Porter’s Five Forces explained

What is the Porter’s Five Forces Model and how to apply it?

Porter’s Five Forces is a market analysis tool which can be used to ascertain both the attractiveness of an industry, and the levels of competition within it. An industry is a set of organisations whose purpose is to satisfy the needs of a group of buyers who are collectively known as the market. For a market to be sustainable long-term, it must be a profitable industry for the businesses competing in it. The businesses within a market must be able to find ways to remain competitive.

By using Porter’s Five Forces, an organisation can determine its ability within a specified industry to earn a profit that gives an acceptable return on the financial investment made. The different forces outlined in the model influence the prices that can be charged, and the costs that have to be met. In general, the stronger the competitive forces in the industry, the less profitable it is for individual firms.

In addition to analysing the attractiveness of a market, Porter’s Five Forces can also be used to help inform make-or-buy decisions, and as an aid to negotiations, helping organisations to map the power balance between buyers and suppliers.

We will now review some of the factors organisations should consider for each of the Five Forces outlined in the model.

Factors to consider

Example of Porter’s Five Forces

Porter’s Five Forces applied to Coca-Cola

Considering Porter’s Five Forces in relation to Coca-Cola, the threat of new entrants is medium. There are two opposing issues. One is that entry barriers are relatively low and there are no consumer switching costs. The counter issue is that Coca-Cola has been a leading brand for a long time and loyal customers are unwilling to switch brand. The threat of substitute products has medium to high pressure.

New beverages regularly enter the market in competition with Coca-Cola. Also other forms of soft drink such as juices are available. The bargaining power of buyers is low. Individual buyers can exert no pressure on Coca-Cola. On the other hand, large retailers buy in volume and so exert a lot of power. The bargaining power of suppliers is also low.

The main ingredients are carbonated water, phosphoric acid, sweeteners and caffeine. Suppliers of these ingredients tend to be much smaller than Coca-Cola and are not differentiated. Rivalry among existing organisations is high. Coca-Cola and Pepsi dominate this market and each have a wide range of products. Other companies enter the market because of their unique flavour, such as Dr Pepper, but have a much smaller market share.

(Source: adapted from www.valuationacademy.com/porters-five-forces-inaction-sample-analysis-of-coca-cola)

Advantages of Porter’s Five Forces

There are many advantages of analysing the competitive position of an organisation.

• Helps assist organisational decision makers in defending and/or growing their market share and profit in an existing or new market. This can aid with make-or-buy decisions.
• Helps organisations identify the extent to which both their buyers and suppliers have power over them which will help to aid pricing and negotiation strategies. Understanding where the power lies allows negotiators to recognise areas of strength and mitigate against areas of weakness.
• Identifies possible threats to the organisation, in the form of substitutes or new entrants.
• Allows organisations to assess the number of competitors, and intensity of competition from rival businesses.

Alternatives to Porter’s Five Forces

There are some disadvantages to Porter’s Five Forces. Porter’s Five Forces analysis is limited as it only examines the microenvironment of the industry or market in which an organisation operates. It does not analyse internal factors within an organisation and does not look at wider macroenvironmental factors that may shape strategy.

Macroenvironmental factors would include things like environmental risks such as the availability of commodities and raw materials, financial risks such as inflation or exchange rates etc., all of which can also influence markets.

To capture these elements, organisations could conduct a STEEPLED analysis, which studies external factors – social, technological, environmental, economic, political, legal, ethical and demographic. This model helps organisations to make decisions, examining wider market factors as a whole, maximising opportunities and minimising threats.

What is bargaining power of buyers?

Bargaining power of buyers is one of the forces in Porter’s Five Forces and is the pressure that customers can put on organisations to provide higher quality products, low prices and increased customer service.

Determine factors

Buyer power from consumers pressures organisations to reduce prices or increase the quality of services or products they offer.

1. Number of buyers relative to suppliers
2. Dependence of a buyer’s purchase on a supplier
3. Switching costs
4. Backward integration

How to assess the buying power of a group?

Buying groups typically consist of organisations looking to establish strong relationships with suppliers and joining forces for a stronger purchasing power. Suppliers tend to offer better price and value to organisations that place large orders and spend big. If you’re part of a buying group, you can consolidate your purchasing power to negotiate better discounts. Here are just some of the ways you can identify the buying power of a group:

• Large volumes of purchases
• Alternative suppliers are easy to find as products/services are standard
• Little penalty for moving to another supplier
• Profits earned are low
• The buyers have full information on demand, market prices and supplier costs