Five Forces Model by Michael Porter

Five Forces model of Michael Porter is a very elaborate concept for evaluating company's

competitive position. Michael Porter provided a framework that models an industry and

therefore implicitly also businesses as being influenced by five forces. Michael Porter's

Five Forces model is often used in strategic planning.

Porter's competitive five forces model is probably one of the most commonly used

business strategy tools and has proven its usefulness in numerous situations. When

exploring strategic management models, you also might want to check out the BCG

matrix, SWOT analysis, IFE matrix, and SPACE matrix models.

Why would I need to use Porter's Five Forces model?

In general, any CEO or a strategic business manager is trying to steer his or her business

in a direction where the business will develop an edge over rival firms. Michael Porter's

model of Five Forces can be used to better understand the industry context in which the

firm operates. Porter's Five Forces model is a strategy tool that is used to analyze

attractiveness of an industry structure.

What is good about Porter's Five Forces model?

Porter has the ability to represent complex concepts in relatively easily accessible

formats. His book about the Five Forces model is written in a very easy and

understandable language. Even though his model is backed up by some complex model,

the model itself is simple and easily comprehensible at all levels. 

Porter's Five Forces model provides suggested points under each main heading, by which

you can develop a broad and sophisticated analysis of competitive position. This can be

then used when creating strategy, plans, or making investment decisions about your

business or organization.

Does Porter's Five Forces model really work?

Theoreticians have different view on this. While some agree that Porter's Five Forces

model is the ultimate explanation of how world works, others disagree. It depends in

what time frame we judge the state of the facts. Even Michael Porter himself

acknowledges that time is of essence when it comes to how his forces interact with each

other. 

Numerous economic studies have shown that different industries can sustain different

levels of profitability. This can be attributed to differences in industry structures.

What is the basic idea behind Porter's Five Forces model?

Porter's Five Forces model is made up by identification of 5 fundamental competitive

forces:

o Barriers to entry

o Threat of substitutes

o Bargaining power of buyers

o Bargaining power of suppliers

o Rivalry among the existing players

Some later economists also consider government as the sixth force in this model.

When putting all these points together in a graphical representation, we get Porter's Five

Forces model which looks like this:

Force 1: Barriers to entry

Barriers to entry measure how easy or difficult it is for new entrants to enter into the

industry. This can involve for example:

o Cost advantages (economies of scale, economies of scope)

o Access to production inputs and financing,

o Government policies and taxation

o Production cycle and learning curve

o Capital requirements

o Access to distribution channels

Patents, branding, and image also fall into this category.

Force 2: Threat of substitutes

Every top decision makes has to ask: How easy can our product or service be

substituted? The following needs to be analyzed:

o How much does it cost the customer to switch to competing products or services?

o How likely are customers to switch?

o What is the price-performance trade-off of substitutes?

If a product can be easily substituted, then it is a threat to the company because it can

compete with price only.

Force 3: Bargaining power of buyers

Now the question is how strong the position of buyers is. For example, can your

customers work together to order large volumes to squeeze your profit margins? The

following is a list of other examples:

o Buyer volume and concentration

o What information buyers have

o Can buyers corner you in negotiations about price

o How loyal are customers to your brand

o Price sensitivity

o Threat of backward integration

o How well differentiated your product is

o Availability of substitutes

Having a customer that has the leverage to dictate your prices is not a good position.

Force 4: Bargaining power of suppliers

This relates to what your suppliers can do in relationship with you.

o How strong is the position of sellers?

o Are there many or only few potential suppliers?

o Is there a monopoly?

o Do you take inputs from a single supplier or from a group? (concentration)

o How much do you take from each of your suppliers?

o Can you easily switch from one supplier to another one? (switching costs)

o If you switch to another supplier, will it affect the cost and differentiation of your

product?

o Are there other suppliers with the same inputs available? (substitute inputs)

The threat of forward integration is also an important factor here.

Force 5: Rivalry among the existing players

Finally, we have to analyze the level of competition between existing players in the

industry.

o Is one player very dominant or all equal in strength/size?

o Are there exit barriers?

o How fast does the industry grow?

o Does the industry operate at surplus or shortage?

o How is the industry concentrated?

o How do customers identify themselves with your brand?

o Is the product differentiated?

o How well are rivals diversified?

