Industry Analysis: Porters 5 forces

Every business school student will be asked to do at least one or two industry analysis as part of their business school program. Industry analysis may be done as part of a specific industry analysis assignment or it may show up as part of a larger project such as an entrepreneurship idea, strategy project, consulting project, etc.

Performing an industry analysis is an essential skill any CEO, business owner, or manager must-have. A good understanding of one’s industry helps establish a profitable position within that industry. There are many ways an industry analysis can be done. On top of the heap is Michael E. Porter’s 5 forces framework for industry analysis.

In the article “The Five Forces That Shape Strategy”, Michael Porter outlined the process of industry analysis using these steps.

Define the relevant industry
Identify the participants and segment them into groups
Assess each of the industry forces
Determine the overall industry structure and test for consistency/accuracy
Explain why some companies within the industry are more or less profitable than the others
Asses recent changes and predict future changes
Identify the parts of the industry structure that you can impact/influence. Also identify parts of the industry that your competitors/buyers/suppliers/substitutes, etc. can impact/influence.
Refine your strategy as needed.

Michael Porter first published his now-famous industry analysis framework in a Harvard Business Review (HBR) article titled “How Competitive Forces Shape Strategy” in 1979. Since then this framework has These articles have been reprinted and referenced in the HBR numerous times including an updated article in 2008 titled “The Five Forces That Shape Strategy”. These and other pieces have also been reprinted in numerous other publications and books that have been translated into many languages.

Why Forces?

The choice of the word forces is very interesting. It connotates a feeling of constant pressure or a press or a pull or a force such as gravity or momentum. These forces are industry forces that every company in an industry must bear. And it is the strength of these forces that determine industry profitability, especially in the medium to long term.

What is Industry Structure

According to Porter, it is these five forces that define an industry’s structure. Every industry will look different and performs different activities. However, every industry/company will have these five components to deal with. The strength and control of each of these five forces will differ in each industry given its unique characteristics.

Another important aspect is that these forces apply to both business to business industries and business to consumer industries too.

Why does Industry Structure Matter?

The structure of the industry, or the 5 forces, determines who keeps the value generated in the industry (you or buyers/suppliers/competitors). This is similar to any negotiation exercise where the person with leverage/power keeps most of the margin. The structure of the industry, or the 5 forces, also determines how much profits are generated as the profits will be caped by potential entrants/substitutes. The strongest force determines profitability because that force can negotiate away most of the value created.

The strength of these forces or in other words the industry structure grows out of the nature of the business, personality of the players, economic factors, technological factors, consumer taste and preferences, etc. Therefore a solid understanding of these underlying factors is important in industry analysis.

Does Industry Structure Change?

Industry structure does not change in a quarter or even a year. It is usually consistent over a longer period. Changes in industry structure do happen – as a result of new developments such as regulation, discoveries, technological advancements, changes in consumer preferences, etc. but these changes usually happen over longer periods and are rarer than we believe.

Why do you need Industry Analysis?

Understanding the industry structure thoroughly helps you

Understand your strengths and weaknesses.
Determine your strategy – in terms of positioning within an industry, what activities you will invest in to strengthen your position vis-à-vis the five forces.
Anticipate changes in the industry structure ahead of time so you can take advantage of the changes coming.
Determine good entry and exit points from a business before it becomes obvious and therefore take advantage of the pricing opportunities.
Direct competition into areas that are advantageous to you.

Since the five forces that play on an industry are so important, lets look more closely at them.

The Treat of New entrants

The threat of new entrants is probably already taught in economics 1-o-1 when dealing with perfectly competitive markets. In economics, we learn that higher margins attract new players. More entrants increase industry capacity and competition thereby driving economic profits to zero. This risk of attracting new entrants keeps a check on profit margins. Competition is more severe if the new entrant is diversifying from neighboring markets because they can leverage its existing assets and cash flows to fight in this industry.

The threat of new entrants is directly dependent on 1) the barriers to entry into this industry and 2) potential retaliation from the current players in the industry.

The barriers to entry include:

Supply-side scale economics: New entrants are less likely to enter if the industry has the economics of scale at work. This is because new entrants have to compete at a disadvantage during their entry period with higher costs as the incumbents benefit from lower cost due to their already larger size due to scale economics – when the cost of production declines as production gets larger.

Demand-side scale economics: the economics of scale can also work on the demand side. Network effects are a classic case of demand-side economics. In addition to network effects, simple size or length of presence may be an advantage in terms of feedback, brand, etc. especially if customers prefer to go with a known product or service to avoid risk. This is more if the product or service is critical to the customer or expensive.

Customer switching costs: The barrier to entry is higher if there are large switching costs. Switching costs refer to the cost or efforts taken to move to a different supplier or service.

