Let me introduce a modified version of my favorite tool for performing external analysis: Porter’s Five Forces Model of Industry Attractiveness.
Porter’s Five Forces Model is a framework for assessing long-term profitability in an industry. It is used to fill in the opportunities and threats sections of a SWOT table. It evaluates how profitable a well-positioned product is in an industry of choice, but neglects the native demand for the product itself. Of course, a product also has to be in demand for it to be profitable. For evaluating how necessary a product is and how much people want it, visit my marketing post on products.
Profitability of a firm in an industry depends on its relative bargaining power when dealing with its business at various positions in the value chain (supplier power and buyer power), the value of its product to buyers (availability of substitutes and complements), and whether the firm will survive competition (industry rivalry and threat of new entrants). Now, let’s dig deeper into Porter’s Five Forces:
- Supplier Power: Supplier power refers to the power which your suppliers exert over you in negotiations. Your supplier has little supplier power if you are the only person willing to purchase a product from your supplier and when you have many alternative suppliers from whom you can purchase your goods. The lower the power your suppliers have over your business, the more attractive the industry is for you. You can reduce supplier power by introducing switching costs for your supplier. For example, you can sign a contract with the supplier that makes you their exclusive and only buyer. In another example, a wholesaler like Walmart could make sure its suppliers pay heavy costs for producing a similar product for your competitors because the competing firms are not as large as Walmart and cannot sell as much of the product, so a whole lot of the product [let’s imagine it is food produce] would go bad if Walmart does not buy.
- Buyer Power: Buyer power refers to the power which your buyers exert over you in negotiations. Your buyer has little buyer power over you if you are the only vendor from whom they can purchase a product and when you have many other customers to whom you can sell the same product. The lower the buyer power your customer has over you, the more attractive the industry is for you. You can reduce buyer power by introducing switching costs for your buyer. For example, if you are a supplier of chips, you can enter your product into Walmart at a cheap price and without revealing the secret sauce for your tasty chips. Once your chips become very famous for its good taste, you can ask Walmart to pay you more because now your product is in demand in multiple stores across the town. In another example, Walmart and other retail stores lock in their customers to their stores by offering everything one needs – thereby introducing switching costs of extra gasoline consumption and time expenditure for the buyer to move to another store – and by promoting discounts in their loyalty programs. For someone with a Walmart loyalty program, it is now increasingly economical to shop at Walmart, so they keep shopping at Walmart.
- Industry Rivalry: Industry Rivalry refers to the intensity with which other competitors in the industry compete with one another. An industry with lower levels of competition is more profitable. For example, the telecommunications business has low industry rivalry in Canada because the few companies offering these services (Rogers, Bell, Telus, etc.) do not offer their services at lower and lower prices that reduce each others’ revenues. In comparison, the retail industry is so competitive that only those retailers which are most cost-efficient (e.g. Walmart) can survive.
- The Threat of New Entrants: One should consider the state of industry competition in the future, which really depends on how easily new competitors can emerge in the industry. The smaller the threat of new entrants, the more profitable an industry is. The threat of new entrants is lower when there are significant barriers to entry into the industry. The reason there are very few telecommunication companies in Canada is the industry’s barriers to entry. Up until a few years ago, the Canadian government had licensed only a few Canadian companies for this business. Yet, now that licenses are granted to foreign companies, these companies do not have the financial muscle to invest in installing enough cellular towers to cover the cities in which the majority of Canadian residents live. In another example, it may be easy to make a new soft drink that people would enjoy drinking with their food, but it would take a tremendous advertisement cost to make a brand as famous as Coca-Cola or Pepsi. Hence, Pepsi, Coca-Cola, and telecommunication companies need not worry about new entrants to their markets.
- Substitutes: Substitutes refer to alternative products that can satisfy the buyers’ needs for or wants of your product. If the product has substitutes, then it is valued less by the customer. For a soccer fan (football fan, according to non-North Americans), there is no alternative to European soccer games on the weekend. There may be many other TV shows to watch, but no other TV shows nor any other sports satisfy the fan’s desire to watch soccer on their free day.
- *Complements*: the force of Complements was not originally acknowledged as one of the five forces described by Porter, but it has the power to influence what customers want. The more products complementary to your product are purchased by a customer, the more popular your product will also be. For example, Coca-Cola is particularly popular in stores where pizza (coke’s complement) is also sold. Also, the iPhone iOS and the Android OS are both benefiting in popularity because of the apps which are exclusively and non-exclusively installed on and run on those operating systems.
Try critically evaluating the Five Forces for your [potential businesses. Then, please assess the following:
- the industry’s current overall attractiveness
- what drives profitability in the industry – which of the forces are more important in generating or restricting profitability
- how is the industry changing in terms of the five forces
- how effectiveness is the company’s current strategy in the changing industry