Porter’s five force analysis is a framework for industry analysis and business strategy development formed by Michael E. Porter of Harvard Business School in 1979. Michael Porter’s Five Forces have become a standard framework for the assessment of profit potential.
According to Michael E. Porter, “Awareness of the five forces can help a company understand the structure of its industry and stake out a position that is more profitable and less vulnerable to attack”. Together these forces determine the strength of the industry, competition and profitability. Companies must be flexible to respond rapidly to competition and market changes and it can surpass its competitors only if it can establish a difference that it can maintain.
1. Threat of substitute products or services: Substitute products or services limit a company’s proﬁt potential by placing a ceiling on prices. The company need to distance itself from substitutes through product differentiation or better performance, marketing, or other means, otherwise it will suffer in terms of proﬁtability and growth potential. For example, in the automobile industry, there are many alternatives available that will serve the same purpose. For example: In the small car segment, there are players like Maruti Alto, Estilo, WagonR, Chevrolet Spark, Hyundai EON etc to choose from. Similarly, in the mid-range there is Nissan Sunny, Honda City, or Maruti SX4. In such a situation, a company must differentiate itself on the basis of cost of the automobiles and its operating costs, look of the vehicle, etc.
2. Rivalry among Existing Firms: According to Michael E. Porter, “Rivalry is especially destructive to profitability if it gravitates solely to price because price competition transfers profits directly from an industry to its customers”. Rivalry could takes many familiar forms, including price discounting, new product introductions, advertising campaigns, and service improvements. For example, in the automobile industry, huge price competition has lead to extensive need to differentiate, new product introduction or entry in another segment. For example: Tata Motors which has a leading position in the commercial vehicle segment is trying to establish itself in the passenger car segment also with differentiated products in the compact, midsize and utility vehicle segments. Other forms of rivalry:
The rivalry also exists in introducing the newest and best technology. All strategies are highly monitored and, in many times, copied among rival firms. To remain ahead in competition, companies are also offering value added services to the customers such as, free vehicle services, easy finance options and long term warranties. All these measures cut into the profit margins.
3. Threat of new entrants: The threat of a new entrant in any industry primarily depends upon the nature of entry barriers that are present. In the automobile industry, the existing loyalty to major brands, high set-up costs, scarcity of resources, high cost of switching companies, slowdown in the economy,rising fuel prices and government regulations serve as entry barriers which reduce competition in the industry. But still there is moderate to high competition in the automobile sector. In recent years, the competition has however further increased with new players entering the market and some smaller players catching up. Many foreign automobile manufacturers are aggressively entering high growth emerging markets such as India amidst slowing demand in the developed economies. Volkswagen has succeeded in establishing its brand in the Indian market since its entry in 2008. After its entry into India, Volkswagen’s Polo, along with Ford India Pvt. Ltd’s Figo and General Motors India Pvt. Ltd’s Beat, managed to capture the market share of companies such as Maruti and Tata Motors Ltd.
4. The power of suppliers: Suppliers have a bargaining power if they are able to capture more of the value for themselves by charging higher prices, limiting quality or services, or shifting costs to industry participants. Companies depend on a wide range of supplier groups for raw materials.
A supplier is powerful if:
a. It is more concentrated than the industry it sells to. For example: Microsoft’s near monopoly in operating systems.
b. If switching costs in changing suppliers is high. For example, shifting from Tata Sky to another service provider will require the subscriber to purchase another set top box.
c. If suppliers offer original (patented) products. For example, many pharmaceutical companies that offer patented drugs.
d. If switching supplier will cost great difficulty. For example, mobile phone companies, where it is difficult to get number portability, especially when you move between cities in India. At the same time changing your service provider often requires the subscriber to get a new connection (phone) number, which causes great inconvenience.
5. The power of buyers: Buyers have a bargaining power if they are able to capture more of the value for themselves by forcing down prices, demanding better quality or more service (thereby driving up costs).
A buyer group is powerful if:
a. There are only a few buyers.
b. If the industry’s products are standardized or undifferentiated.
About the Author
Rajat Sharma is a well known stock market analyst and commentator. He has covered Indian markets for over a decade and is regarded for consistently identifying early stage investment opportunities. Attorney by qualification, Rajat has done extensive work for improving corporate governance and disclosure standards.Follow @SanaSecurities