What Is Porter’s 5 Force? And How To Do an Analysis?
It is important to identify five competitive forces that shape competition in an industry. This framework helps you to determine a company’s weaknesses and strengths. So, What is Porter’s 5 forces?
Table of Contents
- What is Porter’s 5 Force?
- How To Do an Industry Analysis - Porter's 5 Force
Porter’s 5 forces is a framework to identify and analyze five forces that shape competition in an industry and helps understand an industry’s strengths and weaknesses. Also, Porter’s 5 forces is often used to analyze an industry’s structure to determine corporate strategy. This framework can be utilized for any segment to measure the competition in the industry and improve a company’s profits in the long run. Porter’s 5 forces was introduced by Harvard Business School professor Michael E. Porter in 1980.
Michael Porter came up with the model while researching the nature of competition. Industries differ from one other with respect to factors like profitability, product development, etc. Porter outlined 5 factors to analyze the profitability and attractiveness of an industry. This framework is useful especially when entering a new industry sector and/or starting a new business.
Porter’s five forces are:
A company’s power is well affected when other competitors can get into the market. The less money and time it costs for the competitors to enter the market, the easier they can enter the market. It is ideal for existing companies when there is a strong barrier to entry, so that the companies can charge more and have a power to negotiate rules.
Bargaining power of suppliers refers to the power that suppliers can have on the companies by increasing prices, controlling the availability of their products, and lowering their quality.
Bargaining power of buyers is the power customers have in business to make them offer lower prices, better customer service, higher quality of products, and etc.
Substitutes are goods or services that can be used as an alternative to a company’s products and services. Obviously, companies producing goods and services that other competitors can’t copy easily will have more impact on the prices and rules. Customers will have more possibilities to choose a competitor's product if substitutes are available. Thus, a company will have less power.
Rivalry among competitors examines how intense the competition is in the market. It depends on the number of existing competitors and how much impact they have in the market. Rivalry is high when there are many competitors that are equal in power and size, or the industry is growing at a slow pace and it is easy for consumers to switch to other competitors’ products/services for little cost. The concentration ratio is good to use for measuring the industry. Additionally, rivalry will be higher when it is hard for the existing competitors to exit because they need to remain in the industry even if the profit margin is decreasing. The reasons why they can’t exit the market are such as high fixed costs and long-term agreements.
Let’s take a look at Tesla for example.
Threat of entrants can be broken into
- Economies of scale
- Product differentiation
- Cost of entry
- Switching cost
A company is well positioned for long-term profitability and dominance within the industry when the company has a low threat level for all of those sections.
Economies of scale imply that larger companies have an advantage over small companies since larger can make a product cheaper than smaller. Does Tesla have an economy of scale? The answer is yes.
Tesla’s product is quite different, which gives it a huge advantage. It’s not easy for somebody else to come and copy what they do and innovate it further.
How much money would it cost to run the business? In the case of Tesla, it would cost a decent amount of money for a new company to come in and launch an automobile manufacturer. So, that would make the barriers to entry even higher for potential new entrants.
If we look at Tesla’ customers, how expensive or how difficult is it for a customer to switch from driving a Ford to driving a Tesla? We could say that it’s probably a very low switching cost.
In summary, when we look at the entire picture of Tesla in the industry we could say that it is a low threat that new entrants are going to enter.
The less power that a supplier has over a business, it’s better for the business. For example, if we were running a lemonade stand and there were 100 different places nearby that we could buy lemonades from, two things would happen. First, the price of lemonade is likely to be quite low. Second, it's unlikely that we’re going to run out of lemonade anytime soon.
In the case of Tesla, they actually spelled it out quite clearly for us in their quarterly and annual filings in a section called supply risk.
The majority of its suppliers are the only place that they can get the necessary components that they need for their products.
For Tesla, the threat is high in bargaining power of suppliers. This could be a bad thing for Tesla or Tesla’s business because ultimately having limited suppliers implies that suppliers could either raise prices or if the supply ever runs into manufacturing issues, that will have a direct reflection on Tesla’s ability to manufacture.
Because Tesla sells to so many different customers and no one customer represents a large portion of their revenue, customers will have very limited negotiating power. So, the bargaining power of buyers is low for Tesla. You should look to find information in the annual or quarterly filings as well if you are looking for where to find it.
So, we can see that the bargaining power of customers and bargaining power of suppliers are very related. Take the Tesla supplier situation where they only have a few suppliers. Tesla is a very large customer of those suppliers. In theory, Tesla would have a lot of bargaining power over the supplier as a customer. So, that sort of slices both ways. The two of them are most likely to try to work together and keep their business growing. It makes sense to say low threat when it comes to the bargaining power of buyers.
Tesla makes electric vehicles and this is clearly a very unique product, but we don’t have to buy an electronic car. We could buy a more traditional gas-powered or hybrid car, or we could take public transportation. So, there are other options Tesla isn’t the only one we have when it comes to buying a vehicle. Tesla makes a very unique vehicle, but that doesn't mean that there are no substitutes for their products.
As we could see all the forces sort of playing to this one and what we are looking for here is things like how many competitors there are. In theory, the more competition that there is, the worst there is for the companies in that industry. There is likely pressure on margins and sales; they would have to do more discounts along those lines. Then, we want to look at things like product differentiation or switching cost. Now, we know that a customer can switch fairly easily from one car company to another company. And, when it comes to differentiation, Tesla clearly has tons of differentiation compared to their competitors. We can tell that there is a ton of competition within the auto manufacturers industry and Tesla recently reduced the price of their model 3 car because of that. There is no reason to cut down the prices of vehicles unless there is competition out there driving customers in a different direction. Clearly, that would indicate that there is high rivalry amongst manufacturers in the auto industry. Plus, we know how many deals or sales are being offered by different car manufacturers at different times of the year. But, we don’t want to completely write off the fact that Tesla is in fact a unique vehicle and they make very different cars. And we want high-quality electric vehicles that only Tesla can make. Even if Tesla makes a unique vehicle, they are still in the middle of a very fiercely competitive auto market. It makes sense for this particular one of Porter’s five forces to make this threat a medium throat. Porter’s five forces as an analysis is in general is very company specific. As you can imagine if we were doing the same analysis for Ford, we would end up looking very different. It is important to realize that the goal here is to more fully understand the entire process and what the company goes through and where the future of their business possibly lies. If we want to do a thorough analysis of a company, this is a good place to go.