PORTER’S FIVE FORCE MODEL

CONTENTS

The meaning of Michel porter’s five force model

1. Threat of potential new entrants

1.1Sources of entity barriers

2. Bargaining power of buyers

2.1 circumstances that make buyers strong/when does customer bargaining power become high?

2.2. How to reduce the bargaining power of buyers

3. Bargaining power of supplier

3.1 circumstances /situation that make suppliers to have strong bargaining power

4. Threat of substitute products

4.1 Conditions of substitute products

5. Rivalry among competitors

5.1. Factors for intensive rivalry

5.2 How to deal with intense competition

6. Features of attractive and unattractive competitive environment

7. Advantages and limitation of porter’s five forces

MICHAEL PORTER’S FIVE FORCE MODELAccording to porter, the nature of competiveness in a given industry can be viewed as a composite of five forces. Each of these forces affects firm’s ability to compete in a market.

DEFINITION

The five force model developed by Michael porter is a tool that helps in analyzing the attractiveness of an industry; it is used for analyzing competitive environment in terms of five basic competitive forces.

These forces determine the intensity of competition and hence the profitability and attractiveness of an industry can be evaluated. They impact on company’s ability to compete in a given market.

Porter’s five forces are as follows

1. THREAT OF NEW ENTRANTSThis is the likelihood that the new entrants will enter into the same business that the firm operates on. It refers to the possibility that the profits of established firm may be ended by new competitors.

New entrants to the business can raise the competition level, the threat of new entrants depends on the barriers to entry, and if barriers are high the threat is low.

SOURCES OF ENTITY BARRIERS

A. Economies of scale

An organization that has achieved economies of scale is the one that produces very large number of products at low cost per unit. It is harder for a new firm to launch in the industry where it will never gain economies of scale since that it will never be able to sell its products on competitive price.

B. Product differentiation

How is the product different from competitors?

- Strong brand- Customer loyalty- Identification

C. Capital requirements

If the investment requirement is high (amount of capital to fund the business) it will create barrier to an entry, if the capital requirement is low then there won’t be much of a barrier.

D. Customer switching cost

Switching costs are the costs associated with changing from one product/service to another. It is a control mechanism that can be used as an entry barrier.

Switching cost may include search cost, learning costs, equipments costs, and installation costs and start up costs, exit fees. Etc

Examples: cost informing relatives upon changing a mobile operator, cost of learning and equipment installation upon changing manufacturing machines.

E. Access to distribution networks

New entrant need to secure distribution network for its products. If access is hard to obtain then it can create and entry barrier. Example, access of raw materials is controlled by existing business.

F. Government legislation

G. Expected retaliation

Note!!!

The above (source of entity barriers) are used by existing firms to control rival entrance on their business

2. BARGAINING POWER OF BUYERS/CUSTOMERSBargaining power of buyers determines how much customers can impose pressure on the organization. Buyers compete with the supplying industry by bargaining down prices, forcing higher qualities

Bargaining power of buyers can influence over the organization to shape their price, quality of product and distribution channel

Note!!!

The more powerful the customers are, the less profitable the organization will be

CIRMUSTANCES THAT MAKE BUYERS STRONG/HOW CUSTOMERS GAIN HIGHER BARGAINING POWER?

Customer bargaining power is likely to be high due to the following reasons

A. When they purchase the product in large volumes

B. When buyers have better information level they are capable of bargaining with suppliers/manufacturer. Example, when customers know about the production costs they may negotiate for lower cost or price.

C. Standard/undifferentiated

If the product offered is not unique, same as other entity, customers may opt for another supplier/manufacturer

D. When buyers face few switching cost

E. When buyers are aware of product quality provided by supplier and its competition, they are in better position to bargain the price.

HOW TO REDUCE THREATS POSSED BY BARGAINING POWER OF BUYERS

i. Products that are well differentiated.ii. Products that are of superior quality compared to competitor productsiii. High market share

3. BARGAINING POWER OF SUPPLIERSThe term supplier comprises of all sources of inputs that are needed in order to provide goods or services.

The cost of items bought from one supplier (e.g., raw materials and machine components) can have significant impact on company’s profitability.

If suppliers have high bargaining power over a company, then the industry will be less attractive

CIRCUMSTANCES/SITUATIONS THAT MAKES SUPPLIERS TO HAVE STRONG BARGAINING POWER

Suppliers bargaining power is likely to be high due to the following.

i. If supplier’s product have no substitute or fewer substitutesii. If supplier’s product have high switching costiii. If supplier’s industry is dominated by few firmsiv. If the product of supplier is unique/differentiated v. If the supplier’s product is an important input to buyer’s productvi. If the buyer is not an important customer to supplier

4. THREAT OF SUBSTITUTE PRODUCTThe presence of substitute product that performs similar function as the one provided by the company can result to lower profitability because they limit price level and reduce demand for a particular class of products.

A threat of substitute products may exist if there are alternative products with lower prices, better performance and performs the same function as the one served by current company.

In general if there is higher probability of existence of substitute products or if there are substitute product available then the industry will be less attractive

CONDITIONS FOR SUBSTITUTE PRODUCTS

The threat of substitute products depends on the following

i. The cost of switching to substitute ii. The relative price and performance of substitutesiii. Close customer relationships ( affect buyer’s willingness to substitute)iv. Current trends

5. RIVALRY AMONG COMPETITORS (INDUSTRY RIVALRY)This refers to the intensity of competition among the existing competitors. What is important here is the number and capability of competitors.

If a firm has many competitors and they offer equally attractive products and services, then the firm is likely to have little power in competitive environment.

FACTORS FOR INTENSE RIVALRY (COMPETITON)

Competition between existing players is likely to be high due to the following

i. The competitors are in balance. I.e. they have the same size and capabilityii. When the product lacks differentiation, one can switch from one product to another.iii. When competitors have similar strategies based on pricing, product innovation and

promotioniv. When competing organization compete in a mature market

v. When several competitors are trying for the same end results. E.g., diverse sales and increasing market share.

HOW TO DEAL WITH INTENSE COMPETITION

I. Strengthen entity brand through innovation, differentiation II. Increasing consumer warranties or servicesIII. Conducting the business in transparent, ethical and socially responsible manners. This

would ensure support form stakeholders.IV. Increasing market knowledge through market research V. Using price competition

FEATURES OF UNATTRACTIVE COMPETITIVE ENVIROMENT

I. rivalry is vigorousII. Entry barriers are low and entity is likely to enterIII. Competition from substitute is strongIV. Suppliers and customers have considerable bargaining power

FEATURES OF ATTRACTIVE COMPETITIVE ENVIROMENT

I. Entry barriers are highII. There is low competition from substitute.III. Suppliers and customers do have lower bargaining power

In general porter’s five force model helps to understand the strengths of the firm’s current competitive position and the strengths of the position the firm aims to move on.

It also has some major limitation in today’s market environment. It cannot take into account new business model and the dynamics of the market.

ADVANTAGES OF PORTER’S FIVE FORCE MODEL

1. The model is a strong tool for competitive analysis at industry level2. It provides useful inputs for performing swot analysis.

LIMITATIONS/DISADVANTAGES OF FIVE FORCE MODEL

1. The model is best applicable for analysis of simple market structure. A comprehensive description and analysis of all forces is difficult in complex business with segments.

2. The model assumes relatively static market structure. It is hardly a case of today’s market structure.

3. The model is based on the idea of competition, it does not consider other factors like strategic alliance, electronic linking of information system of all companies along value chain.