BUS501: Strategic Management

LEARNING OBJECTIVE

• Apply Porter's Five Forces to the external landscape to derive optimal strategies
  
  

KEY POINTS

• Porter's Five Forces include threat of new entrants (also known as barriers to entry), threat of substitutes, rivalry, bargaining power of suppliers, and bargaining power of buyers.
• Managers use the Five Forces model to help identify opportunities and threats or to evaluate decisions in the context of their organization's environment.
• Attractiveness refers to the overall industry profitability. An "unattractive" industry is one in which the combination of the Five Forces drives down overall profitability.
• In analyzing these five factors, it is useful to rate each category as an external risk factor (i.e., low, medium, or high). Ideal industries have low threats from each of these forces (i.e., low buy power, low rivalry, low risk of new entrants, etc.).
• This model is a useful for the strategic derivation of managers; it allows them to narrow down their focus on specific key issues within a given industry.
  
  

TERMS

• substitute

  A replacement or stand-in for something that achieves a similar result or purpose.

• entrant

  Participant.

Michael Porter, a leading business analyst and professor at Harvard Business School, has identified five key forces that affect the strategy of any industry. His list, Porter's Five Forces, draws upon industrial organization (IO) economics to derive forces that determine the competitive intensity – and therefore attractiveness – of a market.

Industry Attractiveness

Attractiveness refers to the overall industry profitability. An "unattractive" industry is one in which the combination of the Five Forces drives down overall profitability. A very unattractive industry would be one approaching "pure competition". In this state, available profits for all firms are driven to normal profit rates. In analyzing the following five factors, it is useful to rate each category as an external risk factor (i.e., low, medium, or high). Ideal industries will have low threats from each of these forces (i.e., low buy power, low rivalry, low risk of new entrants, etc.).

The Five Forces

Porter's Five Forces include:

1. Threat of new entrants (or barriers to entry): From the view of current incumbents, profitable markets that yield high returns will attract new firms. This results in many new competitors and eventually decreases profitability for all firms in the industry. Unless the entry of new firms can be blocked by incumbents, the abnormal profit rate will tend toward zero (also known as "perfect competition"). From the perspective of new entrants, high barriers to entry mean that the capital costs of getting into the industry make it difficult to compete with current incumbents.
2. Threat of substitute products or services: The existence of products outside of the realm of the common product boundaries, which fulfill the same need, increases the propensity of customers to switch to alternatives. This should not be confused with competitors' similar products; it is instead a different product that fills the same need. Take transportation as an example: General Motors (GM) would view city subways as a substitute for someone buying a new car.
3. Rivalry: For most industries, the intensity of competitive rivalry is the major determinant of the competitiveness of the industry. This involves how many firms are in the industry and how their competitive dynamics reduce profitability. Airlines have an extremely high rivalry, for example.
4. Bargaining power of buyers: The bargaining power of customers is also described as the market of outputs. It is the ability of customers to put the firm under pressure, which also affects the customer's sensitivity to price changes. Picture a supply and demand curve: if the supply greatly outstrips the demand, the buyers have more power than the suppliers.
5. Bargaining power of suppliers: The bargaining power of suppliers is also described as the market of inputs. When there are few substitutes, suppliers of raw materials, components, labor, and services (such as expertise) to the firm can be a source of power over the firm. Suppliers can refuse to work with the firm or charge excessively high prices for unique resources. Similar to the power of buyers, this bargaining power relies on scarcity and basic economics of supply and demand.
   
   

Strategic Implications

Managers use the Five Forces Model to help identify opportunities or evaluate decisions in the context of the environment. Often, the Five Forces are mapped against a SWOT analysis to develop a corporate strategy. To complete a Five Forces analysis, it is often best to build a grid on a piece of paper and label each section. Filling in each section to develop a view of the industry can help managers determine if the industry is truly competitive, a monopoly, or an oligopoly. An important question to ask is: "What will make a company able to compete in this environment?"

Porter's Five Forces

This image illustrates the important factors within Porter's Five Forces model.

Source: Boundless, https://courses.lumenlearning.com/boundless-management/chapter/external-inputs-to-strategy/
This work is licensed under a Creative Commons Attribution 4.0 License.