Porter's Five Forces is a model that identifies and analyzes five competitive forces that make up each industry and helps determine the weaknesses and strengths of an industry. Porter identified five undeniable forces at play in shaping every market and industry in the world, with some caveats. Let's see what Porter's five forces are and what each of them is based on.
What are Porter's five forces?
Porter's Five Forces is a model that identifies and analyzes five competitive forces that make up each industry and helps determine the weaknesses and strengths of an industry. Five forces analysis is frequently used to identify the structure of an industry and determine business strategy. Porter's model can be applied to any segment of the economy to understand the level of competition within the industry and improve the long-term profitability of a company. The Five Forces model is named after Harvard Business School professor Michael E. Porter.
What are Porter's five forces for?
Porter's Five Forces is a business analysis model that helps explain why various industries are able to maintain different levels of profitability. The model was published in Michael E. Porter's book, Competitive Strategy: Techniques for Analyzing Industries and Competitors, in 1979.1 The five forces model is widely used to analyze a company's industrial structure as well as its corporate strategy. Porter identified five undeniable forces at play in shaping every market and industry in the world, with some caveats. The Five Forces are frequently used to measure the intensity of competition, attractiveness, and profitability of an industry or market.
Breakdown of Porter's Five Forces
Porter's 5 forces are:
1. Competition in the sector
The first of the Five Forces refers to the number of competitors and their ability to undercut a company. The greater the number of competitors, along with the number of equivalent products and services they offer, the less power a company has. Suppliers and buyers look to a company's competition if it can offer a better deal or lower prices. On the contrary, when competitive rivalry is low, a company has more power to charge higher prices and set the terms of deals to achieve greater sales and profits.
2. Potential for new entrants in the sector
The power of a company is also affected by the strength of new entrants in its market. The less time and money it costs for a competitor to enter a company's market and be an effective competitor, the more an established company's position could be significantly weakened. An industry with strong barriers to entry is ideal for existing companies within that industry, as the company could charge higher prices and negotiate better terms.
3. Power of suppliers
The next factor in Porter's model concerns the ease with which suppliers can drive up the cost of inputs. It is affected by the number of suppliers of key inputs of a good or service, how unique these inputs are, and what it would cost a company to change suppliers. The fewer suppliers an industry has, the more dependent a company will be on one supplier. As a result, the supplier has more power and can drive up input costs and press for other advantages in trade. On the other hand, when there are many suppliers or low switching costs between rival suppliers, a company can keep its input costs lower and increase its profits.
4. Power of customers
The ability of customers to lower prices or their level of power is one of the Five Forces. It is affected by the number of buyers or customers a company has, the importance of each customer, and how much it would cost a company to find new customers or markets for its production. A smaller, more powerful customer base means each customer has more power to negotiate lower prices and better deals. A company that has many small, independent customers will have an easier time charging higher prices to increase profitability.
5. Threat of substitutes
The last of the Five Forces focuses on substitutes. Substitute goods or services that can be used in place of a company's products or services pose a threat. Companies that produce goods or services for which there are no close substitutes will have more power to raise prices and obtain favorable terms. When there are close substitutes, customers will have the option of not buying a company's product, and the company's power may be weakened. Understanding Porter's Five Forces and how they apply to an industry can allow a company to adjust its business strategy to better utilize its resources and generate greater profits for its investors.