Porter's Five Forces model, named after Michael E. Porter, identifies and analyzes five competitive forces that shape every industry, and helps determine an industry's weaknesses and strengths. This framework is used for analyzing the level of competition present within an industry. This will help in determining the ‘attractiveness’ of the industry i.e. the overall profitability. Five forces model published in 1979, is widely used to determine corporate strategy. Porter identified five undeniable forces that play a part in shaping every market and industry in the world.
These forces are:
Threat of New Entrants: The threat of new entrants is low if barriers to entry are high and the threat is high if the industry has relatively low barriers to enter. The entry of new players into the industry can force the incumbents to lower their prices. The threat of entry therefore puts a cap on the profit potential of an industry. For example, take the Airline industry, here the barriers to enter are very low because of easy availability of flights, skilled personnel’s etc. this is the reason for the entry of many new players into the industry over the last several decades forcing the prices down.
Bargaining Power of Suppliers: In every industry, companies purchase their raw materials from one or more suppliers, which accounts for differing proportions of cost. If the number of suppliers is less and Buyers are large in number, then the suppliers can leverage this to charge higher prices and more favorable terms from the industry competitors. In such scenarios, we say that the bargaining power of suppliers is high. For example, I was working in an IT company which had about 98% return rate of consumers. Here the supplier of IT solutions i.e. my company was very powerful because for consumers the switching cost to shift this supplier was high and thus they preferred to stick to the same supplier. At the same time, if we consider the soft drink industry, the major raw materials are all basic commodities thus the bargaining power of suppliers were very low in that case.
Bargaining Power of Buyers: powerful customers can use their clout to force prices down or demand more services at the same rate, thus capturing more values for themselves. Bargaining power of Buyers is high when they are relatively large in number compared to the suppliers, when the products are undifferentiated and the switching cost is very low. In the airline industry, the services are not differentiated and the switching costs between airlines are also less, thus here the bargaining power of customers is very high.
Threat of substitutes: Competitor substitutions that can be used in place of a company's products or services pose a threat. When a new product or service meets the basic requirements in a different way than the existing one, the industry profitability suffers. For example, email is a substitute for Express mails. The threat of substitutes is high if it offers attractive price performance compared to the existing product or if the switching costs between these products are less.
Rivalry within the industry: This force is mainly concerned with the competition currently present in the market, which is mainly determined by the number of competitors and what each can do. Competition Rivalry is high when there are few competitors, sells an undifferentiated product, when the industry growth is high and switching cost is less. High Rivalry competition can ensue advertising and price wars which can decrease the industry profitability. Concentration Ratio (CR) is used to quantitatively measure the rivalry competition. Cola Wars is one of the most popular example of competition rivalry within the industry.
The Five Competitive Forces that shape Strategy; Micheal E. Porter