Rivalry is the fifth factor in the Five Forces model but probably the one with the most

attention.

What are the assumptions   behind the Five Forces model?

From the risk-return perspective, Five Forces model indirectly implies that risk-adjusted

rates of return should be constant across firms and industries.

How can I analyze my business from inside?

Porter's Five Forces model views the business from outside. It focuses on assessing

competitive position within industry. If you wanted to analyze your firm from within, you

might want to consider the SWOT model. The SWOT model has some aspects of

external view as well but complements Porter's Five Forces model in the internal view.

Another model that you might want to consider is the Balanced Scorecard and IFE/EFE

matrix.

Who is Michael Porter?

Michael Porter is a professor at Harvard Business School and is a leading authority on

competitive strategy and international competitiveness. Michael Porter was born in Ann

Arbor, Michigan

Cement Industry

Barriers to entry, January 3rd, 2009

Cement being a high bulk and low value commodity, outward freight accounts for close

to one fifth of the total manufacturing cost. In addition, for every tonne of cement

produced, close to 1.7 tonnes of raw material (including coal) is transported. In this

scenario, the location of the cement plant becomes crucial. While deciding on the plant

location, there is a trade-off between proximity to raw material sources and proximity to

markets. A split-location cement plant can be a good compromise between the two

options. The plant also has to address issues of logistics (evacuation of cement by rail,

road or waterways), power availability in the region, and The first strategy is to locate

manufacturing facilities near the consuming centres. In this case, outward freight is

minimised and marketing flexibility enhanced at the cost of higher raw material assembly

costs. The second strategy is to locate the plant close to the mineral deposits, so as to

minimise raw material assembly costs. Given that 1.4-1.5 tonnes of limestone are

required per tonne of clinker, locating the plant along the limestone deposits is the logical

corollary. Occasionally, as in areas like Satna, Rewa, and Raipur, the coal pitheads are

also quite close by. availability of materials (limestone, coal, slag, etc).

The bulk of the cement manufactured is consumed near urban centres. In the manufacture

of cement, for every 1 tonne of clinker, about 1.6-1.7 tonnes of limestone and coal need

to be assembled. For OPC, another 50 kg of gypsum is required while grinding the

clinker down. For PPC, up to another 250 kg of pozzolonic material such as fly ash

requires to be assembled. Thus, there can be two broad locational strategies, stemming

from the principal objective, which is not merely to minimise unit-manufacturing cost,

but to minimise unit delivered cost as well. As cement is a low value, high bulk

commodity, freight cost becomes a significant factor in deter mining the landed cost of

cement. This has resulted in a very low volume of inter national trade in cement. World

cement trade has averaged just around 6-7% of the total production. Although, world

trade in cement is limited because of high freight costs, there are countries, which either

import a significant share of their total consumption or export a major share of their total

production. Countries, which impor t a significant share of their consumption, appear to

be falling in the developing world category, where the public expenditure on

infrastructure projects is very high. The Middle East countries (although not falling

in the developing world category) have huge requirements of cement because of

construction work in projects in the oil sector. Also in these countries, unfavourable

conditions (for example, inadequate cement limestone reserves) have discouraged cement

capacity creation. Countries, which export a large share of their domestic production,

appear to be having one thing in common. Countries with high export thrust opt for bulk

transportation for exporting cement. For example, by opting for bulk transportation,

Greece is in a position to export over 50% of its cement production. Bulk transportation

leads to significant advantages such as savings in freight costs and packing costs,

avoidance of transit loss, adulteration, pilferage, bursting of bags and damage to cement.

At the ex-factor y level, Indian cement is quite competitive with many global cement

producing regions. However, a plethora of duties along with infrastructure bottleneck

reduces this competitiveness. As cement is primarily a regional commodity, international

competitiveness is not really a serious issue

Outward freight on cement is an important element in the operating cost of a cement

plant. It accounts for around one third of the total variable costs. Most of the cement

plants in India are located in and around the limestone clusters. These clusters are distant

from the collieries and the markets for cement. Cement has an average lead of around 535

km. Thus, cement companies have to rely on extensive transportation for moving coal

from the coal pitheads to the cement plants and for despatching cement from the plant to

the markets. As both coal and cement are of low value and bulky in nature, freight costs

are considerably high for cement plants. Cement companies use both road and rail

transport to transport cement and to receive coal. Rail dispatches amount for about 33%

while roads carry the balance 66%. The balance 1% is accounted by Sea transporation.

