Definition

Porters 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.
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Understanding the tool

Five forces model was created by M. Porter in 1979 to understand how five key
competitive forces are affecting an industry. The five forces identified are:

These forces determine an industry structure and the level of competition in that
industry. The stronger competitive forces in the industry are the less profitable it is. An
industry with low barriers to enter, having few buyers and suppliers but many substitute
products and competitors will be seen as very competitive and thus, not so attractive
due to its low profitability.
It is every strategists job to evaluate companys competitive position in the industry and
to identify what strengths or weakness can be exploited to strengthen that position. The
tool is very useful in formulating firms strategy as it reveals how powerful each of the
five key forces is in a particular industry.

Threat of new entrants. This force determines how easy (or not) it is to enter a
particular industry. If an industry is profitable and there are few barriers to enter, rivalry
soon intensifies. When more organizations compete for the same market share, profits
start to fall. It is essential for existing organizations to create high barriers to enter to
deter new entrants. Threat of new entrants is high when:

Low amount of capital is required to enter a market;

Existing companies can do little to retaliate;

Existing firms do not possess patents, trademarks or do not have established

brand reputation;

There is no government regulation;

Customer switching costs are low (it doesnt cost a lot of money for a firm to
switch to other industries);
 There is low customer loyalty;

Products are nearly identical;

Economies of scale can be easily achieved.

Bargaining power of suppliers. Strong bargaining power allows suppliers to sell

higher priced or low quality raw materials to their buyers. This directly affects the buying
firms profits because it has to pay more for materials. Suppliers have strong bargaining
power when:

There are few suppliers but many buyers;

Suppliers are large and threaten to forward integrate;

Few substitute raw materials exist;

Suppliers hold scarce resources;

Cost of switching raw materials is especially high.

Bargaining power of buyers. Buyers have the power to demand lower price or higher
product quality from industry producers when their bargaining power is strong. Lower
price means lower revenues for the producer, while higher quality products usually raise
production costs. Both scenarios result in lower profits for producers. Buyers exert
strong bargaining power when:

Buying in large quantities or control many access points to the final customer;

Only few buyers exist;

Switching costs to other supplier are low;

They threaten to backward integrate;

There are many substitutes;

Buyers are price sensitive.

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, to switch from
coffee to tea doesnt cost anything, unlike switching from car to bicycle.
Rivalry among existing competitors. This force is the major determinant on how
competitive and profitable an industry is. In competitive industry, firms have to compete
aggressively for a market share, which results in low profits. Rivalry among competitors
is intense when:

There are many competitors;

Exit barriers are high;

Industry of growth is slow or negative;

Products are not differentiated and can be easily substituted;

Competitors are of equal size;

Low customer loyalty.

Although, Porter originally introduced five forces affecting an industry, scholars have
suggested including the sixth force: complements. Complements increase the demand
of the primary product with which they are used, thus, increasing firms and industrys
profit potential. For example, iTunes was created to complement iPod and added value
for both products. As a result, both iTunes and iPod sales increased, increasing Apples
profits.

Using the tool

We now understand that Porters five forces framework is used to analyze industrys
competitive forces and to shape organizations strategy according to the results of the
analysis. But how to use this tool? We have identified the following steps:

Step 1. Gather the information on each of the five forces

Step 2. Analyze the results and display them on a diagram

Step 3. Formulate strategies based on the conclusions

Step 1. Gather the information on each of the five forces. What managers should do
during this step is to gather information about their industry and to check it against each
of the factors (such as number of competitors in the industry) influencing the force. We
have already identified the most important factors in the table below.
 Porter's Five Forces Factors

Threat of new entry

Amount of capital required

Retaliation by existing companies

Legal barriers (patents, copyrights, etc.)

Brand reputation

Product differentiation

Access to suppliers and distributors

Economies of scale

Sunk costs

Government regulation

Supplier power

Number of suppliers

Suppliers size

Ability to find substitute materials

Materials scarcity
 Cost of switching to alternative materials

Threat of integrating forward

Buyer power

Number of buyers

Size of buyers

Size of each order

Buyers cost of switching suppliers

There are many substitutes

Price sensitivity

Threat of integrating backward

Threat of substitutes

Number of substitutes

Performance of substitutes

Cost of changing

Rivalry among existing competitors

Number of competitors

Cost of leaving an industry

 Industry growth rate and size

Product differentiation

Competitors size

Customer loyalty

Threat of horizontal integration

Level of advertising expense

Step 2. Analyze the results and display them on a diagram. After gathering all the
information, you should analyze it and determine how each force is affecting an industry.
For example, if there are many companies of equal size operating in the slow growth
industry, it means that rivalry between existing companies is strong. Remember that five
forces affect different industries differently so dont use the same results of analysis for
even similar industries!

Step 3. Formulate strategies based on the conclusions. At this stage, managers

should formulate firms strategies using the results of the analysis For example, if it is
hard to achieve economies of scale in the market, the company should pursue cost
leadership strategy. Product development strategy should be used if the current market
growth is slow and the market is saturated.

Although, Porters five forces is a great tool to analyze industrys structure and use the
results to formulate firms strategy, it has its limitations and requires further analysis to
be done, such as SWOT, PEST or Value Chain analysis.

Example
This is Porters five forces analysis example for an automotive industry.
 Porter's Five Forces Evaluation

Threat of new entry (very weak)

Large amount of capital required

High retaliation possible from existing companies, if new entrants would bring
innovative products and ideas to the industry

Few legal barriers protect existing companies from new entrants

All automotive companies have established brand image and reputation

 Products are mainly differentiated by design and engineering quality

New entrant could easily access suppliers and distributors

A firm has to produce at least 5 million (by some estimations) vehicles to be cost
competitive, therefore it is very hard to achieve economies of scale

Governments often protect their home markets by introducing high import taxes

Supplier power (weak)

Large number of suppliers

Some suppliers are large but the most of them are pretty small

Companies use another type of material (use one metal instead of another) but
only to some extent (plastic instead of metal)

Materials widely accessible

Suppliers do not pose any threat of forward integration

Buyer power (strong)

There are many buyers

Most of the buyers are individuals that buy one car, but corporates or
governments usually buy large fleets and can bargain for lower prices

It doesnt cost much for buyers to switch to another brand of vehicle or to start
using other type of transportation

Buyers can easily choose alternative car brand

Buyers are price sensitive and their decision is often based on how much does a
vehicle cost
 Buyers do not threaten backward integration

Threat of substitutes (weak)

There are many alternative types of transportation, such as bicycles, motorcycles,

trains, buses or planes

Substitutes can rarely offer the same convenience

Alternative types of transportation almost always cost less and sometimes are
more environment friendly

Competitive rivalry (very strong)

Moderate number of competitors

If a firm would decide to leave an industry it would incur huge losses, so most of
the time it either bankrupts or stays in automotive industry for the lifetime

Industry is very large but matured

Size of competing firms vary but they usually compete for different consumer
segments

Customers are loyal to their brands

There is moderate threat of being acquired by a competitor