Five Forces Analysis

Michael Porter’s 5 Forces Model evaluates the relative attractiveness of entire industries. Porter introduced the model in 1979, explaining that customers, suppliers, new entrants, substitutes, and industry rivals all play a role in determining the profitability of the industry.

When it’s easy for companies to enter an industry (low barriers to entry), new entrants increase industry supply and often are aggressive in marketing and pricing to get to a sustainable share position. This hurts overall industry profitability.

When suppliers have a stronger position in negotiations than industry players, they can charge higher prices and shift costs to the industry, also hurting industry profitability. Suppliers are strong when the industry doesn’t have many other choices (no substitutes and few alternate suppliers) or when it’s hard to switch suppliers (strong differentiation or high switching costs). The industry is also weak relative to suppliers when the industry represents a relatively small share of the supplier’s revenues or if the suppliers can credibly forward integrate and become new entrants to the industry themselves.

On the flip side, buyers with strong negotiating positions can drive down prices and demand more support and services from the industry, increasing costs and hurting profitability. A group of buyers have power when there are relatively few buyers, their switching costs are low, the industry’s products are standardized, and the buyers group represents a large share of the industry’s revenue. Buyers further strengthen their position by playing industry players off each other to get the best deal and by threatening to backwards integrate and produce the industry’s product for themselves.

The availability of credible substitutes also strengthens the hand of buyers and can reduce demand for the industry’s products, thereby hurting industry profitability. Substitutes provide the same value as the industry, for example, traveling by train is a substitute to the airline industry. The level of threat from substitutes is based on how good of a replacement it is, how cost effective it is relative to the industry’s offering, and how low the switching costs are.

The final threat represented by Porter’s 5 Forces model is the intensity of rivalry within the industry itself. Rivalry is high when there are a relatively large number of roughly equally-sized competitors who are committed to the industry, especially if there is limited growth in the industry. This industry commitment can be due to high exit costs (e.g., assets that would be stranded) or the perceived importance of participation for other businesses. A high level of rivalry results in fierce competition on price, product features and portfolio, and additional services, all impacting industry profitability.

Watch a tutorial here on using Five Forces Analysis in performing a Situation Assessment.

Tools for creating a Five Forces Matrix coming soon!