This is the second post in the series that summarizes the book Understanding Michael Porter. Read the first post on common misconceptions about competition here.
Industry Structure: The Five Forces
It is more useful to think of companies as competing for profits instead of competing for market share or business. A company is not just competing with their rivals for profits, but also with their customers, their suppliers, potential new entrants, and substitutes. These five forces explains the industry's average prices and costs, that in turn determines the profitability of an industry.
The five forces analysis helps answer the following questions:
Why is the current industry profitability what it is? What's propping it up?
What's changing? How is profitability likely to shift?
What limiting factors must be overcome to capture more of the value you create?
Assessing the Five Forces
Each of these five forces have a clear, direct, and predictable relationship to industry profitability. Substitutes, threat of new entrants, bargaining power of buyers, and rivalry tend to reduce prices that a company can charge for it's product or service. Bargaining power of suppliers and rivalry tend to increase costs of producing the product or service.. The more powerful the force, the more pressure it will put on prices or costs or both.
Bargaining Power of Buyers: Powerful buyers will force prices down or demand more value in the product, thus capturing more of the value for themselves. The power of channels through which products are delivered can be as important as the end users (especially if the channel influences the purchase decisions). Customers tend to be more price sensitive when what they are buying is
Undifferentiated
Expensive relative to their other costs or income
Inconsequential to their own performance
Bargaining Power of Suppliers: Powerful suppliers will charge higher prices or insist on more favorable terms, lowering industry profitability.
How do you assess the power of suppliers and buyers?
What percentage of an industry's purchases or sales does a supplier or buyer represent?
How painful would it be to lose that supplier or that customer?
Does the industry need to buyer or supplier more than they need the industry?
Is it easy for the company to switch to a different supplier? Is it easy for the buyer to switch to a competitors product?
Do buyers see little differentiation in the industry's products?
Can a company credibly threaten to vertically integrate into producing inputs that are currently being produced by suppliers?
Threat of Substitutes: Products or services that meet the same basic need as the industry's product in a different way puts a cap on industry profitability. Switching costs play a significant role in substitution. Substitutes gain ground when buyers face low switching costs.
New Entrants: Entry barriers protect an industry from newcomers who would add new capacity. There are different kinds of entry barriers and the following questions help you identify and assess them:
Do economies of scale come into play? If so at what volume? Where do these economies come from - spreading fixed costs, using more efficient technologies that are scale dependent, or increased bargaining power over suppliers?
Will customers incur any switching costs in moving from one supplier to another?
Does the value to customers increase as more customers use a company's product?
How large are the capital investments to enter the business and who might be willing and able to make them?
Do incumbents have advantages independent of size that new entrants can't access?
Does Government policy restrict or prevent new entrants?
Is this industry known for making it tough for newcomers? Does the industry have the resources to compete aggressively?
Rivalry among existing competitors: If rivalry is intense, companies compete away the value they create, passing it on to buyers in lower prices or dissipating it in higher costs of competing. How do you assess the intensity of rivalry?
Is the industry composed of many competitors or if competitors are roughly equal in size and power?
How fast is the industry growing?
Are the exit barriers for leaving the industry high?
Are the rivals irrationally committed to the business?
Price competition is the most damaging form of rivalry, it is more likely when:
It is hard to tell one rival's offerings from another
Rivals have high fixed costs and low marginal costs
Capacity must be added in large increments, disrupting the industry's supply-demand balance
The product is perishable
Typical Steps in Industry Analysis
Define the industry correctly. When there are differences in more than one force, or where differences in any one force are large, you are most likely dealing with a distinct industry and it will need its own strategy.
Identify the players constituting each of the five forces and segment them into groups
Assess the underlying drivers of each force. Which forces are strong or weak, why?
Which forces control profitability? Are the more profitable companies better positioned in relation to the five forces?
Analyze recent and likely future changes for each force. How are they trending? How might new entrants or competitors influence industry structure?
How can you position yourself in relation to the five forces? Can you exploit weakness or industry changes?
Misconceptions About Industry Profitability
Some of the popular misconceptions on the links between industry structure and profitability
Forces that determine industry profitability is different for different industries
Industry profitability is linked to growth of industry, regulation, type of industry - manufacturing or service