The tool was created by Harvard Business School professor Michael Porter. Porter’s five forces model is an analysis tool that uses five industry forces to determine the intensity of competition in an industry and its profitability level. Since its publication in 1979, it has turned into one of the most popular and highly regarded business strategy tools.
Porter was of the firm view that the organizations should keep a close watch on their rivals, but he also encouraged them to go beyond the boundaries of their competitors and make an assessment of other factors impacting the business environment. In this process, he identified five forces that build a competitive environment, and have a take away its profitability.
The five forces identified are:
1. Threat of new entrants: This force determines the ease of new entrants to enter a particular industry. If an industry is profitable and there are hardly any barriers to enter, competition intensifies rapidly. Therefore, with the entry of more rivals, firms begin to compete for the fixed market share, profits start to decline. Hence, it is critical for existing organizations in the industry to build high barriers to entry to discourage new entrants. The threat of new entrants is high when:
• Smaller capital is required to make an entry;
• Existing companies are not influential/dominant to prevent new entrants;
• Existing firms do not have patents, trademarks or do not strong brand value;
• There is no/little government regulation;
• Customer switching costs are low;
• There is low customer loyalty;
• Products are not being able to be differentiated; and
• Economies of scale can be effortlessly acquired.
2. Bargaining power of suppliers: This is determined by the power of the suppliers to raise their prices. It is also determined by the volume of potential suppliers in case the existing suppliers increase the price. Bargaining power will also be lower in case suppliers are not supplying identical product/service but a unique one. And the cost of switching from one supplier to another. Suppliers have dominant bargaining power when:
• There are a small number of suppliers but plenty of buyers;
• Suppliers are large in number and pose a threat to forward integration;
• There are not many substitutes of raw materials;
• Suppliers hold scarce/unique resources;
• Cost of switching suppliers is relatively high.
3. Bargaining power of buyers: The bargaining power of the buyers would depend on the number of buyers and the volume of their order. It would also be a product of the cost of switching from the company’s products and services to products/services of the competitors. Buyers exert strong bargaining power when:
• They buy in high volumes or control many access points to the final customer;
• There are only a few buyers in the market;
• Switching costs to competitors are low;
• They threaten to backward integrate;
• There are many close substitutes;
• Buyers are price sensitive.
4. Threat of substitutes: This force is especially threatening when buyers can easily find substitute products with attractive prices or better quality and when buyers can switch from one product or service to another with little cost. For example, if a company supplies a unique software product that automates data related to human resource records, the buyer/client may substitute the software either by making the process manual or outsourcing it.
5. Rivalry among existing competitors: It refers to the number and strength of competitors in the industry. How does the quality of their products and services compare with the company? Where rivalry is intense, companies can attract customers with aggressive price cuts and high-impact marketing campaigns. On the other hand, where competitive rivalry is minimal, and the product is differentiated, there will be a high monopoly and steady profits for the company. This force is the major determinant of how competitive and profitable an industry is. In a competitive industry, firms have to compete aggressively for a market share, which results in low profits. Rivalry among competitors is intense when:
• There are several competitors;
• Exit barriers are high;
• Industry of growth is slow or negative;
• Products are not differentiated
• Products can be easily substituted;
• Low customer loyalty.
Although Porter originally introduced five forces affecting an industry, scholars have suggested including the sixth force: complements. Complements increase the demand for the primary product with which they are used, thus, increasing the firm’s and industry’s profit potential. For example, Amazon Prime complements Amazon, and Jio TV complements the Jio telecom business. As a result, the sale of both products shot up as compared to competitors.