THE FIVE COMPETITIVE FORCES THAT SHAPE STRATEGY

INTRODUCTION

Competition in today’s industries spreads far beyond today’s direct competitors. As per Porter, an organization’s competitive standing is determined by 4 important factors apart from industry rivals: customers, suppliers, potential entrants, and substitute products. The extended rivalry that results from all five forces defines an industry’s structure and shapes the nature of competitive interaction within an industry. Thus in the long run the combination of these factors drives competition and profitability rather than where the product is in its life cycle. Whether the company earns attractive returns on investment or incurs losses hinges on whether these forces are intense or benign.

THREAT OF NEW ENTRY

The threat of entry in an industry depends on the entry barriers in the industry and the reaction entrants can expect from incumbents. If entry barriers are low and incumbents are unlikely to react much the threat of entry is high. Such a threat of entry is adequate to moderate profitability in the industry. It does not matter whether entry actually occurs or not.

The 7 major barriers to entry are:

1. Supply-side economies of scale- As the volumes produced by a firm grow it enjoys scale economies which reduces per unit costs. They also benefit by spreading technology and marketing costs over larger volumes.

2. Demand-side benefits of scale- This benefit is usually seen in industries where the ‘network effect’ exists.

3. Customer switching costs- Switching costs can be a major factor that can deter new players. If the users of the product face high switching costs they are unlikely to shift to a new vendor especially a new entrant to the market.

4. Capital requirements- If the capital required to be invested is high to begin a new venture the industry is likely to face a minimal threat of new entry. However this barrier stands weakened if the returns are high and expected to remain so.

5. Incumbency advantages independent of size- some incumbents may enjoy advantages such as proprietary technology, preferential access to the best raw material sources and established brand identities. Such advantages may prove to be significant entry barriers.

6. Unequal access to distribution channels- a new player has to setup distribution channels for it’s or service which can prove to be a major entry barrier at times.

7. Restrictive government policy- government policies such as licensing or subsidies can directly deter or aid the entry of new players.

THE POWER OF SUPPLIERS

Suppliers can majorly affect the profitability of the user industry. Supplier power is high if there exist:

1. Large number of suppliers2. Low percentage share of the industry in the supplier’s revenue3. High supplier switching costs4. Easy availability of substitutes of the input5. High possibility of forward integration

THE POWER OF BUYERS

Powerful buyers demand better quality or more service which raises costs. The bargaining power of buyers is high when:

1. Number of buyers is low2. Volume of purchase is high3. Standardisation of products is high4. Switching costs are high5. Possibility of backward integration is high

THE THREAT OF SUBSTITUTES

Substitutes are products that perform the same functions as the original product. Substitutes limit the price an industry can charge. The threat from substitutes depends on the following factors:

1. Price-performance trade-off offered by the substitute2. Buyers switching cost3. Similarity to functions performed by original product

RIVALRY AMONG EXISTING COMPETITORS

Rivalry among competitors, if high, can severely affect industry profitability. It may lead to price wars, inflation of advertising budgets, new product introductions etc. The intensity of competition is high if:

1. Number of competitors is high and their market shares are low2. No clear market leader exists 3. Industry growth is slow4. Exit barriers are high5. Products are similar in nature6. Marginal costs are low7. Excess capacity exists

IMPLICATIONS OF PORTERS FIVE FORCES ON STRATEGY

The Porter’s 5-force model can enable a company to clearly determine its industry structure and develop its strategy accordingly. The 5-force analysis provides a complete picture of where the company stands versus buyers, suppliers, entrants, rivals, and substitutes. This environment analysis can help the company decided its strategy with respect to the following:

Positioning the company

A company can determine which parts of the market witness the highest competitive rivalry and which ones are relatively less competitive. The company can accordingly select its positioning and target those areas of the market where it expects the highest returns. The company will also have to alter its product and other processes accordingly.

For ex. Netflix realized it would be difficult to compete with Blockbuster adopting the same model. They therefore adopted the net-based model.

Exploiting industry change

Industry changes often result in new opportunities which can be grabbed by companies gaining a competitive advantage. If a manager has a clear understanding of the industry structure he can quickly adapt his strategy to suit the new environment. When such changes occur they lead to the development of new needs. In some case these needs are overlooked by industry leaders and can be profitable exploited.

For ex. With the increased internet usage, airline companies soon realized that customers preferred purchasing tickets over the net. The airlines which initially adopted e-ticketing gained

majorly and also reduce their costs. Moreover travel agents who solely relied on air ticket commission were slow to change and now are a dying breed. This change also opened up new opportunities and online sites like makemytrip.com came into existence.

Shaping industry structure

A company which clearly recognizes the major forces that are affecting the industry structure can work towards altering these forces to transform the industry, which ultimately benefits all players. There are 2 ways through which the industry can be reshaped. The company may work towards redividing profitability or towards expanding the profit pool.

In case of Redividing profitability the company has to determine which forces are currently restraining the profitability of the industry. The company can then take measures to contain the leakage of profits to buyers, supplier, and substitutes. The company can reduce the bargaining power of buyers or suppliers thereby retaining a greater percentage of the value chain for the industry.

For ex. In the west, Walmart, the world’s largest retailer, took advantage of its sophisticated distribution to garner a greater share of the value chain from the suppliers. It forced them to streamline their processes and distribution. Soon other retailers also gained he same benefits. Similarly in India, organized retailers are capturing a greater percentage of the price of a product despite selling at prices lower than mom and pop stores due to their increased bargaining power with suppliers.

Expanding the overall profit pool creates win-win opportunities for multiple industry participants. The profit pool can be expanded by serving markets with latent needs that were not served earlier. The company can also join hands with other players to improve co-ordination to reduce overall costs and eliminate wastage.

For ex. When the stock exchanges in India moved over to electronic trading they significantly expand the profit pool for all players. Companies found it easier to manage registration of transfers. This significantly reduced the settlement time and attracted new buyers. The exchanges made it cheaper for their members to trade which increased their volume significantly. Similarly when the brokers started offering online trading to their clients at lower costs volumes jumped. They could offer lower rates since all players i.e. banks, depositories and brokers themselves coordinated and reduced their costs.

COMPETITION AND VALUE

The competitive forces explain the main drivers of industry competition. The company strategy has to take into consideration that competition stretches well beyond existing competitors. A study of the industries competitive forces can help a manger gain crucial insight. He can determine the value gaining and value draining part of the operations and make suitable changes. He can spot new opportunities and exploit them accordingly. Moreover he forecast future danger spots like new entrants, price wars and prepare accordingly. In a world of more open competition and relentless change, it is more important than ever to think structurally about competition.