Porter’s Five Forces
Learning objective: Determine the relative strengths of each of the five forces.
A. Threat of New Entrants
Those industries with high entry barriers will have fewer firms entering. With fewer firms, there is less environmental complexity, and it is easier for one firm to begin to dominate the industry. Economic rents are usually higher in such an environment. This makes the industry attractive. For industries with low barriers to entry, such as the restaurant industry, new firms come and go with great rapidity. This prevents dominance by any one, or a few, firms. Economic rents are usually low. This makes the industry unattractive. The following elements will help determine the level of threat from new entrants.
1. Economies of scale If economies of scale exist, it represents a high barrier to entry. Firms within the industry will have achieved these economies, and if we enter, we will have to match their scale size, but without the benefits of the associated learning curve. Since economies of scale do not exist in any tangible way, you must prove their existence or non-existence. Provide two measures related to the basic premise that increases in capital investment should lead to lower unit costs. Reach a conclusion: based on your analysis, do economies exist? What does this do to the threat of new entrants? Does this make the industry attractive or unattractive? Provide similar conclusions for each of the following sub-sections.
2. Working capital requirements How much money will we have to tie up to keep the doors open? This is money that can not be invested in any other way. It will never earn an income. This is also a barrier to entry in that if firms must tie up large amounts of capital for daily operations, this will deter smaller firms from entering. Working capital requirements are usually provided in the cash flow financial statements.
3. Proprietary product differences Do you see that some firms have a secret process or secret formula? An example would be Coca-Cola. They have a secret formula for their cola soft drink that acts as a high barrier to entry. Very few firms try and compete head-to-head with Coke in the cola segment of the industry.
4. Absolute cost advantages Do you see the presence of patents or copyrights? These are legal constraints to entry created by the government. By definition, they constitute a high barrier to entry. Examples include patents on pharmaceuticals and copyrights on software.
5. Brand identity Is brand identity important in this industry? Do buyers make conscious choices based on brand identity? If so, this would be a high barrier to entry. Examples include Viagra, Coke, and Intel Pentium processors. You must prove that brand identity is or is not important. One way is through an interview with a buyer. Another is to examine marketing expenses for the industry as a percentage of sales across five years. If the trend is upward, then brand identity could be important.
6. Access to distribution How do firms get their product or service to market? Would we need to duplicate the distribution channels, or could we tap into existing channels? This is not an obvious question, and it requires first determining who the buyers are. Kia auto discovered that lack of a distribution system in the form of dealerships limited its access to markets in this country. This was a very high barrier to entry for them.
7. Expected retaliation Do you see indications of retaliation against prior newcomers? This will require research through many historical articles about the industry. An example would be the airline industry. Midway Airlines, a small regional carrier, competed head-to-head with American and USAir, and went bankrupt. Southwest has survived nicely by avoiding the markets dominated by larger airlines such as American and United. This is one of the high barriers to entry for the major segment of the airline industry. From your analysis, you will find that some of these points are not relevant to your industry. You should also appreciate that some points are more important than others. Lastly, you should find that some elements will say that the industry is attractive, while other elements say that the industry is unattractive. Provide a decision matrix to justify your final answer as to the barriers to entrants, the threat of new entrants, and the attractiveness of the industry.
B. Suppliers
While we were concerned about threats in the "entrants" section, here we are concerned with power. Do suppliers have power over firms in this industry? If so, this would make the industry unattractive. The first step is to determine what this industry purchases. Not in detail, but as a generalization. Then, identify items that are recognized as being commodities. These can be dismissed from further consideration. Focus on suppliers of key items that firms in this industry must have. For example, in the micro brewing industry, all inputs are commodity items except hops. Since hops are the key ingredient for specialty beer production, supplier analysis would focus only on hops suppliers.
Evaluate the following elements only for the key item or items in the industry.
1. Suppler concentration Are there more or fewer suppliers than firms in this industry? If suppliers are concentrated (fewer of them) this could give them power over buyers in this industry. For example, Intel is one of only a few providers of CPUs for the PC industry. This gives them power over the PC industry.
