Porters five forces analysis is a framework for industry analysis and business strategy development formed by Michael E. Porter of Harvard Business School in 1979. It draws upon industrial organization (IO) economics to derive five forces that determine the competitive intensity and therefore attractiveness of a market. Attractiveness in this context refers to the overall industry profitability. An “unattractive” industry is one in which the combination of these five forces acts to drive down overall profitability. A very unattractive industry would be one approaching “pure competition”, in which available profits for all firms are driven to normal profit.
Three of Porter’s five forces refer to competition from external sources. The remainder are internal threats.
Porter referred to these forces as the micro environment, to contrast it with the more general term macro environment. They consist of those forces close to a company that affect its ability to serve its customers and make a profit. A change in any of the forces normally requires a business unit to re-assess the marketplace given the overall change in industry information. The overall industry attractiveness does not imply that every firm in the industry will return the same profitability. Firms are able to apply their core competencies, business model or network to achieve a profit above the industry average. A clear example of this is the airline industry. As an industry, profitability is low and yet individual companies, by applying unique business models, have been able to make a return in excess of the industry average.
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Porter’s five forces include – three forces from ‘horizontal’ competition: threat of substitute products, the threat of established rivals, and the threat of new entrants; and two forces from ‘vertical’ competition: the bargaining power of suppliers and the bargaining power of customers.
This five forces analysis, is just one part of the complete Porter strategic models. The other elements are the value chain and the generic strategies.
Porter developed his Five Forces analysis in reaction to the then-popular SWOT analysis, which he found unrigorous and ad hoc. Porter’s five forces is based on the Structure-Conduct-Performance paradigm in industrial organizational economics. It has been applied to a diverse range of problems, from helping businesses become more profitable to helping governments stabilize industries.
Porter’s Five Forces Model
Porter’s five forces model helps in accessing where the power lies in a business situation. Porter’s Model is actually a business strategy tool that helps in analyzing the attractiveness in an industry structure. It let you access current strength of your competitive position and the strength of the position that you are planning to attain.
Porters Model is considered an important part of planning tool set. When you’re clear about where the power lies, you can take advantage of your strengths and can improve the weaknesses and can compete efficiently and effectively.
Porters model of competitive forces assumes that there are five competitive forces that identifies the competitive power in a business situation. These five competitive forces identified by the Michael Porter are:
Threat of substitute products
Threat of new entrants
Intense rivalry among existing players
Bargaining power of suppliers
Bargaining power of Buyers
Threat of substitute products
Threat of substitute products means how easily your customers can switch to your competitors product. Threat of substitute is high when:
There are many substitute products available
Customer can easily find the product or service that you’re offering at the same or less price
Quality of the competitors’ product is better
Substitute product is by a company earning high profits so can reduce prices to the lowest level.
In the above mentioned situations, Customer can easily switch to substitute products. So substitutes are a threat to your company. When there are actual and potential substitute products available then segment is unattractive. Profits and prices are effected by substitutes so, there is need to closely monitor price trends. In substitute industries, if competition rises or technology modernizes then prices and profits decline.
Threat of new entrants
A new entry of a competitor into your market also weakens your power. Threat of new entry depends upon entry and exit barriers. Threat of new entry is high when:
Capital requirements to start the business are less
Few economies of scale are in place
Customers can easily switch (low switching cost)
Your key technology is not hard to acquire or isn’t protected well
Your product is not differentiated
There is variation in attractiveness of segment depending upon entry and exit barriers. That segment is more attractive which has high entry barriers and low exit barriers.
Some new firms enter into industry and low performing companies leave the market easily. When both entry and exit barriers are high then profit margin is also high but companies face more risk because poor performance companies stay in and fight it out. When these barriers are low then firms easily enter and exit the industry, profit is low. The worst condition is when entry barriers are low and exit barriers are high then in good times firms enter and it become very difficult to exit in bad times.
Industry rivalry mean the intensity of competition among the existing competitors in the market. Intensity of rivalry depends on the number of competitors and their capabilities. Industry rivalry is high when:
There are number of small or equal competitors and less when there’s a clear market leader.