Capital required: The capital required to enter a new business is a factor or barrier to entry. Generally, the higher the capital required the higher the barrier to entry. This need not be the case when capital markets are efficient as investors will raise to fund profitable ventures no matter the size of the investment. However, if the capital required is low, there will be many more people willing to invest. Capital may be required not only for physical assets but other factors like brand building, provision of credit facilities, R&D, inventories, etc. The barrier to entry is higher if the capital is used for non-recoverable investments like R&D, branding, etc as opposed to investments in land where recovery is almost certain.

Incumbency advantages other than size: We already spoke of scale economics on the demand and supply side. Other incumbency advantages can deter new entrants. These include other factors in addition to the brand, trust, reputation of incumbents and maybe more akin to locking up premium geographic locations, exclusivity contracts with key players/suppliers, proprietary technological patents, etc.

Incumbency advantages other than size also can include incumbents’ unequal access to distribution channels in key markets. If incumbents have locked up key distribution channels, new entrants must content with having to develop their own distribution channels making it more expensive/requiring more capital.

Government actions/interference: Government regulation in the form of permits, licensing requirements, patent rules, subsidies, etc. is another barrier to entry in certain markets. However, Government actions/interference can also lower the barriers to entry if governments decide to promote an industry by offering subsidies, R&D support, etc.

Expected Retaliation

The threat of new entrants is lower if new entrants expect retaliation from established incumbents. Retaliation from incumbents could be in the form of aggressive price competition, increased advertisements and promotions, legal battles, etc. These retaliatory actions diminish profitability in the industry and so deter new entrants.

New entrants can expect retaliation if:

Incumbents have a prior history of aggressive retaliation.
Market share is important to incumbents making them willing to cut prices and profits to retain market share.
Overall market growth is slow causing incumbents to fight to retain their revenues/profits.
Incumbents have a lot of resources to fight.
Incumbents have high fixed costs and therefore are willing to reduce prices to keep capacity utilization at optimal levels.

To reduce the threat of new entry, you can increase the cost of entry by

Investing heavily in marketing (thereby increasing fixed costs)
Developing R&D/patents; and
Locking up resources such as distribution channels, geographic locations, exclusivity agreements, etc.

The Power of Suppliers

Every industry has suppliers who supply essential ingredients or services that allow the industry to operate. If suppliers have more negotiating power, they can reduce the industry’s profitability by charging higher prices, limiting quality or services and passing on more costs to the industry. This is more damaging if you can’t pass on higher prices to consumers.

Suppliers are powerful if:

The suppliers are more concentrated than the industry it sells to leaving few options for the industry to bargain hunt.
The supplier group does not depend heavily on your industry because it has other avenues or industries or customers it can sell to.
High switching costs will deter buyers from seeking other sources of inputs. This includes location-related costs, learning costs, etc.
There are no viable substitutes or offer highly differentiated products and services.
A Supplier group is more powerful if it can integrate forward into the industry if the buyer stops buying.

Some of the actions you can take to minimize supplier power include:

Develop alternative suppliers; or
Establish industry standards so that the suppliers’ products become a commodity; or
Develop substitute products; or
Find ways to avoid the need for that component or service.

The Power of Buyers

Every industry has buyers and their characteristics differ. The power of the buyers is a huge factor in the profitability of the industry because their power can determine your prices and therefore your profitability. Buyers with leverage reduce your profitability by either negotiating lower prices, demanding better quality and services and/or passing on more costs to you.

The power of buyers is high if:

There are a few buyers and so sellers need to compete to win these buyers. This occurs when the buyers are more concentrated than the industry it buys from.
Each buyer buys large volumes. This is especially important if the buyers are significantly larger than you. The buyers’ power is significantly more if you have high fixed costs and are under pressure to keep capacity utilization high.
The power of buyers is higher if your products and services are standardized or commoditized and therefore easily available in the industry elsewhere.
The buyer group does not depend heavily on your industry and substitutes are available elsewhere.
There are few switching costs and so the buyers can easily switch between suppliers.
Buyer groups can integrate backward into the industry if they are not able to get appropriate terms.
The power of buyers is higher if they act as intermediaries like distributors who can influence the end consumers buying decisions. Sellers have to agree to many of their terms because these buyers have the power to impact your sales figures.

An industry will suffer lower profitability if the buyer group is price sensitive and are using all available tactics to drive price down. Buyer groups are price sensitive if:

The product or service is a large part of their costs.
The buyers themselves have low profitability, low growth and or needs to cut costs to be sustainable.
The product or service is not a critical component of their operations and does not impact the buyers’ quality & costs. For example, movie producers do not look at price when buying quality cameras or a good tax account/consultant will save far more than his fees and so the quality truly matters making the buyers less sensitive to price.
The product has little impact on other costs.

You can minimize the power of buyers by the following actions

Develop alternative buyers; or
Develop new features to differentiate yourself; or
Increase switching costs; or
Find new distribution channels, etc.

Threat of Substitutes

A substitute for your product or service can be anything that replaces the need to buy your product or service. It may be a direct substitute such as a war story vs. a romantic movie. Or it could be in an entirely different form or nature. For example: reading a book or going for a job could be a substitute for going to a movie. A second-hand car could be a substitute for a new car as the buyer has replaced the need to buy a new car. Building a house yourself or moving into an RV is a substitute for hiring a contractor.

