Understanding the industry with Porter’s 5-force model is one of the core elements of well conducted business analysis. According to the TOP-DOWN approach, industry analysis normally follows the environmental analysis.
When introduced, Porter’s 5-force model turned the perception of profitability upside down. Michael E. Porter, a world-renowned economist, professor and author of the leading literature on strategic management, linked the attractiveness of the industry to forces such as clients, suppliers, competitors, substitutions and new entrants.
The strategic management tool is crucial for proper understanding of industry profitability and its developments.Interestingly, unlike some other more quantitative methods, Porter’s 5-force model is primarily based on qualitative evaluation.
Quantification of Porter’s 5-force model?
With quantification and visual presentation of the model one is able to communicate the findings of the Porter’s 5-force model more efficiently. Seeing the spikes or deviations is easy and fast to understand and very powerful decision-making base. With this approach, we can also successfully compare the effect of:
- reference company in relation to its comparable peers
- reference company in relation to time – now vs future.
Let’s better understand also the key forces on which the model focuses on:
1st force of the Porter’s 5-force model – the bargaining power of buyers
The bargaining power of buyers is present when buyers abuse their power to lower purchase prices, increase quality, add additional services, etc.
Factors that influence the bargaining power of buyers are: Concentration of buyers, Fragmentation of suppliers, Alternative sources of supply, Low switching costs, The importance of product / service for the customer, The risk of takeover by the buyer etc.
2nd force of the Porter’s 5-force model – the bargaining power of suppliers
Supplier bargaining power exists when suppliers misuse their power to increase selling prices, reduce quality, dispose of additional services, etc.
Factors that influence the bargaining power of suppliers are: Concentration of suppliers Fragmentation of customers Alternative sources of supply High switching costs Strong supplier brand The importance of the transaction for the supplier The risk of takeover by the supplier etc.
3rd force of the Porter’s 5-force model – the newcomers entry threat
The entry of new competitors usually leads to a lower profitability of all competitors in the industry.
Factors influencing the threat from new entrants are: Initial investments in property, plant and equipment, Economies of scale, Experiences Access for supply and distribution channels, Expected retaliation, Loyalty of customers and suppliers, Legislation and policy, Differentiation etc.
4th force of the Porter’s 5-force model – the danger of substitutes
The profitability of companies operating in the sector is influenced not only by competition and new entrants, but also by substitutes.
The threat of substitutes is three-dimensional: Product / service for substitution, Substitution of demand, Generic substitution.
5th force of the Porter’s 5-force model – the rivalry
Factors that influence the rivalry are: Competitors are in balance, Low differentiation, Slow market growth, High fixed costs in the industry, High exit barriers etc.