Characteristics Of Porter's Five Forces Model

This report aims to discuss the characteristic of Porter’s Five Forces model which had greatly contributes to strategic management. Porter (1980) sees competition in an industry being governed by five different sets of forces and an industry’s attractiveness is contingent on the strength of these five forces. Nevertheless, this model is being debated since it is purely derived from industrial perspective. To be the market leader, resource- base theorists suggested organizations must aware of its intrinsic strength and weakness therefore enable them to formulate strategy efficiently. Apart from perspective imperfect, Porter’s five forces also limited by some factors when applying in certain industry.

To present the contributions as well as limitations of Porter’s five forces framework, this report will examine the five forces of soft drink and airline industry. All the information is collected from text books, journals, articles, annual report and websites.

1.0 Introduction

All purpose of strategy is to help an organization survives and be profitability in the industry. An industry is a group of firms that produce a similar product or service, for instance cosmetics or financial services. (L. Wheelen T., D. Hunger J., 2006). The understanding of the industry structure and its competition environment is a critical ingredient of a successful strategy. Firms need to examine the level of profitability of the industry they are entered, whether it is potentially high profitable in the future. Michael Porter (1980), a Harvard strategy professor contended that the industry profitability is determined by five forces of competition, they are the competition from new entrants, competition from substitutes, and competition from established rivals as well as the power of suppliers and power of buyers. (M. Grant R., 2008). By examine the strength of five forces reveal why an industry is attractive and only then can organization formulates strategy to gain competitive advantage in the market place. Unfortunately, Porter’s five forces framework has been involved into several criticisms. Some of theorists argued that Porter’s Five Forces framework is lack of rigorous since it is based on Industrial Organisation (IO) economic perspective and in reality, the strength of the forces may differ from business to business. (Campbell D., Stonehouse G., Houston B., 2002). The prediction of industry attractiveness based on the five forces is unclear and lack of trustworthy. To judge whether Porter’s five forces framework is useful to predict the industry potential profitability, this report will applying this model into soft drink and airline industry.

2.0 The Values of Porter’s Five Force Framework

Porter Five Forces framework was derived from Structure-Conduct-Performance (SCP) paradigm of IO which concerned on the industry structure was influence by conduct and performance of organizations. (Jenkins M., Ambrosini V., Collier N., 2007). Insight into organization heterogeneity in terms of market attractiveness evaluations and understanding of market entry enable them to make better decisions and prevent from potential loss or go into liquidation. (Dixit A, K. Chintagunta P., 2007). Michael Porter indicated that ‘the industry structure grows out of a set of economic and industrial characteristics that bring out the strength of each competitive force and the forces are threat of new entrants, threat of substitute, the rivalry among existing competitors, the bargaining power of buyers and suppliers.’ (M. Grant R., 2008). The strength of the five competitive forces can determines the long-run profit potential of an industry by how much of economic value retained by companies in the industry versus bargained away by customers and suppliers, threaten by substitutes or forced by new entrants. (E. Porter M., 2008). The stronger of these forces, the more limited the organizations’ ability to set higher price and earn greater profits. The low forces, in contrast, become an opportunity for organizations to generate strategies. (L. Wheelen T., D. Hunger J., 2006).

In order words, this framework suggested the source of organizational profits is market positions, and the positions protected by barriers to entry into the market. (Jenkins M., Ambrosini V., Collier N., 2007). Many strategic analysis tools formed based on the industrial perspective as Porter’s five forces did, for instance the PESTEL analysis is the useful environment scanning tool that examine the external factors influence an organization. Game theory, which founded by Von Neumann and Morgenstern (1944) contends that the rivalry among competitors is interdependent, but the issue is generally concerned with a firm’s external environment. (M. Grant R., 1998)

3.0 Five Forces of Soft drink industry

3.1 Rivalry amongst competitors

Porter described the rivalry amongst existing competitors is ‘jockeying for position’, where they compete in the form of products price, products innovation and differentiation, advertising and promotion as well as after-sales services slugfests for purpose of scramble for market share and earn superior profits. The degree of rivalry in an industry is determined by several variables; they are the degree of competitors’ concentration, the level of rivalry, product’s differentiation, the industry growth rate and exit barrier. (G. H. Richard., 1983)

Soft drink industry considered a consolidated industry, where the industry is leading by few large companies, such as Coca-cola, Pepsi-cola and Cadbury Schweppes. These companies who seize large proportion of market share had earned superior profit. In order to gain competitive advantage from competitors, Coca-cola and Pepsi-cola have spent large investment in advertising and promotion to build strong brand identify among consumers and become a barrier for new entrants. Coca-cola build customer loyalty by it unique coke recipe while Pepsi-cola serving different soft drink to capture market share of Coca-cola. The unique recipe of soft drinks had gained many loyal customers which uneasily duplicate by competitors. In the position of market leader, they can determine the price of soft drink and thus avoid price war. (M. Grant R., 2008)

According to Agarwal and Gort (1996), the late entrants have relatively lower survival rates because the exit barrier is formed in competitive intensify. (Dixit A, K. Chintagunta P., 2007) The exit barrier in soft drink industry is significant because firms require large capital investment to achieve economic of scale in order to compete with strong competitors. Yet, according to the average return on invested capital (ROIC) of US industries, the profitability of soft drink industry increase consistently indicates that the market value of soft drink tends to grow in future. (Kindly refer to Appendix V).

