Harvard Says Use This Model to Make Significant Business Decisions
Porter's Five Forces model can help you make significant business decisions based on your industry. But what is Porter's Five Forces model, what are the five specific forces and how can you use Porter's Five Forces model to your advantage?
Let's dive in.
What is Porter’s Five Forces model?
According to Investopedia the Porter's Five Forces model "identifies and analyzes five competitive forces that shape every industry and helps determine an industry's weaknesses and strengths." It's "frequently used to identify an industry's structure to determine corporate strategy," and it "can be applied to any segment of the economy to search for profitability and attractiveness."
Porter's Five Forces model is named after Michael E. Porter of Harvard Business School. He developed the model in 1979, and the model was then published in Michael E. Porter's book, Competitive Strategy: Techniques for Analyzing Industries and Competitors in 1980.
It's been around ever since, helping entrepreneurs and companies alike to make business decisions. Porter's Five Forces model is useful for a number of reasons. It helps organizations to understand the different factors that affect their profitability in their industry or other industries they want to explore.
"The model is widely used to analyze the industry structure of a company as well as its corporate strategy," according to Investopedia. "Porter identified five undeniable forces that play a part in shaping every market and industry in the world, with some caveats. The forces are frequently used to measure competition intensity, attractiveness and profitability of an industry or market."
There are tons of ways to use Porter's Five Forces model to one's advantage — and many companies have done just that for the last three decades since it's been around.
"When you understand the forces in your environment or industry that can affect your profitability, you'll be able to adjust your strategy accordingly," according to Mind Tools. "For example, you could take fair advantage of a strong position or improve a weak one, and avoid taking wrong steps in future."
In order to use the Five Forces model to your advantage, however, you need to understand what the five forces specifically are.
What are the five forces?
Here are the five forces outlined in Porter's Five Forces model.
1. The competition in the industry
Competition in the industry refers to the number of competitors and their abilities to undercut. Competition, of course, is key to any industry, but depending on the type of competition, some companies will perform better than others.
The competition in the industry force is "an assessment of how easy it is for suppliers to drive up prices," according to CGMA. "This is driven by the: number of suppliers of each essential input; uniqueness of their product or service; relative size and strength of the supplier and cost of switching from one supplier to another."
In other words, the bigger the number of competitors (and their products and/or services), the lesser the power a company has in the industry.
"Where rivalry is intense, companies can attract customers with aggressive price cuts and high-impact marketing campaigns," adds Mind Tools. "Also, in markets with lots of rivals, your suppliers and buyers can go elsewhere if they feel that they're not getting a good deal from you."
2. The potential of new entrants into the industry
A company is also affected by the potential of newcomers in the industry.
"The less time and money it costs for a competitor to enter a company's market and be an effective competitor, the more a company's position may be significantly weakened," according to Investopedia. "An industry with strong barriers to entry is an attractive feature for companies that allows them to charge higher prices and negotiate better terms."
Newcomers can threaten that power.
"New entrants will add new capacity, thus supply, to the market which will reduce prices (at least in the medium term)," according to CGMA. "The pace at which competition can form depends on a number of factors."
3. The power of suppliers
Suppliers hold a lot of power over the industry, as well. This force refers to how easily they can drive up the cost of inputs.
"It is affected by the number of suppliers of key inputs of a good or service, how unique these inputs are, and how much it would cost a company to switch from one supplier to another," according to Investopedia. "The fewer the number of suppliers, and the more a company depends upon a supplier, the more power a supplier holds to drive up input costs and push for advantage in trade. On the other hand, when there are many suppliers or low switching costs between rival suppliers a company can keep input costs lower increasing profits."
4. The power of customers
Customers, of course, can make or break an industry. So this force refers to the ability that customers have to drive prices down. This is determined by how many customers a company has — as well as their significance, a smaller but more powerful customer base still has more power to bring prices down than a larger, less powerful customer base.
5. The threat of substitute products
The threat of substitute products force refers to any products or services that can be used in place of a company's products or services and, therefore, pose a threat to the company. So companies that produce products and services that are unique and have little to no substitutes will have an easier time increasing prices and profiting. Those that produce products and services that have a lot of substitutes, however, will have a hard time keeping customers.
"For example, if you supply a unique software product that automates an important process, people may substitute it by doing the process manually or by outsourcing it," according to Mind Tools. "A substitution that is easy and cheap to make can weaken your position and threaten your profitability."
Therefore, the company's power is weakened.
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AnnaMarie Houlis is a feminist, a freelance journalist and an adventure aficionado with an affinity for impulsive solo travel. She spends her days writing about women’s empowerment from around the world. You can follow her work on her blog, HerReport.org, and follow her journeys on Instagram @her_report, Twitter @herreportand Facebook.
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