The enthusiasm and excitement of starting a new business can quickly diminish when you realise you are faced with the task of analysing the complex business landscape that cascades around you. The number of factors to consider can be overwhelming, leading to errors in judgement and unnecessary risk taking. This article aims to assist you in tackling this process by providing a simplified overview of Porter’s Five Forces Analysis. This is not a step by step guide, nor a list of dos and don’ts, but rather a set of factors that should be considered when assessing the competitive intensity and attractiveness of a market.
Porter’s Five Forces Analysis was created by Harvard Professor Michael Porter in 1979 and it provides a framework for industry analysis and business development. Porter proposes there to be five forces which either inhibit or prohibit a company’s ability to succeed in a given market.
- Threat of new entrants
- Threat of substitutes
- Bargaining power of buyers
- Bargaining power of suppliers
- Intensity of rivalry
Threat of new entrants
A market is much more attractive if it is difficult to enter. This may sound odd at first as it seems more logical to pursue a market that is easy to enter. However, if you can do it so can everyone else, and if it is extremely easy for other businesses to enter a market with little skill, experience or start-up costs you will find it extremely difficult to create and capture any value from that market. Alternatively, if a market is extremely difficult to enter you will be much less likely to receive pressure from new competition in the future. The obvious catch here is that if a market is difficult to enter for everyone else, it will also be difficult to enter for you. But if you are able to overcome the barriers to entry you will be in a much stronger position to secure dominance in the market over the long-term.
One of the main factors to consider is legal restrictions such as patents, copyrights, regulations and legislation which may limit your ability to enter a market. Additionally, skill levels, knowledge and experience feature highly on the list of potential barriers. High start-up costs, running costs, exit costs and sunk-costs (those which cannot be returned) can also limit the ability of entry for new businesses. Lastly, the strength, market share and potential retaliation of current companies and brands along with their existing commitments and partnerships with key stakeholders, suppliers and buyers may also make a market very difficult to enter. If you can overcome these barriers to entry and enter a market which has a low risk of other new entrants you will be in a very favourable position.
Threat of substitutes
A market is more attractive if the threat from substitute products and services is low. If you are planning to enter a market where your customers will have the option to substitute your product or service for an alternative you should think carefully. Some examples of substitute products might include butter and margarine, beer and wine or pork and beef. To put this into context, if you were to go to a supermarket and they had no butter, or the butter was significantly higher in price than the margarine, you would likely buy the margarine. This would suggest that butter has a high threat of substitution from margarine.
However, when we consider the other two examples of beer and wine or beef and pork the threat of substitution is slightly lower. People who drink beer may not like wine and similarly people who are planning to cook with beef may not see pork as a suitable substitute. If your customers have less scope to substitute your product or service for another you will have much more pricing power and control of the market.
Bargaining Power of Buyers
A market is more attractive if buyer bargaining power is low. In simple terms you will have more control if you enter a market where there are only a few select businesses selling to a vast number of buyers. In this environment people will have to buy from you, at the prices you set, as alternative options are limited. The opposite would be to enter a market where there are many businesses selling to few buyers. In this environment the buyer would have more bargaining power over who they buy from and at what price. This is not to say that you should rip people off with over inflated prices but it does allow you to maximise your profit margins.
There are three main factors to consider when assessing the bargaining power of buyers. Firstly, you need to consider the potential for switching from one company to another. If buyers are limited in their ability to switch companies you will retain more control over them.
Another question to ask is, “could my buyers do what I do?” If Coca Cola sell to a small independent café it is unlikely that the café will start producing their own coke. But when you consider companies on a larger scale, such as McDonalds, the threat from McDonalds starting to produce their own coke is quite high as they have the infrastructure to achieve it. This is known as ‘backward integration’ and if your buyers have the potential to replicate your products and services your long-term success could be limited.
Lastly, you will need to consider the potential for buyer segmentation? If a market has vague information on pricing and service offers it is likely that buyer segmentation is taking place. A classic example is the airline and hotel industries who will charge different rates to different people. Flights and hotels cost more during holiday seasons than they do at other times of the year. If you enter a market where buyer segmentation is possible you will have more control over your buyers.
Bargaining power of suppliers
A market is more attractive if supplier bargaining power is low. If you consider everything we discussed in the previous section for bargaining powers of buyers, you would want the opposite to be the case for your suppliers. You would have the most bargaining power if you were one of few buyers purchasing from a wide range of suppliers. An attractive market would therefore have many suppliers fighting for your business, low switching costs, high threat from supplier substitutes, pricing and service offer information that is clear and transparent and you as a buyer would be difficult to segment.
Finding a market to enter that provides strong bargaining powers for your business both from your suppliers and your buyers is difficult. However, this is the ideal and you will need to judge the relative benefits on each side when considering your new venture.
Intensity of rivals
A market is more attractive if intensity of rivalry is low. A new market is better to enter if the number of existing businesses is less. Even if you enter a market that has one or two dominant brands it will be more favourable than entering a market with multiple brands. The ‘four firm’s ratio’ is often used to identify the top four companies within a market to assess what their collective market share is. The higher the percentage the more attractive the market is to enter as it increases your ability to offer something different thus claiming a meaningful percentage of the market.
When new businesses enter a market existing companies will often retaliate and resist in order to maintain their dominance. Growing markets and those with the scope for diversification are more favourable as the risk of fight back will be less due to there being enough growth potential for everyone.
Another consideration is the potential for existing companies to coordinate their efforts to defend their market share. For example, prices may be held at a set level, distribution channels may be tied up and supply chains may be limited due to contractual agreements. If the potential for coordination is low the market will be more attractive to enter.
There is a lot to think about, and rightly so. After all you are entering a new market with your business and your success depends on your ability to assess the landscape and act accordingly. As stated in the introduction this is not a do and don’t guide and you will never find a market that fits perfectly into every aspect of this model. Instead you should use these five factors along with the key points I have outlined within each section to explore, assess and make an informed decision about where to position your new business or venture. To support you in this process I have provided a short summary for each of the five forces:
- Threat of new entrants – More attractive if threat of new entrants is low
- Threat of substitutes – More attractive if threat of substitutes is low
- Bargaining power of buyers – More attractive if bargaining powers of buyers is high
- Bargaining power of suppliers – More attractive if bargaining powers of suppliers is low
- Intensity of rivalry – More attractive is intensity of rivalry is low
Although Porter’s Five Forces Analysis has received some criticism and modification over the years its fundamental principles are as relevant today as they were back in 1979. A modern critique of the model is beyond the scope of this article but I would recommend you look into this in more detail if you wish to broaden your knowledge of industry analysis and business development strategy.
I hope you have found this article useful and if you would like to discuss any aspect of this model, or propose some of your own thoughts, I would love to discuss them with you so please post a comment.