You have a great idea and you want to start a business. You feel like you’ve developed a great product or service for consumers to consider in the marketplace. You believe that you can establish a great profit margin with your product or service and have a great return on investment (ROI). Unless your product or service is the only one of its kind and does not exist anywhere in the world, you should consider understanding Porter’s Five Forces Model before bringing your product to market.
Harvard Business School professor Dr. Michael Porter created the framework and concept known as the “Porter’s Five Forces Model.” According to Dr. Michael Porter, “There are five competitive forces that shape strategy in an industry. Knowledge of the five forces can help a company understand the structure of its industry and define a position that is more profitable and less vulnerable to attack. “The five forces that determine an industry’s competitive intensity are:
1. Threat of entry
2. The power of providers
3. The power of buyers
4. Threat of substitutes
5. Rivalry between existing competitors
These five forces are critical for new business owners and entrepreneurs to understand before bringing their products or services to market or entering a specific industry. In this article, I am going to provide a simplified explanation of the five forces so that new business owners and entrepreneurs understand their purpose.
Threat of entry – Each industry serves a limited market. Firms in a specific industry compete for a substantial part of that market. What happens when a new company enters the industry? The new company consumes a part of the market. The pre-existing companies lose a part of their customers and with that a part of their income. If too many companies enter the industry, this affects the ability of companies to gain significant market share. As the number of suppliers in the industry increases, it affects the general demand for the products or services that companies offer, which affects the bid price. “The threat of entry, therefore, places a limit on an industry’s profit potential. When the threat is high, incumbents must keep their prices low or boost investment to deter new competitors (Porter, 1979)” . To protect the industry from new entries, pre-existing companies create barriers to prevent new companies from entering the industry. Without going into details, Dr. Michael Porter cautions that there are seven main sources that established companies use as advantages for barriers to entry: supply-side economies of scale, demand-side benefits of scale, switching costs. of customer, capital requirements, ownership advantages regardless of size, unequal access to distribution channels and restrictive government policy.
The power of providers – Suppliers are companies that create special supplies, raw materials, specialized personnel or equipment for service companies within specific industries. The power of a provider depends on its size and financial strength. A provider serving a variety of industries or offering a unique product or service not offered elsewhere could be extremely powerful, especially when it comes to cost. A strong supplier can drive up costs and make it difficult for companies to increase their profit margin or pass on those costs to their customers. “Powerful suppliers, including labor providers, can squeeze profitability out of an industry that cannot pass cost increases onto its own prices (Porter, 1979).
The power of buyers – “Buyers are powerful if they have bargaining leverage relative to industry participants, especially if they are price sensitive, and use their influence primarily to pressure price reductions (Porter, 1979)”. Powerful buyers who buy large quantities of goods or services from an industry could influence prices in that particular industry. The powerful buyer could threaten to buy from a competitor of a company if they think the price of the company is too high. Powerful buyers could also demand higher quality or better service, which can have the opposite effects and increase the cost to the company you are buying from. It is extremely important as a new business owner or entrepreneur to create a product or service that is attractive to multiple buyers. Having a healthy portfolio of buyers with the same purchasing power would help alleviate a buyer’s influence.
Threat of substitutes – “When the threat of substitutes is high, the profitability of the industry suffers. Substitute products or services limit an industry’s profit potential by putting a ceiling on prices … Substitutes not only limit profits in normal times, but they also reduce the bonanza that an industry can reap in good times (Porter, 1979) “. The most important point for a business owner or entrepreneur to understand about the threat of substitutes in an industry is how it affects demand and prices. Substitute goods provide the consumer with an alternative to the preferred one, either directly or indirectly. The cross elasticity of demand refers to the sensitivity of the quantity requested for a product or to the price change of another product or else. To keep this simple, if the consumer is very sensitive to changes in the price of a preferred good, the demand for that good will decrease, while the demand for the substitute good will increase further. “If an industry does not distance itself from substitutes through product performance, marketing, or other means, it will suffer in terms of profitability and often growth potential (Porter, 1979).”
Rivalry between existing competitors – “High rivalry limits an industry’s profitability. The degree to which rivalry reduces an industry’s profit potential depends, first, on the intensity with which firms compete and, second, on the basis on which they compete. (Porter, 1979) “Business owners and entrepreneurs should carefully study and analyze the number of companies within the industry in which they want to operate and how intense the rivalry is between those companies. Fierce rivalry within a saturated industry could wreak havoc on the profitability of that industry. Companies within an industry that are equal in stature and compete on price make it extremely difficult for that industry to be profitable. For example, companies offering similar or identical products and services will often lower the prices of their products or services to gain a competitive advantage. As a new business owner or entrepreneur, entering a saturated industry and having a price war makes it extremely difficult to make a profit, especially if pre-existing companies have the advantage of economies of scale.
According to Porter, many factors drive the intensity of rivalry and the basis on which companies compete. Business owners and entrepreneurs should do more research on Porter’s Five Forces model to gain a deeper understanding of those contributing factors. In conclusion, according to Porter, “Understanding the forces that shape industry competition is the starting point for developing strategy. All companies should already know what the average profitability of their industry is and how it has changed over time. time. The five forces reveal why the industry profitability is what it is. Only then can a company incorporate the conditions of the industry into the strategy. “
Porter, ME “How Competitive Forces Shape Strategy.” Harvard Business Review 57, no. 2 (March-April 1979): 137-145.
HarvardBusiness. “The Five Competitive Forces That Shape Strategy.” Youtube, YouTube, June 30, 2008, http://www.youtube.com/watch?v=mYF2_FBCvXw.