3.2 Threat of Entry

A high barrier to entry benefits the existing players in an industry because the competition is stable and established companies can take advantage of this opportunity to raise prices and generates favorable returns. The established companies who run a larger production may benefit from economic of scales and create barrier to the new comer. Others, the government regulation can also be a barrier to entry. (Johnson G., Scholes K., Whittington R., 2008)

The barrier to entry can be created by existing companies by build strong brand loyalty. Although there is no significant restriction from government towards soft drink business, the efforts of Coca-cola and Pepsi-Cola to built brand loyalty have significantly threatened new companies to enter the business. (Kolter p., Armstrong G., 2008). Further, when the new companies intend to enter the market, both companies have take retaliate action by cut down the prices and forcing the new entrant to curtail expansion plans. (M. Grant R., 2008). Since the barrier to entry is high based on strong market leaders, the industry is considered attractive.

3.3 Threat of Substitute

When the use of product can be wholly substitute by products out of the industry, customers will switch to substitute if the price of the product goes up. To the extent that switching costs are low, substitutes may have significant impact on the profitability of an industry. (L. Wheelen T., D. Hunger J., 2006)

Through industry innovation, incumbents are struggling to produce diversity beverages to satisfy different consumers’ taste. The soft drink seems gradually substituted by carbonated beverage. In responding to the competition of substitute, Coca-cola expanded its business through alliance and acquisitions like Coke-Nestea and Coke -Minute Maid. Meanwhile, Pepsi-cola diversify their products’ flavor such as Pepsi with orange juice. (Meghan E., Deichert M, Ellenbecker M, Klehr E., Pesarchick L., Ziegler K., 2006). Yet, Coca-cola had builds extremely strong customers’ loyalty in the flavor of Coke since the early 1960’s, there are no visible beverages can substitute Coke and it has been the top-selling soft drink over centuries. (Coca-cola, 2010). Briefly, substitutes become less of a threat because of the concentrated manufacturers’ effort in diversification.

3.4 Bargaining Power of Buyers

Buyer power is determined by switching costs, the relative volume of purchases, the standardization of the product, brand identity, and quality of service. (Thompson J., Martin F., 2005)

Companies are not merely selling their products to consumers, but large proportions of products are distributed to retailers such as supermarkets. Coca-cola and Pepsi-cola mainly distributed their soft drink products to supermarkets such as Tesco and Sainsbury. Although these retailers purchase soft drinks in large quantity, they do not have much bargaining power because they need different kind of soft drink products to generate consumer traffic, especially the popular brand name like Coke and Pepsi. Vending, basically deals with fixed price, was the most profitable channel for the soft drink industry. With no buyers to bargain, Coke and Pepsi bottlers could sell directly to consumers through machines owned by bottlers. (Meghan E., Deichert M, Ellenbecker M, Klehr E., Pesarchick L., Ziegler K., 2006). Therefore, the position of buyers in soft drink industry is weak because companies are not heavily relied on single distribution channel, but other route like vending machine or fast food chain. (Soft drink Industry, 2010)

3.5 Bargaining Power of Supplier

The suppliers are powerful if they are in the position of well brand name, less competitors and high product differentiated. (Mike W. Peng, 2006). The main inputs of soft drink making are sugar and packaging. Sugar can be obtain from many sources and if the price of sugar increase, soft drink manufacturers can alternatively switch to corn syrup, as happened in the early 1980s. Thus, suppliers of nutritive sweeteners do not have much bargaining power to soft drink manufacturers. In contrary, they need to built long term relationship with soft drink manufacturers to make long-run profit in the business, for example, Monsanto signed long term Nutrasweet sweetener supply contracts with Coca-cola. (M. Grant R., 2008)

Soft drink packaged by aluminum can and bottle. The manufacturers of aluminum can and bottle are almost similar and therefore they engaged in price competition to survive in the industry. With more competitors vying for supply contract with large soft drink manufacturers, soft drink manufacturers are able to negotiate extremely favorable price and thus suppliers’ bargaining power is relatively weak. (Meghan E., Deichert M, Ellenbecker M, Klehr E., Pesarchick L., Ziegler K., 2006)

3.6 Summary on Five Forces of Soft Drink Industry

Overall, in soft drink industry, the rivalry is moderate since the concentrated producers had avoided significant price competition. The industry is considered attractive because high entry barrier prevent new entrant from fragment profits, there is no visible substitute and the bargaining power of suppliers and buyers are relatively weak.

