Business Growth Fundamentals – Porter’s 5 Forces
Are you wondering, why some industries just make more money than others? Are you wondering how you can also make more money in your industry? Read on to find out how to identify a good market with high profit margins.
Michael D. Porter, a Harvard professor, invented and published the “Porter’s Five Forces” model in 1979. His model assesses the competitive situation of an industry and identifies five different forces – or “threats” – that influence the setup of the market and how much profit can be generated in it.
Let’s take a look at the five forces and how they influence market prices:
Force 1: Threat of New Entries
The first force is the threat of new entries. It describes how many companies could theoretically still enter the market. That means: How high are the barriers for entering the market? Do you have to invest a lot of capital to start a business in this industry? Do you have to buy machinery or an entire plant to even get involved, or can you just take a computer and start right away, like in an online business?
The barrier of entrance is usually very decisive for how much competition you have. If you act in an industry that has a very low entrance barrier, you will have a lot of competition, especially if the industry is attractive or if there’s a lot of money in this industry. Entry barriers can also be patents or any legal regulation that you need to comply with. If you have high barriers for entry, the exit transit is usually very high as well. For example, if you had to purchase a bunch of machinery to start, it is very difficult to exit without going bankrupt since you most likely had to finance the upfront investments.
When the barriers are high you will probably have less competition. But it also means that you have to invest heavily before becoming a serious player within this industry.
Force 2: Industry Rivalry
The second factor is the direct industry rivalry. This is your direct competition, for example, Pepsi and Coca Cola. They offer practically the same product and therefore are direct competitors. Within the energy industry you find companies like E.ON, RWE, etc. They’re direct competitors. Shell, BP, Chevron within fuel industry. Lamborghini, Ferrari, Porsche, McLaren in the automotive high-end sports sector. Bentley and Rolls Royce on the luxurious side. Patek Philippe and Audemars Piguet in the watch market, and tons of others at various price points and specializations in every industry. So, how many direct competitors do you have?
The more competitors you have, the more profit is usually in that market. Because companies wouldn’t survive otherwise when there is no money to be made.
Force 3: Threat of Substitution
The third force is the threat of substitution. Substitutes are products than can serve the same market need as you supply, but which uses a different technology. A classic example of a substitute for meat is tofu. For Coke it would be water, juice, or any other non-alcoholic liquids. It still serves the purpose of drinking a refreshment. Butter can be replaced by margarine. Butter is an animal product, whereas margarine is made from plants. But still, it’s the same thing, you put it on your bread and then you eat it. That’s a classical substitute.
The number of substitutes in the market also has an impact on your overall level of competition. Even though they’re not direct competition, they can still influence your market price. For example, if you have very high cost for butter, people will probably buy margarine, because it serves the same purpose and it’s cheaper. So even though it is not a direct competition, it may still harm your profit margin, because the product serves the same need. You always have to monitor potential substitutes and know: How many are available? Are they gaining market share from you? Could they take you out of business? Because they may impact your price significantly.
Force 4: Bargaining Power of Suppliers
The bargaining power of suppliers is the forth competitive force. The question here is: Who has power over whom in your supplier relationships? Are you dealing with monopolies that can dictate any price they want, and you need to buy it because there is no alternative? Or do you have several suppliers to choose the best from and have alternatives if one doesn’t fit your requirements any longer? Who has power? You or your suppliers? That is very important when it comes to price and negotiation strategies. If you are highly dependent on one supplier and this one supplier experiences difficulties of any kind, it can take you out of business or at least hurt your operations. Keep this in mind and develop strategies to avoid worst case scenarios. Also, if a monopoly supplier increases their prices, you have almost no alternative but to pay. But what will be the reaction of your clients? Will your profit margin still be positive, or do you have to increase your prices as well as a consequence? Do competitors face the same problem or can they avoid this issue due to another technology?
Force 5: Bargaining Power of Buyers
The last market force is the bargaining power of buyers. This force identifies how price sensitive your buyers are. If you increase the price of Apple’s iPhone by 10%, will your clients still buy it? If you increase the petrol price by another 10 cents, will customers still buy? The question is: How much power do you have over your customers? If you need your car to get to work and there is no alternative, you will have to pay the price. That’s the way it is. But if you have another alternative that fulfills the same purpose, the customer gets to choose.
This dimension of competition assesses how much you can change your prices without losing your customers. You need to consider the other forces as well. If there are many substitutes available, you have a high competition, your customers might go somewhere else. Very easy. If there is no real competition, or if there is nothing to replace your product, then you have a very good chance for increasing prices without losing clients. The more substitutes there are, the higher the risk when increasing prices.
To sum it up
All those elements of Porter’s 5 Forces are important for defining the price policy, your positioning and also your relationship with your suppliers and customers. It also helps to decide if you want to dive into an industry or not. How easy is it to get into a market? Will you have a lot of competition? Is the market profitable?
If you offer the same services or products as everybody else, and there are 1,500 options out there, you probably won’t be able to charge €10,000, when everybody else is charging 2,000. Unless you can position yourself differently and create a really strong USP. If you find a way to position yourself to not be a direct substitute of existing products, but be perceived as more valuable, then you are also able to charge a higher price.
If you are active in several industries, execute this analysis for each entity separately. Apply this to your business, make this analysis for your own industry, and then check out where you’re standing.