i.e. business sector.
According to Michael Porter each business sector is potentially influenced by five factors that he refers to as ‘forces’. The combined power of Porter’s five forces determines the eventual profit potential of the business sector. The Porter’s five forces model and therefore the opportunities for making a profit differ from business sector to business sector.
Porter’s five forces model / competitive forces model
- Supplier power
- Buyer power
- Threat of substitutes and complementary goods
- Threat of new entrants on the market
- Competitive rivalry
Suppliers, first of Porter’s five forces model, can exercise more power by threatening with increased prices or a deterioration of quality. Supplier power depends on the following six factors:
– The number of suppliers
When there are more suppliers, an organization can switch to another supplier in case of threats.
– The number of substitutes that are available
Substitutes provide alternatives in case the supplier makes threats. Because of these substitutes, an organization is less dependent on one supplier. A catering entrepreneur could for instance sell another brand of coffee if there is a conflict situation with the current supplier.
– The importance of the business sector for the suppliers
If a supplier creates a lot of profit from a certain business sector, it is crucial to maintain their buyers.
– Switching costs
The higher the switching costs, the less inclined an organization will be to choose another supplier. The supplier can therefore exercise more power because the buyer will not easily choose another supplier.
– Product standardisation
When products are standardised on account of advantages related to money, time and efficiency, a buyer will be less inclined to change suppliers. Think for example of Microsoft: because everyone uses Windows, users will not easily opt for another operating program.
– Vertical integration
The possibility of vertical integration determines how easy it is for suppliers themselves to produce certain products with a high demand within a business sector. The consequences could be that the present organization loses customers because they are served by the new organization. The organization will then probably have to find another supplier.
The second of Porter’s five forces model is buyer power. When buyers have much power, they can put pressure on the price by playing off the competitors against each other. The power of customers depends on:
- The part of the total market turnover that is purchased per buyer
- The importance of the product for the buyer
- The degree of product standardisation
- The switching costs and the profits of the buyers
- The threat of vertical integration
- The importance of the products within the business sector and the quality for the buyer
- The degree in which buyers are informed about demand, market prices and costs within the business sector
Threat of Substitutes
All companies compete in a broad sense with other business sectors where substitutes are produced. These substitutes, third of the five forces, limit the potential revenue for a business sector. The DVD has supplanted the VHS videotape, for example. Substitutes can also be looked for ‘further away’. A family wants to go on a holiday or buy a new car, for example. The first product has nothing to do with the other but it can still displace the other. This is the third force of Porter’s five forces is buyer power.
Complementary goods display a positive correlation with the market. For example when DVDs are becoming much more attractive for consumers (e.g. declining prices) this will have a positive effect on the DVD player market. Marketing will therefore respond to this effect by means of cross-selling. A good example is a large basket filled with reading glasses that are on sale and which are placed next to the magazines and books.
Threats of new entrants on the market
Organizations entering a business sector are striving for market share. As a consequence, prices of products or services could decline or the costs of the current organizations (competitors) could be higher. Both effects have a negative effect on the profitability within a business sector because the reward will have to be shared with more people.
The probability of new entrants entering the market depends on the existing entry barriers and the reaction of existing competitors to the new entrants. Michael Porter has formulated six major sources of barriers to entry:
– Economies of scale
Economies of scale deter entry by forcing new entrants either to come in on a high scale or on a low scale with high costs as a consequence.
– Product differentiation
When established enterprises enjoy brand identification and customer loyalty, new entrants are forced to invest heavily to be able to compete with this.
– Capital requirements
In some sectors, large financial resources are needed before a new entrant can start producing a product. Think of for instance aircraft manufacturing or the automotive industry.
– Switching costs
Switching costs are non-recurring costs customers are faced with when they switch suppliers. When these costs are very high, it is harder to persuade customers to switch suppliers.
– Access to distribution channels
When the logical distribution channels have all been provided by current enterprises, new entrants will have to make investments so they can distribute their products in the marketable sales channels.
– Government policy
The government or the authorities can limit or exclude entrance to a business sector by laying down legal measures such as licence obligations.
Competition in the business sector
The fifth of Porter’s five forces model. When the internal competition (competition between existing firms in the market) is high, for example because of high exit barriers, major strategic risks (there is a lot at stake), little differentiation and low switching costs, high fixed costs and storage costs, low growth or equivalent competitors, the margins can be severely affected by downward pressure. This creates a low profitability and organizations can react strongly to potential new entrants in such markets.
In an industry where homogeneity prevails, such as mobile telephony, the internal competition is very fierce. Companies cannot differentiate so much with respect to the product and therefore they must try and drive away the competitor from the market by means of price wars, for example. As a consequence, the battle for market share will be very fierce and aggressive.
The core of formulating a competitive strategy lies in the positioning of the organization in the business sector. Proper positioning is one strategy from which an organization can defend itself against the Porter’s five forces modelor they can make it work in favour of the organization.
The possibilities and strategies that need to be implemented in order to achieve this position are largely influenced by the structure of the business sector in which an organization operates.
- Porter, M.E. (2008). The Five Competitive Forces that Shape Strategy. Harvard Business Review, January 2008, p.86-104.
- Porter, M.E. (1980). Competitive Strategy. Free Press, New York, 1980.
- Porter, M.E. (1979). How Competitive Forces Shape Strategy. Harvard Business Review.
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