It is important to understand the industry or sector in which an organisation sits in order to maximise the output of that organisation. Michael Porter’s Five Forces Model can be used to analyse an entire industry or strategic group of close competitors and theorises that industry competition and profitability are influenced by the pressures of five competitive forces:
- Threat of new entrants
- Threat of substitutes
- Bargaining power of customers
- Bargaining power of suppliers
- Competition and rivalry
The Five Forces Model can be used when understanding the inherent attractiveness or profitability of a particular market segment then identifying the actions to take relating to each individual force acting on the organisation to limit the dangers of threats and maximise the potential of opportunities.
So lets look at each of these five forces in detail and how they relate to an organisations profitiability:
Threat of new entrants
This is the threat of a rival business being started from scratch and taking an organisations share of the market. What barriers are there in the market that will prevent or deter this a rival company from starting up and how easy will it be for that company to take your share of the market. If one thinks of Adidas or Nike as an example, whilst it might be relatively easy for a rival clothes company to start up and start producing sportswear it is much more difficult to directly attack Adidas and Nike’s share of the market as they have simply spent too much money for too long promoting their goods and it is easier for them to maintain this than for others to get into the market.
They key factors to consider here are the brand identity, the capital cost of starting up a company, any regulations or patents that may be in place restricting access to industries, and the knowledge of the industry and management of that knowledge – which is something a start up company will usually be lacking, at first.
If the barriers to new entrants entering an industry or sector is insignificant then this will have the effect of reducing the price one can charge, and therefore profits, as rivals can easily enter the market and undercut your price point.
Threat of substitutes
This is the threat of substitute product satisfying the same customer needs. Relative price performance is a factor here, whilst there other sportswear brands satisfying similar customer needs they do not compete at the same price point as Adidas or Nike as that would price them out from their market altogether, they are not considered premium sportswear. It’s not that Adidas or Nike’s goods are significantly superior in quality to other brands its just that if someone was going to spend that much money on sports clothes they would buy Adidas or Nike. Those lower down the brand-chain have a significantly higher threat of substitute products at the same price/quality level.
The threat of substitutes then will reduce profits as customers will be able to switch if the price rises.
Bargaining power of customers
Customers that are larger in size and more organised will generally be able to drive down the price an organisation can charge and therefore reduce its profits. The prime example here is supermarkets and the grocery suppliers. The supermarkets are larger and more organised and therefore can decide the price they are able to buy these goods at affecting the profitability of the smaller farmers.
Bargaining power of suppliers
Suppliers that are larger in size and more organised will also generally be able to drive up the price an organisation pays and therefore reduce its profits. Using the supermarket example again, if one thinks of the branded products a decent supermarket must have – the Heinz ketchup, the Coca-Cola soft drinks, Gillette razors etc – one can see how this puts these suppliers in a stronger position to drive up their price and therefore reduce the profits of the supermarkets. If the supermarket doesn’t pay they lose out on the branded product which in turn could lose them customers who go elsewhere to get those goods.
Competition and rivalry
Intense competition and rivalry in an industry will drive down profits, and is a combination of the number and nature of competitors. This could result from slow growing or declining markets, excess capacity, barriers to exit and other factors. Keeping the supermarket example alive, the rivalry between the main supermarkets is a factor in
Industry life cycles
This is the last piece of the industry jig-saw puzzle, understanding where an industry is in its life-cycle plays a key part in analysing the competion.
Industry Life Cycle: Introduction > Growth > Shake-out > Maturity > Decline
Most of the above are self-explanatory and it should go without saying that sales volume will be low in the introduction stage, increase during growth, stabilise in shake-out, remain stable in maturity and then decline in decline. Shake-out, just to explain if this is new, is where those unsuccessful business are closed down and only the successful ones carry on. The internet bubble at the turn of the century will probably bring a few examples to mind for most people of this industry life-cycle, where a new industry came in, there was massive growth, a lot of companies lost money and closed down in the shake-out and the sales volumes stabilised in the maturity stage, although this last bit may be a bit harder to determine/verify.
The industry-life-cycle-stage will also have implications for cost and strategy.