The share of road over rail has only gone up over the years. For coal transportation, the

dependence on rail network is still very high and accounts for around 70% of coal

movement Although rail transportation is more economical for distances beyond 250-300

km, cement companies have started preferring road transportation even for longer

distances because of several reasons. Rising railway traffic coupled with insufficient

investments by the railways for increased wagon supplies and the fact that the cement

industry is not an important customer of the Railways (cement cargo accounts for just 7-

8% of the total railway freight) have resulted in a shortage of wagon supply to the cement

industry. The railways had launched the "Own Your Wagon" scheme-a scheme where

companies could buy wagons and lease it to the Railways and the Railways would in turn

operate these wagons and ensure their availability to the owner. But the unfavourable

ter ms and conditions of this scheme prevented its successful commercialisation. The The

Railways have also increased their tariff on a regular basis (often higher than the

increases in the road sector), making them uneconomical vis-à-vis road tariffs even for

longer distances.

Bargaining power of buyers

The Indian cement industry with a total capacity of about 200 m tonnes (MT) in FY09 is

the second largest market after China. Although consolidation has taken place in the

Indian cement industry with the top five players controlling almost 60% of the capacity,

the balance capacity still remains pretty fragmented.

Despite the fact that the Indian cement industry has clocked production of more than 100

MT for the last five years, registering a growth of nearly 9% to 10%, the per capita

consumption of around 134 kgs compares poorly with the world average of over 263 kgs,

and more than 950 kgs in China. This, more than anything, underlines the tremendous

scope for growth in the Indian cement industry in the long term.

Cement, being a bulk commodity, is a freight intensive industry and transporting cement

over long distances can prove to be uneconomical. This has resulted in cement being

largely a regional play with the industry divided into five main regions viz. north, south,

west, east and the central region. While the southern region always had excess capacity in

the past owing to abundant availability of limestone, the western and northern regions are

the most lucrative markets on account of higher income levels. However, with capacity

addition taking place at a slower rate as compared to growth in demand, recently the

demand supply parity had also been restored to some extent in the Southern region.

Considering the pace at which infrastructural activity is taking place in different regions,

the players have lined up expansion plans accordingly.

Given the high potential for growth, quite a few foreign transnationals have been eyeing

the Indian markets and are planning to acquire domestic companies. Already, while

companies like Lafarge, Heidelberg and Italicementi have made a couple of acquisitions,

Holcim has acquired stake in domestic companies Ambuja Cements and ACC and has

increased its stake gradually to gain full control. After acquiring stake in big companies,

transnationals eyed median capacity producers. Italcementi acquired 100% stake in Zuari

Cement and 95% stake in Shree Vishnu. Cimpor, the Portugese cement manufacturer,

acquired Grasim’s stake (53.63%) in Shree Dig Vijay. However, it must be noted that the

transnationals will find the going tough since cement is a game of volumes and with the

median capacity of fragmented players, the transnationals will have to acquire capacities

piecemeal and this route is fraught with a lot of uncertainties. The global players put

together account of quarter share of the domestic market. Further, turning around few of

the companies at a time when the cycle is at its peak would be a difficult task.

Considering the long term growth story, fair valuations, fragmented structure of the

industry and low gearing, an another wave of consolidation would not come as a surprise.

Key Points ---------------------------------------

Supply -- The demand-supply situation is tightly balanced with the latter being

marginally higher than the former.

Demand -- Housing sector acts as the principal growth driver for cement. However, in

recent times, industrial and infrastructure sector have also emerged as demand drivers for

cement.

Barriers to entry -- High capital costs and long gestation periods. Access to limestone

reserves (principal raw material for the manufacture of cement) also acts as a significant

entry barrier.

Bargaining power of suppliers -- Licensing of coal and limestone reserves, supply of

power from the state grid and availability of railways for transport are all controlled by a

single entity, which is the government. However, nowadays producers are relying more

on captive power, but the shortage of coal and volatile fuel prices remain a concern.

