What is Porter’s 5 Forces?
Porter’s 5 forces is defined as an external threat analysis model for enterprises. Named after Harvard professor Michael E. Porter, this method breaks down the competitive landscape into 5 threat forces. These are deemed as universal business forces involved in any industry structure regardless of product or service.
The 5 external factors that make up Porter’s 5 forces are:
- Threat of competition from rival firms
- Threat from new industry entrants
- Threats from substitute products/ services
- Threat from bargaining power of customers
- Threat from bargaining power of suppliers
This model is a key tool for enterprise strategic planning, where key management members plan the larger goals and objectives that drive the company’s operations.
Threat components of Porter’s 5 Forces model
Here is the detailed explanation of the 5 key threat components that are to be analyzed in Porter’s 5 Forces model:
- Threat of competition from rival firms
In any industry, there will be a range of competition across all market segments for a business to navigate. The degree of competition may vary based on geography, politics, user preferences etc. The general assumption here is that the market is relatively free from crony capitalism and political favoritism.
A business may choose to manage this threat by acquiring unique selling point (USP) strengths in their products/ services. These may be special features that are hard to replicate, constant innovation to produce new and useful features, inorganic growth through competition acquisitions, reduced prices through increased production-chain efficiency etc.
- Threat from new industry entrants
A business may already know how to deal with existing competition in their range of products/ services. However, an existing threat always remains – a new entrant with a business edge.
Any new entrant is not the real issue since existing competition may alone erode them before they become a threat. However, if a new entrant has a special niche that is lacking in the existing vendors, then that may soon become a threat that any business needs to rise up to if they are to stay competitive.
Financially, managing this threat may include maintaining a special contingency fund to be used to deal with new and sudden competition, making a budget for acquiring a rival of the new entrant and then growing and merging it with the main business, or directly offering to but out the new entrant.
Operationally, the business may need to develop similar features and/or pricing as the new entrant’s offering. This may involve legal poaching of employees, replicating certain aspects for immediate effect (in case of non-patented features) and then trying to improve it more than what the new entrant can offer etc.
- Threats from substitute products/ services
A substitute product may be a type of product that doesn’t need to be the same product line but eats away at a business’s existing market demand. A simple example would be the 2007 introduction of the iPhone and the subsequent erosion of Nokia and Blackberry. An iPhone was not the same product line of feature phones which was largely what Nokia and Blackberry were offering – it was simply a better product line which was on a league of its own.
Another example would be the early 2000s MP3 players replacing the entire CD market.
- Threat from bargaining power of customers
Bargaining power of existing customers points to the uniqueness and demand of your product/ service, compared to competition. The more unique the product, the less the bargaining power of customers. Alternatively, if the product does not carry a sales edge, then competition will attract more customers and buyers and existing customers can bargain in return for purchase. If the demands are not met, then customers tend to migrate to customers or alternative products.
- Threat from bargaining power of suppliers
The bargaining power of suppliers comes from the level of uniqueness of the product/ raw material they are supplying to the business. If the supplier market is small and the item being supplied is in high demand, then such a supplier will have a high bargaining power compared to the businesses purchasing their supplies.
However, if the supplier market gets new entrants or new competition or sees the entry of a substitute product – the same threats that threaten any business, then their bargaining power vis-a-vis any customer (business) reduces.
Vendor diversification is a good way to deal with the threat coming from supplier bargaining power. In case of very niche suppliers, the business may choose to start their own supply line to their business through vendor acquisitions or starting one from scratch.
Benefits of Applying Porter’s 5 Forces for Enterprise Planning
- Improves external threat management
Portor’s 5 Forces are the key tool for any enterprise management team for the study, analysis and discovery of external threats. Understanding threats and threat potential is the first step to planning for steps involved in managing them, and ensuring growth plans are not hindered by their existence or emergence.
- Provides direction for acquisitions and mergers
Threat management and growth often go together and are the key pillars for any company when considering mergers and acquisitions.
Mergers: In the ancient and medieval times, marriages often took place among rivals who looked towards threat management through unification where their combined strength are needed to deal with a larger 3rd rival. The other reason may be to end rivalry and become larger together.
Mergers are the modern corporate version of such marriages. Often firms become more competitive, gain market share and can compete with rivals much more efficiently through such mergers.
Acquisitions: As the saying goes – if you can’t beat them, buy them. Instead of equating it to medieval conquest, which is a messy affair and leads to much mutual damage, an acquisition is usually a mutually beneficial arrangement that seeks to preserve maximum value of the entity being purchased instead of damaging it.
Acquisitions are a great threat management tool which can reduce competition and gain market share. However, acquisitions can also lead to reduced liquidity and/or owner’s stake in the company, which may in turn expose the company to newer threats if not managed properly.
A well known example of a similar situation gone wrong is 2007 Royal Bank of Scotland (RBS) full-cash acquisition of ABN Amro for $17 Billion, which plunged the bank into dispair next year when it found itself out of cash to deal with the housing crisis in the US.
- Key pillar for disaster management and recovery planning
An enterprise disaster management and recovery plan is a contingency plan that kicks in case of extraordinary developments that threaten the existence of the business. These can be natural disasters or man-made, including business fraud. Portor’s 5 Forces provides a holistic framework to analyze and prepare for such disasters at an enterprise planning level.
- Helps defend against hostile takeovers
Although Portor’s 5 Forces is meant to be focused around the product/ services offering, the analysis process leads to focus on competitor moves in general. This includes the threat arriving out of hostile takeover bids from competitors or a business seeking to make an entry.