Cott Corporation is a good example who earned favorable profits in this industry. Cott recognized the unique Coke taste to the mind of consumers thus established its private-label cola called “RC Cola” and successfully taking 5.5 percent shares of U.S. soft drink market in year 2005. (M. Grant R., 2008). Cott Corporation has proved that Porter’s five force framework is useful to predict industry profitability, which in accordance with the SCP concept of Porter.

4.0 Debates and critiques on Porter’s Five Forces Framework

As outlined that Porter’s Five Forces Model was derived from industry perspective and it is therefore expected that the model is limited when applied at the firm level. In the early eighties, strategic management was much dominated by IO perspective, where the organization’s performance is contingent on its external environment and thus loses the sight of organizational perspective. (Jenkins M., Ambrosini V., Collier N., 2007)

The resource-based view, in contrast, examines the link between the internal characteristics of an organization and organization’s performance. (Campbell D., Stonehouse G., Houston B., 2002) It highlights the core competency of an organization are the main sources of sustainable competitive advantage. (Kotenlnikov V.). Hamel and Prahalad (1994) explained that ‘core competence does not appear on balance sheet, distribution channel or even brand and patent, but an aptitude to manage them may be one.’ Correspondingly, Penrose (1959) argued that ‘a firm is a collection of resources and that a firm’s performance depends on its ability to use them.’ (Jenkins M., Ambrosini V., Collier N., 2007). In addition to the industry competition structure, resource-based approach examine deeply into the skills and competences of each competitor, the design of value-adding activities, the technologies employed and strategic groupings. The strategic analysis model like value-chain and SWOT analysis are contributions of resource-based view which provide a greater understanding of organization’s core competences and enable organization well manage their resources and capacities to formulate appropriate strategies. (E. Spanos Y., Lioukas S., 2001). Baden-Fuller C. and Stopford J. (1992) said that ‘it is not industry matter, but the firm itself’, as happened in airline industry. (De Wit B., Meyer R., 2005)

5.0 The Five Forces of Airline Industry

5.1 Rivalry amongst competitors

The intense rivalry in airline industry caused by undifferentiating products and services, for instance, most of them were using similar aircraft like Airbus A320 family. (Shawn S., 2004)To be the ideal choice of customers, airlines had competing in fare price and their on-board products and service. They struggle to enhance their frequencies and timing of flight to avoid their competitors a frequency advantage. The barrier to exit is one of the significant factors that result fierce rivalry. The capital investments are a large sum and it is difficult to dispose the assets suppose the carriers are suffering in loss. Trans World Airline is the example of company who can remain competitors for three more years before gone into liquidation. (Ridderbusch K., 2006) The reason of high fixed costs significant influence the profitability of industry, like revealed in Appendix V, the ROIC of airline industry is slightly five percent and therefore the industry’s growth rate is slow.

5.2 Threat of Entry

The main entry barriers of airline industry are capital requirement and retaliation from established airlines. To establish an air transport business is a huge investment, including the expensive assets of airplane and safety facilities. This barrier had been reduce by bank institutions who encourage airline carriers by extend credit. (Vecchio J.D., 2000) There is not significant entry control in international airline industry such as US and Europe, but airport slot can be a barrier to entry. The condition of congested slot in hub airport has makes it difficult for new entrant to gain access to attractively-time slot. However, the congested slot issue has benefits the existing airlines. (Shawn S., 2004). Incumbents enlarge their business by hub system and thus they could serve more cities from their hubs and offer greater frequency flight to satisfy different customers’ need. (Vecchio J.D., 2000)

5.3 Threat of Substitute

Apart from oversea reason, people tend to choose rail transport although they can reach destination in shortest time by air transport. Railway became a good substitute of airway as it provide city centre to city centre travel which makes convenience to consumers and its fare price is always cheaper that airlines. The market of airlines became worse when the development of rail transit. Through constantly innovation and development in railway industry, people today can choose long haul rail transit to reach destination in short time, as air transport did. (Shawn S., 2004)

5.4 Bargaining Power of Buyer

Airline offers transportation service to two groups which are travel agents and consumers. Traditionally, travel agency system is overwhelming because it is the main distribution channel for airline. The airlines who much depends on travel agents forced to reduce fare price to keep long-term relationship that able to sustain competitive advantage in the market.