Bargaining power of customers -- Cement is a commodity business and sales volumes

mostly depend upon the distribution reach of the company. However, things are changing

and few brands have started commanding a premium on account of better quality

perception.

Competition -- Due to large number of players in the industry and very little brand

differentiation to speak of, the competition is intense with players resorting to expanding

reach and achieving pan India presence.

Financial Year '09 ---------------------------------------------------

During FY09, the industry maintained volume growth of around 10% YoY. The industry

added nearly 30 MT in FY09 over the previous year taking the total capacity to nearly

212 MTPA. India owing to its locational advantage has been catering to the cement

requirements of the Middle East and the South East Asian nations. However, the exports

were curtailed in FY09 in order to satisfy the domestic demand and contain inflation.

While demand growth stood at 10% YoY, average industry cement realisations (average

of price per bag of cement) were higher by about 5% YoY. The growth in realisations

slowed down as additional capacities coming on stream eased the supply pressures.

The overheated real estate sector has cooled off now. Considering the financial turmoil

witnessed globally, financial institutions have tightened their credit norms. This cautious

stance has led to a credit crunch and the same has impacted upcoming projects. On

account of general economic slowdown and these issues, the demand for cement has

moderated. However, stimulus packages announced by the government and agricultural

income gave a fillip to the demand for the commodity.

The industry volumes and realisations were higher during FY09 that boosted topline

growth. However, cost of operation did also witnessed northward movement that exerted

pressure on margins. The cement industry on an average maintains two months inventory

of fuel and such costs. The crude prices have only started cooling off November 2008

onwards, the benefit of which should start flowing in starting quarter ended March 2009

onwards. Smooth supply of state grid power is another problem. To ensure smooth

functioning of plants and lower costs, industry has opted to set up captive power plants

based on coal. This has resulted in increase in demand for coal. But coal linkages for the

industry are poor. Recently the ratio has dropped below 50%. So the players either have

to purchase it from open market or import it. This has increased cost of operation. The

industry had lined up huge capex plans with that depreciation costs have moved up. All

of this dented profitability.

Prospects ----------------------------------------------------

The industry is likely to maintain its growth momentum and continue growing at around

8% to 9% in the medium to long term. Government initiatives in the infrastructure sector

and the housing sector are likely to be the main drivers of growth for the industry.

In the recent past, demand has surpassed supply, resulting in healthy cement prices

across the country. However, this scenario is likely to reverse as the industry has lined up

huge capacity expansion plans. With the growth in the sector and waning demand supply

gap, cement producers have lined up capacity expansion plans either by brownfield or

greenfiled expansion route. The fresh capacities announced till date will add up 60 MT to

the existing capacity (200 MT), and are expected to go on stream by FY10. As the

capacities become operational, which has started taking place, supply may once again

outstrip demand putting downward pressure on margins. Having said that, temporary

relief may be provided if there are delays in any of the proposed expansion plans.

While infrastructure spending has been a boon, there was also a strong cushion from the

steady growth of the construction sector (read housing). However, recently the demand

has slowed down as real estate and construction activities in the urban areas have taken a

back seat with economic slowdown. The importance of the housing sector in cement

demand can be gauged from the fact that it consumes almost 60%-70% of the country’s

cement. If this support wanes, it would impact the growth in consumption of cement,

leading to demand supply mismatch. Also, the hike in prices of coal and petroleum

products could impact cement companies’ margins.

In the budget, while the government refrained from cutting lowering the burden of taxes

and duties on cement, it imposed customs duty of 7.5% on RMC cement. Imposition of

7.5% customs duty on concrete batching plants is likely to negatively impact the ready

mix concrete manufacturers. However, it won’t have a severe impact as RMC constitutes

not more than 5% of total cement consumption. The government has increased budgetary

allocation for roads under NHDP. Further, with more incentives being spelled out for the

infrastructure and housing sector, cement manufacturers will continue to benefit. The

budget measures such as increasing excise duties have proved to be futile and in the

future too, we believe that it is the market dynamics that will determine these variables.

Good agricultural income has supported demand for the commodity despite slowdown in

real estate sector. Going forward, we believe the government’s initiatives in the

infrastructure and housing sectors are likely to be the main drivers of growth for the

industry in the long run.