2. Presence of substitute inputs The presence of substitute inputs lowers the power of suppliers. For example, in the auto industry, aluminum can substitute for steel. This lowers the power of the steel industry. A lack of substitutes, such as no substitute for the CPU gives the suppliers power.
3. Differentiation of inputs Are suppliers able to differentiate their products/services in some way? Whether legitimate or not, Intel has differentiated its CPU such that many consumers (not buyers) prefer computers with Intel inside. This ability to differentiate gives suppliers power.
4. Importance of volume to supplier Do we, as an industry, buy a significant percentage of the total production of the suppliers output? For example, the PC industry buys virtually all of the CPUs that Intel produces. This gives the PC industry power over the suppliers. Without the PC industry there would be no CPU manufacturers.
5. Impact of inputs on our cost or ability to differentiate If suppliers have a significant impact on an industry’s cost structure, or value chain, this gives them power. The same is true if they impact firms’ ability to differentiate their product or service. Again, the PC industry is a good example. Intel’s ability to impact PC manufacturers’ final product gives them power.
6. Threat of forward or backward integration Is there any indication that vertical integration is occurring? If suppliers are coming forward to gain access to distribution channels, this gives them power. If there are indications of firms backward integrating to capture margins, this gives firms in the industry power over suppliers.
7. Access to capital Assuming that we enter this industry, at some point in the future we will want access to capital for expansion or other business reasons. You need to determine whether we would likely have access to capital on acceptable terms. Since we can’t know the future, we have to use the past as an indication. Determine the average profitability for the industry over the last five years. Net income as a percentage of sales works. Plot a graph comparing industry profitability against inflation. In your opinion, does the return on investment represent a reasonable income? If so, we can expect that we would have access to debt financing on reasonable terms. If not, access to debt financing is likely to be expensive.
8. Access to labor If we enter, would we have access to labor on favorable terms? Does this industry have unions? If so, they limit access to labor and usually increase costs. Do firms in this industry require highly skilled knowledge workers? How is the present labor market for this industry? As with the threat of new entrants section, provide conclusions for each subsection as to the power of suppliers. Then provide an overall conclusion for this section using a decision matrix. Do suppliers have power and is the industry attractive?
C. Buyers First, determine who the buyers are. This is not a marketing paper, so don’t think ultimate consumer. What are the channels of distribution for the industry? Your analysis should focus on the primary buyer, not on the consumer unless there are no intermediaries. Here again, we are concerned with power. Do buyers have power over firms in this industry? If so, the industry is unattractive. The easiest way to get answers is through an interview with a buyer.
1. Buyer concentration Are there more or fewer buyers than firms in the industry? If buyers are concentrated, this gives them power. An example would be the airframe industry. There is only one U.S. based buyer for commercial aircraft parts – Boeing. Therefore, the buyers for the commercial aircraft parts industry are concentrated, giving the buyers power, making the commercial aircraft parts industry unattractive.
2. Buyer switching costs Do buyers have switching costs that would limit their willingness to switch suppliers? If the industry has been able to create switching costs, that gives the industry power over the buyer and makes the industry attractive. An example would be the software industry. The switching costs are the time required to learn a new program. This makes it less likely that a buyer would switch readily from, say, Excel to Lotus. This buyer switching costs gives power to the software industry.
3. Buyer Information Do buyers understand what is happening in this industry? If so, it is less likely that the industry can make competitive moves to increase profit margins. An example would be the auto tire industry. Buyers (auto manufacturers) know what it takes to make a tire. Therefore, they have power over the tire industry. This is demonstrated by the relatively low margins in the tire industry.
4. Threat of backward integration Backward integration is the process of firms acquiring their suppliers, or beginning the process of providing for themselves the means to produce the input. This can occur for several reasons, among them: to guarantee a dependable source of the input or to capture the margins normally paid to the suppliers. Are there indications that buyers are backward integrating? If so, this gives them power, making the industry unattractive.