Customers have low switching costs
Industry is growing
Exit barriers are high and rivals stay and compete
Fixed cost are high resulting huge production and reduction in prices
These situations make the reasons for advertising wars, price wars, modifications, ultimately costs increase and it is difficult to compete.
Bargaining power of suppliers
Bargaining Power of supplier means how strong is the position of a seller. How much your supplier have control over increasing the Price of supplies. Suppliers are more powerful when
Suppliers are concentrated and well organized
a few substitutes available to supplies
Their product is most effective or unique
Switching cost, from one suppliers to another, is high
You are not an important customer to Supplier
When suppliers have more control over supplies and its prices that segment is less attractive. It is best way to make win-win relation with suppliers. It’s good idea to have multi-sources of supply.
Bargaining power of Buyers
Bargaining Power of Buyers means, How much control the buyers have to drive down your products price, Can they work together in ordering large volumes. Buyers have more bargaining power when:
Few buyers chasing too many goods
Buyer purchases in bulk quantities
Product is not differentiated
Buyer’s cost of switching to a competitors’ product is low
Shopping cost is low
Buyers are price sensitive
Credible Threat of integration
Buyer’s bargaining power may be lowered down by offering differentiated product. If you’re serving a few but huge quantity ordering buyers, then they have the power to dictate you.
Michael Porters five forces model provides useful input for SWOT Analysis and is considered as a strong tool for industry competitive analysis.
Each element of a Porters five forces model is best considered in the context of other elements in the model. Examples: supplier power is increased if there is a high degree of rivalry between companies trying to obtain the supplies; entry barriers are increased if there is a substitutes threat.
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A Porter’s five forces analysis can be usefully performed alongsideSWOT analysis, PESTLE analysis, and other analysis techniques. The next two sections outline how analysis techniques can be used together in the pursuit of an understanding of the multitude of elements affecting the bottom lines of companies like Tesco plc.
Porters five forces and SWOT analysis
A Porters five forces model can be enhanced by using SWOT analysis. A SWOT analysis is an analysis of the strengths, weaknessesopportunities and threats affecting the company. Each element of a Porters five forces analysis can be looked at in the context of each element of a SWOT analysis, leading to twenty different ways of looking at the company.
Porters five forces and other analysis techniques
Other corporate analysis techniques, like PESTLE analysis and Gap analysis, add further possibilities for understanding a company. PESTLE analysis can give you an impression of the political, economic, sociological, technological, legal and environmental factors that influence Porter’s five forces. Gap analysis allows you to see the gap between where a company is and where it should be, and what forces need to be applied.
Porters five forces at Tesco PLC
This section considers how Porters five forces might be applied to the problems facing Tesco PLC, including an investigation of the threat of substitutes from other supermarkets, buyer power in relation to grocery purchases, grocery supplier power, and the power of the customer at the till.
Classical economics predicts that rivalry between companies should drive profits to zero. This is partly down to the threat of substitutes. For instance, Tesco has competition from companies like Sainsbury that can provide substitutes for their goods. This drives the price of groceries down for customers of both companies.
Buyer power acts to force prices down. If beans are too expensive in Tesco, buyers will move to Sainsbury. Fortunately for Tesco, there are few other large supermarket companies. This means the market is disciplined; that is, the supermarkets have a disciplined approach to price setting. Discipline stops them destroying each other in a profit war.
Supplier power is an important part of the Porters five forces model. Implications for Tesco are many. Supplier power is wielded by suppliers demanding that retailers pay a certain price for their goods. If retailers don’t pay the price, they don’t get the goods to sell. But large supermarkets, like Tesco, have an overwhelming advantage over the small shopkeeper-they can dictate the price they pay the supplier. If the supplier does not reduce the price, they will be left with a much smaller market for their produce.
