Porter’s Five Forces: Analyzing Industry Structure for Competitive Advantage

Michael Porter (1986) defined an industry as a group of companies manufacturing products that are very close substitutes for each other. Further analysis of the industrial structure is the cornerstone of his model.

The analysis of industrial structure is the fundamental basis of the model proposed by Porter (1986), since, according to the author, an industrial structure has a strong influence in determining the competitive rules to be observed and understood when analyzing an industry or the companies that comprise it.

One of the basic assumptions of Porter’s model is that every company that competes in an industry must have a competitive strategy. This strategy can be developed explicitly through a planning process, or it can evolve implicitly through the activities of the various functional departments of the company.

The development of a competitive strategy determines how the company will compete, what its goals should be, and what policies are needed to realize them. This development links the company with its means of action, i.e., it relates the company with the industry or industries in which it competes, in order to understand the competition and identify structural features that enable the formulation of strategies in search of competitive advantages.

Thus, the profitability of an industry depends on its structure, and it is the structure that lays down the rules of competition. According to Porter, this depends on five basic competitive forces that are shown in Figure 1.

Figure 1: Industry Competitive Forces (Porter, 1986)

The combined pressure of these five forces determines the profitability of the industry, given that prices, costs, and investments, the basic elements of profitability, are influenced to different degrees of intensity by each of these competitive forces.

In fact, the prices companies can charge are influenced by the bargaining power of buyers, since these, when very strong, demand high-value services that impact costs and investments and, thus, the prices of products.

The bargaining power of suppliers determines the costs of raw materials and other inputs, thereby influencing the costs. The intensity of rivalry among firms in the industry influences prices, but also the costs of competing in areas such as product development, advertising, and sales efforts. The threat of new entrants sets a ceiling on the price strategy as well as the volume of investment, aiming to deter new entrants. Ultimately, the threat of substitute products affects the prices that the industry can charge, setting a ceiling for them.

Thus, the analysis of the five competitive forces corresponds to finding the best position for the company, from which it identifies the strengths and weaknesses of the particular market situation, as well as the influence of these forces in defining competitive strategies.

The five competitive forces – the threat of entry, the threat of substitution, the bargaining power of buyers, the bargaining power of suppliers, and rivalry among firms in the industry – reflect “the fact that competition in an industry is not limited to established participants. Customers, suppliers, substitutes, and potential entrants are all “competitors” to firms in the industry and may have greater or lesser importance depending on the particular circumstances.” (Porter, 1986, p.24).

The five competitive forces jointly determine the intensity of competition in the industry and provide a basis for the positioning of a company in the industry. They also highlight areas in which the trends reflect threats and opportunities. Certain technical and economic characteristics of an industry are critical to the strength of each competitive force. The following are the features most relevant in determining the intensity of each of the competitive forces.

The threat of new entrants is characterized as the possibility of the entry of new companies that often bring substantial resources, such as new production capacity and a great desire to gain market share.

The entry of new competitors can result in a reduction in the profitability of existing enterprises since the entry of new competitors implies a fall in prices and increased demand for inputs, which will lead to inflating the cost of the final product.

For Porter (1986), even the acquisition of an existing company in an industry by companies from other markets should be seen as an input, since, very probably, this acquisition will inject new features and new management capacity into the industry, aiming to increase the market share of the existing business.

The intensity of the force represented by the threat of new entrants depends on entry barriers established by firms already in the industry. There are six main sources of entry barriers:

1. Economies of Scale: These refer to declines in unit costs of a product as the level of production increases, forcing incoming companies to join on a large scale or subjecting themselves to a cost disadvantage. Economies of scale may be present in almost all functions of a company, including manufacturing, purchasing, research and development, network services, marketing, use, and distribution sales forces. Economies of scale can also be present in the economies of scope (using the same factors to produce different goods) and monetary savings (obtaining factors of production at lower prices).

Vertical integration is also a kind of barrier to entry; it creates economies of scale in the early stages of production or distribution. In this situation, since the entering firm will join in an integrated manner or face a cost disadvantage, as well as a possible exclusion of inputs and markets for its product, most established competitors are integrated.

2. Product Differentiation: Differentiation comes from the identification of a company’s brand, either through customer service, differences in the products, the advertising effort, or by having entered first in the industry, among others. These factors develop a sense of loyalty in their buyers.

Differentiation creates a barrier to entry since new entrants are forced to invest heavily in breaking the ties established between customers and existing businesses.

3. Need for Capital: The need to invest large quantities of financial resources to compete creates an entry barrier. Capital is essential for investments in production facilities, to keep inventory, cover initial losses, and even risky activities such as, for example, research and development and initial advertising.

