Strategy
Porter’s Five Forces Model – How To Understand the Competitive Landscape
In this installment of the Viral Octopus knowledge series, we are going to talk about a powerful business management theory for understanding the competitive environment that a particular business faces. Michael Porter developed his theory of Porter’s “Five Forces” analysis at Harvard Business School and published it in 1979. Since then it has exploded in popularity to become one of the most used fundamental perspectives for business analysis. What are Porter’s Five Forces? The number and strength of competitors that a company faces, the potential for new competitors to enter the market, the state of supplier relationships, customer relationships, and the possible impact of substitute products are all important forces to consider when analyzing a company’s potential strategic options and possible threats to profits.
Competition in the Industry
The most obvious force in the model is the number of competitors a company has for a particular product or service and the health and power of those competitors. If you have a unique product and no competitors, that is a great position to be in. You are free to set prices for maximum profitability without worrying about the possibility someone will undercut you. For most companies, there are other alternatives battling them for customers. Competition on price or quality can cut into your profits. So can better marketing, even if your competitors don’t offer a better product or price. And competitors can also cause problems by striking deals with suppliers that leave your company out in the cold.
Possible New Competitors
Existing competition is not the only competitive threat to consider in your analysis. If there are not significant barriers to entry in your market, you could face new competitors in the near future. These potential competitors are the second force in Porter’s Five Forces model. If it does not take much time or money to get started, you could reach profitability on a product only to find the market flooded with competition before you can recover the costs of developing and launching the product. On the other hand, if a significant investment of time and money are required, you can breathe a little easier knowing the market share you establish will probably not be subject to new threats in the near future.
Supply Limits
The third of Porter’s Five Forces deals with the supply of input materials and services that a company needs to create and deliver its products and services. If a company depends on a single supplier for a unique input, they will be vulnerable to that supplier increasing their prices. On the other hand, if there are many alternative suppliers for all the required inputs, a company can hope to negotiate lower prices. When analyzing supply conditions, companies should also consider the cost of switching suppliers. In some cases, even though there are other options, disruptions or required adjustments involved in switching suppliers can impose significant costs, once again leaving a company at risk of price increases.
Customer Negotiating Power
The fourth of the Five Forces shows us it can be as important to have many customers as it is to have many options for suppliers. If a company only has one big customer, or just a few large customers, those customers will have a lot of negotiating power, especially if the company has competitors and the cost of switching is not high. If the big customer threatens to leave, the company may have no better choice than to capitulate to whatever demands the customer is making. On the other hand, if a company has many smaller clients, they can choose to risk increasing their prices or refuse demands for better deals.Threat of Substitutes
Porter’s fifth force focuses on the potential lateral competition from close substitutes for your product or service. If there is no replacement for what you make, you don’t have to worry about substitute goods. Whoever offers the first commercial trip to the moon won’t find their customers turning to similar alternatives. But if you sell coffee – and here we know some loyal coffee drinkers may find the idea ridiculous – you could lose some sales to tea purveyors. In fact, some consumers drink both coffee and tea and others have been known to switch their principal caffeinated beverage preference and change their whole buying behavior. So be aware of this potential type of competition and develop your product, marketing, and brand identity strategies to anticipate and combat potential losses to substitutes.
Summing Up The Porter’s Five Forces Model
What drives your business decisions? The answer should be: clear goals and a strategy to achieve them form a solid base for everything we do. Every detail comes back to a big picture. Porter’s Five Forces can help form a part of that big picture – a clear view of the competitive landscape. Maintain profits and optimize strategies when considering entering new markets. Be on the lookout for the dual threats of existing and new direct competition, indirect competition from substitutes, and adverse negotiating conditions arising when you have a short list of possible suppliers or a limited number of large and essential customers. By recognizing and addressing all these threats, you can assess new opportunities and come up with strategies to mitigate the threats to existing operations. Now you have a new tool. Don’t hesitate to use it. Plan a way to apply this idea today while it is still fresh in your mind.
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