8.5 Analysing Industry : Porter's five factor model
PORTER'S FIVE FACTOR MODEL
The first step in performing an industry analysis is to assess the impact of Porter's five forces. "The collective strength of these forces determines the ultimate profit potential in the industry, where profit potential is measured in terms of long-term return on invested capital. The goal of competitive strategy for a business unit in an industry is to find a position in the industry where the company can best defend itself against these competitive forces or can influence them in its favour. Understanding the underlying forces determining the structure of the industry can highlight the strengths and weaknesses of a small business, show where strategic changes can make the greatest difference, and illuminate areas where industry trends may turn into opportunities or threats."
- Ease Of Entry
Ease of entry refers to how easy or difficult it is for a new firm to begin competing in the industry. The ease of entry into an industry is important because it determines the likelihood that a company will face new competitors. In industries that are easy to enter, sources of competitive advantage tend to wane quickly. On the other hand, in industries that are difficult to enter, sources of competitive advantage last longer, and firms also tend to benefit from having a constant set of competitors.
The ease of entry into an industry depends upon two factors: the reaction of existing competitors to new entrants and the barriers to market entry that prevail in the industry. Existing competitors are most likely to react strongly against new entrants when there is a history of such behaviour, when the competitors have invested substantial resources in the industry, and when the industry is characterised by slow growth. Some of the major barriers to market entry include economies of scale, high capital requirements, switching costs for the customer, limited access to the channels of distribution, a high degree of product differentiation, and restrictive government policies. For example, any entrepreneur can enter the hotel industry because the requirements of skills and capital are very low.
- Power Of Suppliers
Suppliers can gain bargaining power within an industry through a number of different situations. For example, suppliers gain power when an industry relies on just a few suppliers, when there are no substitutes available for the suppliers' product, when there are switching costs associated with changing suppliers, when each purchaser accounts for just a small portion of the suppliers’ business, and when suppliers have the resources to move forward in the chain of distribution and take on the role of their customers. Supplier power can affect the relationship between a small business and its customers by influencing the quality and price of the final product. For example, the supplier power of Intel in microprocessors, Microsoft in operating systems, Sharp in flat screens, and SeaGate in disk drives has been a powerful factor depressing the profitability of the PC manufacturers.
- Power Of Buyers
The reverse situation occurs when bargaining power rests in the hands of buyers. Powerful buyers can exert pressure on small businesses by demanding lower prices, higher quality, or additional services, or by playing competitors off one another. The power of buyers tends to increase when single customers account for large volumes of the business’ product, when substitutes are available for the product, when the costs associated with switching suppliers are low, and when buyers possess the resources to move backward in the chain of distribution. A great example of this is Wal-Mart. They are so dominant in the retailing business that Wal-Mart practically sets the price for any of the suppliers wanting to do business with them.
- Availability Of Substitutes
"All firms in an industry are competing, in a broad sense, with industries producing substitute products. Substitutes limit the potential returns of an industry by placing a ceiling on the prices firms in the industry can profitably charge," Porter explained. Product substitution occurs when a small business customer comes to believe that a similar product can perform the same function at a better price. Substitution can be subtle - for example, insurance agents have gradually moved into the investment field formerly controlled by financial planners, or sudden - for example, compact disc technology has taken the place of vinyl record albums. The main defence available against substitution is product differentiation. By forming a deep understanding of the customer, some companies are able to create demand specifically for their products. For example, the absence of close substitutes for a product, as in the case of gasoline or cigarettes, means that consumers are comparatively insensitive to price.
Competitive battles can take the form of price wars, advertising campaigns, new product introductions, or expanded service offerings - all of which can reduce the profitability of firms within an industry. The intensity of competition tends to increase when an industry is characterised by a number of well-balanced competitors, a slow rate of industry growth, high fixed costs, or a lack of differentiation between products. Another factor increasing the intensity of competition is high exit barriers - including specialised assets, emotional ties, government or social restrictions,strategic inter-relationships with other business units, labour agreements, or other fixed costs which make competitors stay and fight even when they find the industry unprofitable.