Porter’s 5 forces is a model that helps to identify the weaknesses and strengths of an industry, empowering the potential investor with insights. In fact, the model is used by more than just investors, companies and analysts also make use of its structure, allowing them to analyze the competitive forces in an environment and build an appropriate business strategy.
Below we outline how the Porter’s five forces model works, where it came from, and how you can use it to your advantage.
What is the Porter's Five Forces model?
Porter’s Five Forces focuses on identifying and analyzing five competitive forces within an industry that can be used to establish what the industry’s strengths and weaknesses are. The five forces analysis can be applied to any segment of the economy and can determine a company’s business strategy, level of competition, or long-term industry profitability.
The Five Forces are:
- Competitive forces in the industry
- Potential of new entrants into the industry
- Power of suppliers
- Power of customers
- The threat of substitute products
This model is designed to help analysts and managers comprehend the competitive landscape that a particular company faces and how the company is positioned within it.
Where did Porter’s Five Forces model come from?
The five forces analysis model was created by and named after Michael E. Porter, an established Harvard Business School professor. The model was introduced in Porter’s book, Competitive Strategy: Techniques for Analyzing Industries and Competitors.
Developed in 1979, the five forces analysis model was created to provide industry outsiders with insight and knowledge into the positioning and competitive strength of an organization. The business analysis model has become an important tool in the financial sector and is still widely used today, over 40 years later.
Breaking down Porter’s Five Forces
Below is a breakdown of the Five Forces analysis model which is universal across almost every market and industry in the world. The model looks at the company’s positioning within the market to determine how much power it holds.
1. The competition in the industry
The first of Porter's Five Forces analysis model focuses on the number of competitors a company has and its ability to undercut them. The more existing competitors and competitive rivalry a company has, along with the number of similar products and services they offer, the less power the company holds.
When the company has a high level of competitive rivalry, suppliers and buyers will gravitate toward the lower prices, while when competition is low, companies have more control over the prices they charge and the terms of their deals.
More power equates to a competitive advantage which typically equates to more sales and profits. Hence, why industry competition and competitive forces shape strategy.
2. The potential of new entrants into an industry
Of course, new entrants into the market also pose a threat to a company’s power. This can be measured by looking at the amount of time and cost it would take to be a potential competitor. The more resources needed, the more established the company’s position.
The stronger the barriers to entry, the better for companies already positioned in the market.
3. The power of suppliers
This point in Porter's five forces analysis model looks at the power the suppliers hold in terms of driving up the costs of resources. This can be determined by looking at the number of suppliers available, how unique their products are, and the cost of a company switching to another supplier.
The fewer the number of suppliers, the more a company depends on them in turn driving up the supplier’s power. The supplier then has more control over their input costs which can result in lower profits for the company.
4. The power of customers
The power of customers looks at how much control the consumer has to drive a company’s prices down. This looks at the number of customers a company has, the impact of each customer, and the cost of finding new customers or markets to sell to.
The smaller the customer base, the more power they have to negotiate lower prices. While a larger customer base with many smaller clients is able to charge higher prices and in turn increase profitability.
5. The threat of substitutes
The final of Porter’s Five Forces analysis model is the threat of substitutes and looks at the threat that substitutes goods and services can pose to a company. The more unique and more difficult a product or service is to substitute, the better the company’s positioning. As consumers will have little else to turn to, the company automatically accumulates more power.
These Five Forces analysis can assist a company in building a strategy that ensures well-utilized resources and boosted profits, however, this strategy will need to be consistently visited to ensure that any changes in the external environment are factored in.
What are the downsides of Porter’s Five Forces?
The most pressing downside of the Five Forces model is that it was designed to look at an individual company, as opposed to the wider industry. Additionally, this proves difficult when the company falls into two or more industries, making the framework less impactful.
The final downside is that the model is designed to measure all five aspects equally against each other which isn’t always the case. Some factors might be more prevalent in one industry but less relevant in another.
Porter's Five Forces Model vs SWOT analysis
Another tool used in the business sector is SWOT analysis, which looks at the strengths, weaknesses, opportunities, and threats of existing companies. When comparing the two the most prominent differentiation is that Porter’s Five Forces model tends to examine the external environment and competitive strategy of a company while SWOT looks at the internal aspects of an organization.
In conclusion
This business analysis model aids in assessing the competitive landscape within a company's industry. The level of influence a company wields across these factors could potentially shape future profitability.
Porter’s Five Forces forces company’s to look beyond their organization and at the greater industry structure in order to map out future plans and strategies. While this framework still plays a valuable role in the business sector, it should not be the only tool used by a company to determine its strategy.
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