5. Pull through Have firms in this industry been able to create pull through? This requires that intermediaries exist. If brand identity is important in this industry then pull through most likely exists. Quantitative analysis of advertising expense as a percentage of sales over time for the industry is one way of demonstrating that pull through could exist. The easiest way to answer the question is through an interview. If pull through exists, this gives the industry power over the buyer. An example would be the cereal industry, which has established pull through such that major grocery chains have to carry major brands. This pull through gives the cereal industry power over the buyers, making the industry attractive.
6. Brand identity of buyers Does the industry impact the brand identity of its buyers? If so, this would give the industry power over the buyer. For example, while high performance tires with a brand name seen on racing cars would favorably impact the brand identity of a very expensive sports car, a brand of tire that automobile assembly plants put on compact cars would negatively impact the brand identity of this car.
7. Price sensitivity Are buyers price sensitive? This deals with elasticity of demand. Is the industry able to pass cost increases on to the buyer, or must they absorb them? If buyers are not price sensitive, this gives the industry power and makes it attractive.
8. Price to total purchases Do the buyers’ purchases of this industry’s product/service represent a significant percentage of their total purchases? If so, this would give the industry power over the buyers. They would be dependent on a constant supply of goods or services for their survival. As with the supplier section, provide conclusions for each subsection as to the power of buyers. Then provide an overall conclusion for this section using a decision matrix.
D. Substitute Products An industry will be attractive if there is no threat from substitute products. A substitute is any product or service that will fulfill the same need while using a different technology. An example would be substituting plastic for paper for food carry out. The electric car is a substitute for the internal combustion engine; therefore the auto as we know it, even though the auto industry is the primary developer. The relevance is that substitutes can render obsolete the present capital investment of the industry.
1. Relative price/performance relationship of substitutes The electric car has not caught on, in part, because it does not have the same performance characteristics as the traditional auto. Another example: few business people put cheap pens in their shirt pockets. They prefer a very expensive pen. The prestige factor is much higher for the higher-priced pen. The need being satisfied is not the ability to write, but the image being portrayed.
2. Buyer propensity to substitute
Despite the benefits offered by the substitute product or service, do people really want it? The ultra-sonic clothes washer was a flop. It got clothes as clean as the conventional washer, using cold water and no soap. But people preferred the hot water and soap despite the additional costs. Another example: special interest groups forced McDonald’s to switch from styrofoam containers to paper containers for carry out food. This section does not require a decision matrix. Based on your study of the industry, what do you conclude about the attractiveness of the industry?
E. Rivalry
An industry characterized by high rivalry is unattractive because it limits the ability to achieve above normal economic rents. At the other extreme, industries with no rivalry are usually dominated by a few major firms which could limit strategic flexibility.
1. Degree of concentration and balance among competitors
As the business cycle, or life cycle, progresses, there is a tendency for consolidation to occur within industries. At the beginning of the 20th century, the US had around 300 firms in the auto industry. We now have two. As a rule of thumb, an industry is concentrated if five or fewer firms control 60% or more of market share. Concentration tends to increase rivalry, but must be considered along with balance.
If concentration does not exist, then balance is not an issue. The industry is, by definition, fragmented. This reduces rivalry and makes the industry attractive. Assuming that the industry is concentrated, then look for balance. If the two largest firms have market shares within 10% of each other, then the industry is balanced. This increases rivalry, making the industry unattractive. If one firm is dominant in market share, this means that the larger firm is setting the competitive rules for the industry. This reduces rivalry and makes the industry attractive.
2. Diversity among competitors
Are firms following different strategies? If so, they have found market niches and this reduces rivalry. If they are all following the same strategy, they are fighting for the same markets and this increases rivalry, making the industry unattractive.
3. Industry growth rate (past and projected) If there is a positive trend to industry growth rate, and it is greater than the inflation rate, then firms are able to grow without taking market share from other firms in the industry. This reduces rivalry and makes the industry attractive. Quantitative analysis is required with a graph of the five year growth rate trend.
4. Fixed costs to value added It is necessary to demonstrate whether fixed costs and value added are high or low. If fixed costs are high, this usually means that economies of scale are possible in the industry. If fixed costs are high, and value added is low, the industry is at or near maturity, and the product/service is most likely a commodity. This increases rivalry and makes the industry unattractive.