Substitutes put an upper limit on prices that can be charged. Once the price hits that limit customers seek alternative products or avoid the product or service entirely. Substitutes reduce profits in normal times and reduce bonanza in abnormal times.

The threat of Substitutes is high if:

Substitutes have an attractive price-performance trade-off with your product (eg Skype vs landlines, Video streaming vs DVD rentals).
Your product has low switching costs and your customers can easily switch to another product.

To minimize the power of substitutes, you could

Differentiate itself from substitutes by virtue of product features, branding, marketing, convenience, availability, etc.
Reduce costs to create more value is also a way to reduce the power of substitutes as it makes substitutes more expensive relatively.

Differentiation is key to be able to retain its customers. Also, CEOs and owners must be mindful of new developments – regulatory, technological, taste and preferences, etc. that create new substitutes for your products and be prepared for the challenges.

Rivalry Among Competitors

We looked at the threat of retaliation against new entrants earlier. Here we look at how the competitors within an industry compete against each other. This competition occurs in many forms. Some of the competition happens through price discounting, promotions, better features and varieties, branding, R&D, service improvements, etc. All of these forms of competition and rivalry increases costs and therefore drive profits lower.

There are two aspects of competition within an industry that impact the profitability of an industry: 1) intensity and 2) the basis on which competition happens.

Intensity of Competition

Generally the more the intensity of competition, the lower the profits in an industry. For example, if a company is forced to introduce new products and features to keep up with the market, it will incur higher R&D and related costs reducing profits. This is visible in the chip industry where the need to stay on top of the technological race keeps costs high and profits in check.

Basis of Competition

The basis on which competition occurs also matters. If all competitors are competing in the same dimension, it will become difficult to differentiate and costly for all involved. Whereas, if different competitors compete on different dimensions – say on lower prices vs. services, they essentially focus on different segments of the markets and the impact on profitability is lower (even if present). Competition maybe even good as it may improve industry profitability when done on different dimensions! Non-price rivalry also keeps a check on profits and it is less likely (but possible) than price rivalry because this also improves the product & customer value which intern increases prices, decreases the power of substitutes, raises the barrier to entry, etc.

Rivalry INTENSITY among competitors is higher if:

There are many competitors in the market.
Competitors are similar in size and so have roughly equal capacities and capabilities.
Industry growth is slow which creates the need for competitors to target each others’ customers vs getting newer customers.
Exit barriers are high so the current players have to stay and fight instead of getting out.
Competitors are highly committed to the business – this includes political/state commitment, egos. etc.
Competitors cannot understand each other market signals clearly either because they do not understand strategy or because of different objectives, etc.

Rivalry based on PRICING among competitors is higher if:

Products are similar or commodities.
No switching costs.
High fixed costs and low marginal costs.
Capacity is expanded in large increments.
Product is perishable.

Industry Analysis: Other Points to Consider

Good industry analysis requires that you keep the following points in mind:

Understanding the industry structure. This is not drawing up a list but understanding the finer points of a system at work.
Industry growth/Technology/Government involvement by themselves are not positive or negative. What happens as a result of industry growth, technology developments and Government involvement and how it plays out is important and determines the industry structure.
Appropriate time horizon to be considered. The appropriate time horizon may be the full business cycle (3-5 in most cases some long lead time ones like mining can need 10 years).
An industry must not be simply be declared attractive or unattractive. It is important to understand the underpinnings of competition and the root causes of profitability.
The five forces covered here impacts the investment required, prices and costs required to operate in the industry. The results of the investments, prices and cost flow into financial statements. Therefore, the end results of the current structure of the industry will be visible in the financial statements of the companies that operate in the industry.

Responsibility of Industry Leaders

In industries where there exists a clear and strong industry leader, it is the responsibility of the leader to develop and maintain a good industry structure. This will ensure that profits are not driven to zero by poor strategic decisions that lead to intense competition along a common dimension resulting in price-based competition but instead, all the players retain a fair amount of profitability. It is usually the industry leaders that can venture into actions that weaken the strengths of the five forces – for example by increasing the profit pool through advertising, setting industry standards and thereby commoditizing suppliers products or developing new methods via R&D or leading price increases that all others can copy, etc.

DEFINING the Industry

According to Michael Porter, the five forces described in the five forces framework for industry analysis help determine the industry you operate in and the competition you face.

Generally speaking, if the five forces are similar across markets, countries and products, we are dealing with one industry. A single clear strategy is sufficient when we are dealing with one industry. If anyone of the five forces is significantly different or more than one of the five forces is quite different we are dealing with different industries and different strategies may be needed.

There is an element of judgment involved in selecting or defining industry boundaries. Incorrect definitions of the industry will lead to a misunderstanding of the forces at work and result in expensive strategic mistakes. Companies may need separate strategies for the different industry segments that they play in.