Tesco, Asda, Sainsbury and other supermarket chains put up considerable barriers to entry. Anyone starting up a new supermarket chain has barriers imposed on them, implicitly or explicitly, by the existing supermarkets. For instance, Tesco may have cornered the market for certain goods; the new supermarket will not be able to find cheap, reliable suppliers. Tesco also has the advantage of economies of scale. The amount it pays suppliers, per-item, is a lot less than the corner shop. It achieves this, partly, through buying large volumes of goods. A small supermarket chain can only buy a relatively small volume of goods, at greater expense.
Porter’s five forces in other industries
Before developing a Porters five forces model of Tesco consider other industries, from real estate agencies to the bicycle manufacturing industry. This will give you the broadest picture of how Porters five forces can be used. Here we’ll consider, briefly, two industries outside the supermarket sector.
Porters five forces and the auto industry
Anyone planning to launch an automobile company would do well to consider Porters five forces. Such a model would highlight the intense rivalry and the high barriers to entry found in this industry. It might make them think again about moving into this area.
Established auto companies, though, might find they have a lot going for them if they produce a Porter’s five forces model of their activities. They tend to be more powerful than their suppliers, and they have little threat of other companies producing ready substitutes, given the long lead team needed to produce new car designs.
Porters five forces model in the airline industry
It’s worth looking at Porters five forces models of significantly different industries when formulating a Porters five forces models of Tesco. So don’t just look at Porters five forces models of Sainsbury, Asda or other obvious competitors.
By looking at a Porters five forces model of British Airways you might might get some useful, new insights. For instance, British Airways is the dominant player in its industry, so a Porters five forces model of British Airways might teach you something about dominant players in general. This could be very useful when creating a Porters five forces models of Tesco plc.
The bottom line
A Porters five forces model provides a “bottom line” way of understanding a company. It considers economic rivalry to be of central importance, and suggests you should concentrate on factors affecting the company’s profit in a systemic model defined by that rivalry. Critics of Porters five forces analysis suggest it is too limited, but it can be supplemented with other models like SWOT or PESTLE analysis.
Michael E. Porter, “The Competitive Advantage of Nations” – Michael Porter introduces the Porter diamond of national advantage and the Porter value chain diagram.
Porter is a recognized leader in competitive analysis elaboration and his five forces model has contributed to the study of competition (Porter 1979). It is necessary to point out that Porter’s approach to alternative strategies’ generation is a well-defined one and is based on the following statement: Company’s position stability in a market is determined by: costs of production and marketing of goods; irreplaceable products; competition’s sphere (the volume of market adaptation).
A company may achieve competitive advantages and strengthen its positions at the expense of: ensuring lower costs on production and marketing of products. Low costs mean the company’s ability to elaborate, produce and sell goods with comparative characteristic features but with lower costs than competitors. A company gets additional profit if it undercuts its products in a market; ensuring that product stays irreplaceable with the help of differentiation. Differentiation means the company’s ability to provide its customer with the product of great value, in other words, with the product of high use value. Differentiation gives the possibility to establish higher prices that brings higher profit. Besides, a company has a choice what market to compete in: the entire market or some its part. This choice can be done using the relation between the market share and company’s profitability suggested by Porter.
Companies which do not have possibilities for becoming leaders in a market must concentrate their efforts on some sector and strive for gaining more advantages with reference to competitors. Large companies become successful with big market share, as well as relatively small companies with narrow specialization. A tendency of small companies to behave the way large companies do regardless their real possibilities, will lead to the loss of competitive advantages. Small companies must follow the rule in order to achieve success: Segment the market. Shrink productive programme. Achieve and maintain maximal share in a minimal market.
Porter’s model is not correct because if every company adopts these strategies, none would be able to have a competitive advantage. Knights does not fully agree with Porter’s theory emphasizing that it is attractive to management because it gives ‘some illusion of control, legitimacy and security in the face of uncertainty’ (Knights 1992, pp. 514-536). Nevertheless, the concept of ‘unequal power’ is supported by senior management worldwide. In general, Porter’s model has some major limitations in today’s market environment. It cannot take in consideration new business models and the dynamics of markets.
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