You have a great idea and you want to start your own business. You feel like you have developed a great product or service for consumers that will be considered in the market. You believe you can create a large profit margin with your product or service and get a huge return on investment (ROI). If your product or service isn’t one of a kind and doesn’t exist anywhere in the world, you should think about understanding Porter’s Five Forces model before launching your product.
Dr. Michael Porter, a professor at Harvard Business School, created the foundation and concept known as the “Porter’s Five Forces Model.” According to Dr. Michael Porter, “There are five competing forces that shape strategy in an industry. Awareness of the five forces can help a company understand the structure of its industry and take a position that is more profitable and less vulnerable to attack.” determine the competitive intensity of the industry:
1. Threat of entry
2. Strength of suppliers
3. The power of buyers
4. The threat of substitutes
5. Rivalry among existing competitors
These five forces are crucial for new business owners and entrepreneurs to understand before introducing their products or services to the market or entering a specific industry. In this article, I am going to give 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. Companies in a particular industry compete for a significant share of that market. What happens when a new company enters the industry? The new company consumes market share. Existing companies are losing some of their customers, and with it some of their profits. When too many companies enter the industry, it affects the ability of companies to gain significant market share. As the number of suppliers in the industry increases it affects the overall demand for products or services offered by the company, which affects the supply price. “Thus, the threat of entering the industry limits the industry’s profit potential. If the threat is high, existing companies must restrain their prices or increase investment to deter new competitors (Porter, 1979).” In order to protect the industry from new acquisitions, previously existing companies create barriers to prevent new companies from entering the industry. Without going into details, Dr. Michael Porter advises that there are seven main sources that operating companies use as benefits for entry barriers: economies of scale on the supply side, benefits of scale on the demand side, switching costs, requirements to capital, benefits in office regardless of size, unequal access to distribution channels and restrictive government policies.
Strength of suppliers – Suppliers are companies that create special materials, raw materials, personnel or specialized equipment for service companies in certain areas. The power of the supplier depends on its size and financial strength. A provider that serves a variety of industries or offers a unique product or service that is not offered elsewhere can be extremely powerful, especially when it comes to cost. A strong supplier can increase costs and make it difficult for companies to increase profit margins or pass these costs on to their customers. “Powerful suppliers, including labor suppliers, can squeeze profitability out of an industry that is unable to withstand rising costs at its own prices (Porter, 1979).
The power of buyers “Buyers are powerful if they have the leverage to negotiate with industry, especially if they are price sensitive, using their influence primarily to put pressure on prices (Porter, 1979).” Powerful buyers who purchase a large number of goods or services in an industry can affect prices in that particular industry. A powerful buyer may threaten to buy from a competitor of the company if he believes that the company’s prices are too high. Powerful buyers may also demand higher quality or improved service, which can have the opposite effect and increase cost for the company in which it buys. As a new business owner or entrepreneur, it is extremely important to create a product or service that is attractive to multiple buyers. Having a healthy portfolio of buyers with the same purchasing power will help facilitate the presence of a large influence of one buyer.
The threat of substitutes – “When the threat of substitutes is high, the profitability of the industry suffers. Substitute products or services limit the industry’s profit potential by setting a ceiling on prices … Substitutes not only limit profits in normal times, they also reduce profits that the industry can make in good times (Porter The most important point that a business owner or entrepreneur needs to understand about the threat of substitutes in the industry is how it affects demand and prices. Substitute goods directly or indirectly provide the consumer with an alternative to advantage. Cross-elasticity of demand refers to sensitivity to demand for one product or commodity before the price change for another commodity or commodity.To keep this simplified, if the consumer is very sensitive to changes in the price of a preferential commodity, demand for this commodity will decrease, while demand for substitute goods will increase . ”If the 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 among existing competitors – “High competition limits the profitability of the industry. The degree to which competition reduces the profit potential of the industry depends, first, on the intensity of competition of companies and, secondly, on the basis on which they compete (Porter, 1979).” and entrepreneurs need to carefully study and analyze the number of companies in the industry in which they want to work, and how intense the competition between those companies is. Fierce competition within a saturated industry can damage the profitability of that industry. Companies in the industry, which is equal in level and competing in price, greatly complicate the profitability of this industry. For example, companies that offer similar or identical products and services often lower the prices of their goods or services to gain a competitive advantage. As a new business owner or entrepreneur entering a saturated industry with a price war, it is extremely difficult to make a profit, especially if pre-existing companies have an advantage in economies of scale.
According to Porter, there are many factors that determine the intensity of rivalry and the basis on which companies compete. Business owners and entrepreneurs need to further study Porter’s Five Forces model to gain a deeper understanding of these factors. In conclusion, according to Porter, “Understanding the forces driving competition in an industry is the starting point for developing a strategy. Every company should already know what the average profitability of its industry is and how it has changed over time. Five forces reveal why the industry “profitability is what it is. Only then can the company incorporate industry conditions into its strategy.”
Porter, M. E. “How Competitive Forces Shape Strategy.” Harvard Business Review 57, vol. 2 (March-April 1979): 137-145.
HarvardBusiness. “Five competing forces that shape strategy.” YouTubeYouTube, June 30, 2008, http://www.youtube.com/watch?v=mYF2_FBCvXw.