4. Cost of Change: These are the costs that the buyer faces when switching from one supplier to another. They may include the purchase of new equipment, training costs of employees, costs of testing and qualification of new sources, and even psychic costs of undoing a relationship. When they are high, they are a barrier to entry.

5. Access to Distribution Channels: A new company entering an industry needs to secure distribution for its product, making price discounts to persuade the retailer to make room with promises of promotions and the like. If access to distribution channels (wholesale and retail) is limited and the greater the control of the contestants on these channels, the harder it is to enter the industry.

6. Cost Disadvantages Independent of Scale: Porter also sets out some factors that have advantages of full costs for firms in an industry, impossible to be matched by potential entrants, regardless of the economy of scale. These factors are: (a) the patented product (which are protected by patents or trade secrets), (b) favorable access to raw materials (the incumbents have control over the sources of raw materials that are more favorable, or have under control at prices much lower than the total), (c) favorable locations, (d) government subsidies (grants government’s preferred) and (e) learning curve or experience (the costs decline to the extent that a company accumulates experience in manufacturing the product). According to Porter (1986), the effects of experience are reflected in the reduction of costs – marketing, production, distribution, and especially in the actions that involve a high degree of participation of manpower in operations and complicated tasks.

Finally, the government, through government policy, may also act to limit or prevent the entry of new firms in the industry with controls, for example, limits on access to raw materials and operating licenses.

In addition to these barriers, other factors may discourage the entry of new competitors in the industry:

(A) Expected Retaliation: When potential entrants have strong expectations of retaliation on the part of incumbents, entry can be deterred. The threat of retaliation is greater when the companies today have a history of strong retaliation to entrants, high liquidity, excess capacity, a high degree of commitment to the industry, or illiquid assets and slow growth of the industry.

(B) Price of Admission Deterrent: Industries where profitability is very low do not encourage the entry of new competitors. The return may be low by a levy from the market or may be a strategy, temporary business down to prevent the entry of new competitors.

The rivalry among competitors in an industry can be defined as the jockeying for position among companies that already operate in the same market. It is characterized by the use of tactics such as price competition, the battle of advertising, and the introduction of services or increased guarantees to the buyers. (Porter, 1986).

According to Porter (1986), firms in an industry are mutually dependent, and therefore the competitive moves of a company have an immediate effect on its competitors, which encourages competitiveness.

As the author states, price competition, for example, is highly unstable, and very likely to leave the entire industry worse off in terms of profitability. The price reduction is easily imitated by competitors; once matched, they reduce the revenues of all businesses unless the price elasticity of the industry is quite high.

The intensity of the rivalry can be analyzed taking into account the interaction of several factors, which are:

1. Numerous Competitors and Well Balanced: When there is a large number of firms in an industry, or when there are few but balanced in relation to size and resources, the rivalry increases. On the other hand, when the industry is dominated by a few firms, highly concentrated, leading companies can impose rules or coordinate the actions of other companies by means such as price leadership.

2. Slow Industry Growth: Typically, companies seek to expand market share; the slow growth of industry competition turns into a game, causing a far more unstable situation than when the condition is a fast-growing industry.

3. Fixed Costs or Senior Storage: Companies with high fixed costs, when there is excess capacity, cause strong pressure that results in a rapid escalation of price reductions.

4. Lack of Differentiation or Switching Costs: Differentiation creates a sense of loyalty to the purchaser, which creates insulation against competition. Moreover, the lack of differentiation makes the choice of buyers based largely on price and service, which results in an intensity of competition between companies in the industry.

5. Production Capacity of Large Increases in Increments: The economies of scale can provide excessive increases in production capacity, breaking the balance between supply and demand of the industry, which could lead to alternating periods of overcapacity and price reductions for the industry.

6. Competitors Divergent: Situations are among the competitors in an industry in which goals and strategies are very different with regard to competition, a relationship of shock occurring continuously throughout the process.

7. Major Strategic Interests: These are situations in which the goals of certain businesses consist of establishing a strong market position while sacrificing profitability, increasing instability and competition in the industry.

8. High Exit Barriers: Some companies operating at a deficit do not leave the industry in hopes of getting a return on their investment. Given the difficulty of leaving those companies, the profitability of the entire industry can be permanently reduced because companies with excess production capacity are forced to compete, adding to the rivalry. These situations are characterized by very high labor agreements, restrictions of government and social order, and inter-relationships such as strategic market access, etc.

Identifying substitute products is achieved by searching for other products that can perform the same function in the industry.

Replacement products may limit or even reduce the rates of return of an industry by forcing the establishment of a ceiling on prices that companies can fix as profit.

In a broad sense, all firms in an industry are competing with the industries of substitutes, so that “the more attractive the price-performance alternative offered by substitutes, the firmer the pressure on industry profits.” (Porter, 1986, p.39).