The available of internet benefits consumers as they can access to the fare price and compare with each other. Many customers choosing airline travel because they can reach destination in short time, thus they always find for price discrepancy of the same exact flight. Considered airline travel is relatively luxurious trip, the fall in fare price would significantly increase the demand, especially those plans for a family vacation. Since the trend of demand is elastic, customers’ switching from each other is visible suppose the market fall into price war. (Vecchio J.D., 2000)

5.5 Bargaining Power of Suppliers

The suppliers in airline industry are concentrated producers such as Boeing and Airbus. These suppliers became a threat to airlines because they provide high quality airplanes and pilot training services. (Johnson G., Scholes K., Whittington R., 2008)

The power of supplier can determine by labor union. Industries which depend massive on employees are low profitability because the more skill people the more they need to pay. Aviation industry required high talent people such as pilots and have a high percentage of employees unionized and it is therefore less profitability. (M. Grant R., 2008)

5.6 Summary on Five Forces Analysis of Airline industry

Through exploring five forces, airline industry is easy to entry but hard to exit, threaten by powerful supplier and buyer as well as substitute, and the rivalry is intensified. Therefore airline industry is extremely unattractiveness and all organizations stuck in the industry and are likely to suffer. In reality, however, Ryanair has survived and successfully seize significant market share in Europe. (Mike W. Peng, 2006) The key success of Ryanair is its concept of no-frills, low fares and hassle-free which effectively take cost advantage and perform better punctuality than competitors. However these strategies are zero without the effective management team and good employees’ performance. Ryanair implemented a third year of pay freeze to achieve cost saving however satisfy its cabin crew by maximize their time off. Despite lowest fares price, Ryanair continues maintain a safe and reliable air travel to meet customers’ need. (Ryanair, 2010) The successful of Ryanair in such an unattractiveness industry are its people’s competencies that make sustainable competitive advantage, as suggested by Hamel and Prahalad.

7.0 Other Limitations

7.1 Hyper competition

Another critique is that competition is a dynamic process of rivalry that constantly reformulates industry structure. Joseph Schumpeter viewed competition is the dynamic forces of innovations which continuously restructure industry and tends to unstable. (M. Grant R., 1998, 2008). Since it is based on the industrial perspective in the eighties, the five forces model is ineffective to predict competition and profitability if the industry structural transformation is rapid like High-tech industries. (Recklies D., 2001). Today’s IT and software industry are continuous being revolutionized by innovation. Organizations struggle to gain competitive advantage comes from an up -to-date knowledge of environmental trends and competitive activity tied with a willingness to risk a current advantage for a possible new advantage. This fast growing market structure indicates that is difficult to master the market trends and it is therefore limited for Porter’s five forces to predict the attractiveness of the industry. (L. Wheelen T., D. Hunger J., 2006)

7.2 The Complement as an important force

Traditionally, Porter contends that the industry’s attractiveness is driving by the potential suppliers of substitute good and service. This force is doubtful that as the presence of substitute reduce the value of the products, complements’ value will increase. Andrew Grove, the former CEO of Intel suggests complements should be added into Porter’s forces framework because it contributes visible impact, like the available of software add value to hardware. Yet, apart from IT industry, complements influence the competitiveness in other industries, for example the value of water heater increase if consumers access to gas supplier and service. Given the characteristic of complements is crucial to most products, the analysis of competition environment should take them into account. Organizations should reduce the bargaining power of complement suppliers in order to stimulate the demand of the products, like the strategy took by Nintendo. Nintendo controls the operation of games software producers by provides developer licenses and through development of games software successful augments the demand for Nintendo video game console. (M. Grant R., 2008)

8.0 Conclusion and Recommendation

Generally, Porter’s five forces are lack of rigorous and limited by its industrial perspective. In the case of Cott’s triumphant in soft drink industry is not merely the commercial market, but much depend on its intrinsic management who wisely distribute its product in grocery channel which saving cost in term of no advertising and promotion. Cott popular with affordable soft drinks and their revenues increase dramatically through the growing of grocery retailers like Wal-Mart. (Cott, 2010). Therefore, Porter’s five forces seem lack of reliability relative to resource based analysis model. However, as Barney and Zajac (1994) said, ‘the examination of strategy implementation skills (i.e., resources and capabilities) cannot be understood independently of strategy content and the competitive environment within which the firm operates.’ (E. Spanos Y., Lioukas S., 2001).

In conclusion, managers should conduct the strategic analysis not simply based on Porter’s five forces, but examining in combination with other intrinsic perspective strategic analysis tool like SWOT analysis. SWOT model emphasized the elements of Strength-Weakness of an organization in addition to the Opportunities-Threats from external source. Furthermore, managers may apply PESTEL framework to supply the lack of Porter’s five forces model. (Trundy G., 2006). PESTEL framework emphasize the important elements of Politic, Economic, Social, Technology, Environmental and Legal to carry out a deeper external environment scanning that may influence organizations’ performance in the market.