Porter's Five Forces Model
Porter's Five Forces model is a strategic tool developed in 1979 by Micheal Porter. This model summarizes the 5 marketing factors which affect the performance of a particular company.
The weight of Porter's Five Forces determines the abilities and competencies of a firm involved to make profit. If all these forces get high, then profits will be limited. Conversely, if the Porter's Five Forces are weak, it is possible to generate a significant profit. The important and vital point is therefore to prioritize all these forces so as to identify the key success factors in the industry, you can say that, these forces are the strategic elements that must be mastered to gain a competitive advantage. So these five forces give marketers and management an insight into a company's competitive position, and its profitability.
Rivalry Among the Competing Firm
Rivalry refers to the competition within an industry. Rivalry among competing firm in the industry may be weak, with few competitors that don't compete very aggressively. Or it may be intense, with numerous competitors fighting in a cut-throat environment.
Factors that affect the intensity of rivalry are:
- Number of firms in an industry – increased firms will lead to increased competition.
- Fixed costs – a company with high fixed costs as a percentage of total cost, must sell more products to cover those costs, increasing market competition.
- Product differentiation - Products that are relatively of the same nature compete each other on the base of price. Brand identification can reduce rivalry among competing firms.
Potential Entry of New Firms
One of the defining characteristics of competitive advantage is the industry's barrier for new entrants. Industries with high barriers to entry are usually too expensive for new firms to enter and with low barriers to entry are relatively cheap for new entrants.
The threat of new entrants increased as the barrier to entry is reduced in a particular marketplace. As more firms enter in a market, rivalry increase, and profitability of firm will fall to that point where there is no incentive for new firms to enter the industry.
Here are some barriers for new potential entrants:
- Patents - patented technology is a huge barrier preventing new firms from joining the market.
- High cost of entry - the more it will cost for commencement of a business in an industry, the higher the barrier to entry.
- Brand loyalty - when brand loyalty is strong within a particular industry, it can be very expensive and difficult to enter the market with a new product.
This is perhaps the most overlooked elements of strategic decision making, and therefore most damaging. It's vital that business owners must not only look at what their company's direct competitors are doing, but they must also know what other types of products people could buy as a substitute of their company’s products.
Switching cost is that cost which a customer incurs to switch to a new product and when this switching cost is low the threat of substitutes is high. When companies deal with new entrants, they aggressively price their products to keep customers from switching. When the threat of substitute products is high, profit margins will tend to be low.
Michael Porter's Five Forces Template
Bargaining Power of Buyer
There are two main kinds of buyer power.
- Price sensitivity
- Negotiating power
Customer’s price sensitivity: when each brand of a product is similar to all the others, then the customer will base the purchase decision mainly on price of the product. This price sensitivity will increase the competitive rivalry and will result in lower prices as well as lower profitability.
Negotiating power: Larger buyers tend to have more influence on the firm, and can negotiate lower prices. When there are many small customers of a product, the company supplying the product will have higher prices and higher margins and if a company sells to a few large purchasers, those purchasers will have significant leverage to negotiate better pricing.
Some factors affecting buyer power are as under:
- Size of buyer –larger buyers will have more power and impact over suppliers.
- Number of buyers - when there are a small number of buyers, they will tend to have more power and impact over suppliers. The best example is Department of Defense as a single buyer with a lot of power over suppliers.
- Purchase quantity - When a customer purchases a large quantity of a suppliers product or output, it will have more power over the supplier.
Bargaining Power of Supplier
Buyer power refers to the relative power a company's customers has over it. When there are multiple suppliers are producing a commoditized product, the company will make purchase decision based on price, which tends to lower costs. On the other hand, if a single supplier (monopoly concept) is producing something then the company will have little leverage to negotiate a better price.
Size of company also plays a factor here as well. If the company is larger than its suppliers, and company purchases output (raw material or products) in large quantities, then the supplier of such company will have very little power to negotiate on price. Wal-Mart is a best example, suppliers have no power because Wal-Mart purchases in very large quantities.
Some important factors that determine supplier power are:
- Supplier concentration – fewer suppliers for a given product have more power over the company.
- Switching costs - suppliers will have more power if the switching cost to another supplier is higher.
- Uniqueness of product – those suppliers who produce products especially for a company will have more power than commodity suppliers.
Pulling it all together we come to know that, it’s very important for a company to analyze these five forces and their affect on company. Porter’s five forces analysis model is also important for investment decision. This strategic tool enables a company for good explanation of the profitability of an industry, and the firms within it. If management or marketer of a company wants to know why their company is able or unable, to make a high profit, this is the first analysis management or marketer should do.