You have an idea and want to start your own business. You believe you have a product or service that consumers will love. Your product or service can make a large profit margin and provide a high return on investment (ROI). Before introducing your product to market, it is important to understand Porter’s Five Forces Model.
The framework and concept of “Porter’s Five Forces Model” were created by Dr. Michael Porter, a Harvard Business School Professor. Dr. Michael Porter says that there are five factors that influence industry strategy. Understanding these five competitive forces will help companies understand their industry structure and position themselves to be more profitable and less susceptible to attack. These are the five factors that determine an industry’s competitive intensity.
1. The threat of entry
2. The Power of Suppliers
3. Buyers have the power
4. Substitutes in Crisis
5. Rivalry amongst existing competitors
This is a critical concept for entrepreneurs and new business owners to grasp before introducing products or services to the market or entering a particular industry. This article will provide an overview of these five forces to help entrepreneurs and business owners understand their purpose.
The threat of Entry
Every industry serves a small market. A specific industry has many companies competing for a significant share of the market. What happens when a new company enters an industry? The new company takes over a significant portion of the market. Existing businesses lose some of their customers, and thus, a part of their revenue. Companies can’t gain a large share of the market if there are too many companies in the industry. The industry’s supply chain is impacted by the increase in suppliers. This affects the demand for the services or products they offer, which impacts the price of the product. “The threat to entry puts a limit on an industry’s profit potential. In order to stop new competitors from entering the market, incumbents will need to lower their prices or increase investment when there is a high threat (Porter 1979). Pre-existing companies build barriers that prevent new businesses from entering the industry to protect them from potential threats. Dr. Michael Porter explains that there are seven main sources of advantages for entry barriers that incumbent companies use: Supply-side economies, Demand-side advantages of scale, Customer switching cost, Capital requirements, and Incumbency benefits independent of size.
The Power of Suppliers
Suppliers are companies that provide special supplies, raw materials, or equipment to support specific industries. The size of a supplier’s business and its financial strength will determine how powerful it is. A supplier that can offer unique products or services to a range of industries could be very powerful, especially in terms of cost. Strong suppliers can increase costs, making it more difficult for companies to increase profit margins or pass these costs on to their customers. Porter, 1979. “Powerful suppliers, which include labor suppliers, can extract profitability from an industry that cannot pass on increases in costs to its customers (Porter).
The Power of Buyers
“Buyers have the power to influence industry participants’ pricing decisions. They are especially powerful if they have negotiation leverage. The price of goods and services in an industry can be influenced by powerful buyers who purchase large quantities. If the company’s prices are too high, a powerful buyer might threaten to buy from its competitor. The buyer could demand a better product or a higher level of service, which may cause the company to pay more. As a new entrepreneur or business owner, it is crucial to offer a product or service that appeals to many buyers. A healthy portfolio of buyers with equal buying power will help to reduce the influence of one buyer.
The threat of Substitutes:
“When substitutes are high, industry profitability suffers.” By setting a price ceiling, substitute products and services reduce an industry’s profit potential. Substitute products and services not only reduce profits in normal times but also decrease the industry’s potential for profit in good times (Porter 1979). What substitutes can do to a company’s profits and how they affect pricing is the most important thing a business owner or entrepreneur needs to know. Substitute goods offer consumers an alternative to the desired product, either directly or indirectly. Cross-elasticity refers to how sensitive a product or good is to price changes. This can be simplified by saying that if a consumer is sensitive to price changes for a preferred product, the demand for that product will decline while the substitute good demand will increase. “If an industry doesn’t distance itself from substitutes through product quality, marketing or other means it will suffer in terms profitability-and often growth potential (Porter 1979).
Rivalry amongst existing competitors
“High competition limits an industry’s profitability. Porter, 1979. The extent to which industry profit potential is affected by rivalry depends on two things: the level of competition and the basis for which they compete. Entrepreneurs and business owners should take the time to analyze the number and intensity of rival companies in the industry they are interested in. Fierce competition within a saturated market could cause financial problems for the industry. It is extremely difficult to make a profitable industry if there are many companies in the same industry. To gain a competitive edge, companies offering similar products or services will usually lower their prices. A price war can make it difficult for entrepreneurs or business owners to make profits in a saturated market. This is especially true if there are already large companies that have the advantage of economies of scale.
Porter says there are many factors that determine the level of competition and the basis for companies competing. Entrepreneurs and business owners should do more research on Porter’s Five Forces Model in order to understand the contributing factors. Porter concludes that “Understanding industry competition is the first step to developing strategy.” Every company should know the industry’s average profitability and how it has changed over time. These five factors are the reason industry profitability is what is it. Only then can companies incorporate industry conditions into their strategy.