Thus, the competitive strength of substitute products represents a significant threat to established firms in an industry.

According to Porter (1986, p.40), “the substitute products that require more attention are those that (1) are subject to trends improving their trade-off of price-performance product industry, or (2) are produced by industries with high profits.”

As Porter states, buyers compete with the industry by forcing down prices, bargaining for higher quality or more services, and playing competitors against each other and may even compromise the profitability of the industry.

The greater or lesser pressure from buyers when it comes to price reduction depends on certain characteristics of the group of buyers in relation to its market position as well as the relative importance of their purchases compared to its total business.

Therefore, a large group of buyers has bargaining power in the following circumstances:

1. Volume Purchasing or Buyers’ Degree of Concentration in Comparison with Industry Offeror: If a large portion of sales is purchased by a particular buyer, this means that its importance in the results increases.

2. Participation in the Total Cost of Goods: The more significant the costs for which buyers purchase the goods they need, the greater the pressure to buy products at the best possible price. In contrast, when the product sold by the industry represents a small fraction of the cost, the buyer is less sensitive to price.

3. Standardization of Product Differentiation or Not: In this case, buyers faced with many choices of vendors play one company against another in the certainty of being always able to rely on alternative suppliers, forcing the price down.

4. Fewer Moving Costs: Buyers increase their bargaining power when the seller faces switching costs. On the other hand, high switching costs relate the buyer to certain vendors.

5. Profitability of Buyers: When buyers’ profits are low, conditions are created for them to seek a reduction in the cost of purchases. However, buyers with high margins of profitability are generally less price-sensitive.

6. Threat of Backward Integration: Buyers create a position where they can negotiate concessions when they are partly integrated or pose a real threat of backward integration. Some buyers have adopted partial backward integration, i.e., they produce some of what they require of a particular component or product and buy the rest from outside suppliers. With that, they have strong bargaining power since their threats are real. Moreover, partial production gives them very detailed knowledge of costs.

On the other hand, the buyer’s bargaining power may also be partially neutralized when companies threaten the industry with forward integration, i.e., manufacture or provide the service the buyer needs.

7. Importance of Product Quality: Buyers are less price-sensitive when the quality of your product is affected by the product of the industry.

8. Availability of Information: When the buyer has all the information on demand, actual market prices, and costs of suppliers, it increases their bargaining power in relation to a situation of insufficient information. Thus, with total information, buyers are provided to ensure receiving the best prices and to challenge providers’ complaints that their profitability is threatened.

These sources of information, which give the buyer bargaining power in the industry, may be caused by the consumer, industrial, and commercial buyers.

Thus, consumers tend to be more price-sensitive when purchasing products that are not distinguished, but they represent a relatively high expenditure in relation to its sales and less price-sensitive when purchasing products in which quality, for example, is important to them.

Industrial and commercial buyers are represented by wholesalers and retailers, as well as under the same rules consumers can enhance their bargaining power relative to manufacturers (retailers, when they can influence the purchasing decisions of consumers, wholesalers when they can influence the purchasing decisions of retailers and other companies for which they sell).

Suppliers may threaten the companies in an industry to raise their prices or reduce the quality of products and services and, thus, may compromise the profitability of an industry if it fails to pass cost increases on their own prices.

The conditions that make suppliers powerful tend to mirror those that make the strong buyers. Porter cites the following circumstances that characterize a group of powerful suppliers:

1. Degree of Concentration of Suppliers: When suppliers are formed by few companies and are more concentrated than the industry for which they sell, they have a greater capacity to exert an influence on prices, quality, and conditions.

2. Lack of Substitutes for its Products: The absence of substitute products increases the bargaining power of concentrated suppliers.

3. Importance of Industry to the Vendor: Vendors will have more influence on the industries when the sale to a particular industry is not significant relative to the total volume of sales.

4. Importance of Inputs for Industry Buyer: When the input is important to the success of the product formation of the purchaser, or the quality of the manufactured product, it increases the bargaining power of suppliers.

5. Differentiation of Inputs and Cost of Change for the Purchaser: Vendors can remove the possibility for the buyer to play one supplier against the other by differentiating their product but also by raising the switching costs (equipment, technical assistance, etc.). If the switching costs are imposed on providers, that effect is reversed.

6. Threat of Forward Integration: This condition exists when the industry refuses to improve the conditions of purchase against suppliers of products used by the industry. Porter also suggests that, besides considering other companies as suppliers, human resources (skilled labor, for example) should also be recognized as a supplier to wield great power in many industries. When the workforce is well organized, or there is a reduced supply of skilled labor, the power of suppliers of human resources is high.