i n d u s t r y a n a l y s i s a n d t h e f i v e f o r c e s m o d e l

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Industry Analysis:Porter’s Five Forces Model

Michael [email protected]

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Exhibit 1.2 The vocabulary of strategy


Exhibit 2.1 Layers of the business environment


PEST Analysis is Complete(see previous slides)

• Remember the PEST focuses upon the remote external environment

• These are the factors that NO company can control

• But the company MUST heed the conclusions from its PEST analysis

• Aligning with such trends is very wise• Ignoring them is very risky if not foolish

Scenario Planning


Scenario Planning

• This demands consideration of a range of scenarios

• To be meaningful, if should include the most optimistic and most pessimistic scenarios

• This is intended to compel executives to ask the “what if” questions


Scenario Planning

• Organizations sometimes undertake this exercise

• The aim is to construct scenarios and then consider the strategic implications of these


Scenario Planning in the Auto industry

• Price of oil is $200 per barrel;

• Price of oil is $100 pb




Scenario Planning and the Auto Industry

Scenario Implication(s) for auto company

Price of oil is $200 per barrelPrice of oil is $100 pbPrice of oil is $50 pbPrice of oil is $30 pb


Scenario Planning in the Auto industry

• Now that is very simplistic and considers only one variable – an economic factor

• Clearly proper scenario planning would be much more sophisticated, and factor in multiple variables to identify many scenarios

Industry Analysis


“The point of industry analysis is not to declare the industry attractive or unattractive but to understand the underpinnings of competition and

the root causes of profitability”Michael Porter, “The Five Competitive Forces

that Shape Strategy”, Harvard Business Review, January 2008.


Defining the Relevant Industry

• Quality of industry analysis is compromised if it is not well defined– Avoid defining it too broadly – obscures

differences among products, customers or geographic regions

– Avoid defining it too narrowly – overlook s commonalities


Defining an Industry: Employ two key dimensions

Scope of Products or Services• The one product may be

sold to very different buyers and thus despite product similarities, we have two or more industries:

• Motor oil is sold for lawn mowers, cars, trucks and thus we have three industries as the industry structure is very different

Geographic scope• Most industries exist in

many countries.• Is competition local,

national, regional or global?


Steps in Industry Analysis

1. Define the relevant industry2. Identify participants – who are:

– The buyers and buyer groups– The suppliers and supplier groups– The competitors– The substitutes– The potential entrants



3. Assess the underlying drivers of each competitive force to determine which forces are strong and which are weak and why;

4. Determine overall industry structure– Why is the level of profitability what it is?– Which are the controlling forces for profitability– Are more profitable players better positioned in

relation to the five forces



5. Analyze recent and likely future changes in each force – positive and negative

6. Identify aspects of industry structure that might be influenced by competitors, by new entrants, or by ‘your’ company


Exhibit 2.1 Layers of the business environment


Why Undertake Industry Analysis

• The purpose is to determine the attractiveness or unattractiveness of the industry

• And in particular the sources of the above by consideration of five key forces (Porter’s five forces model, developed in 1979)

• Unlike factors considered in PEST analysis, a company CAN influence industry attractiveness


Industry Analysis

Is the Industry Attractive?

Yes

Can we increase this?

Are we committed to this

industry?

No Can we change this?


Porter 2008: Updated Version of “The Five Forces”

“In essence, the job of the strategist is to understand and

cope with competition”

Remember this is the dominant view of strategy;Remember in week 1 we posed the question is this view still as applicable

today


Common Mistake

• Competition is defined too narrowly

• Competition includes direct rivals

• But competition for profits demands considerations of four other competitive forces:

• These five forces combined define an industry’s structure


Exhibit 2.2 The five forces frameworkSource: Adapted with the permission of The Free Press, a Division of Simon & Schuster Adult Publishing Group, from Competitive Strategy: Techniques for Analyzing Industries and Competitors by Michael E. Porter. Copyright © 1980, 1998 by The Free Press. All rights reserved


Porter’s Five Forces and Industry Analysis:

His examplesIndustries with intense forces

• Airlines• Hotels• Textiles

Industries with benign forces

• Software• Soft drinks• Toiletries


Industry Analysis

Benign Forces

Many companies are

profitable

Intense forces

Almost no company earns

an attractive ROI


Porter’s Key Point is this:

• Industry structure determines profitability

• Not • the nature of the product or service• whether the industry is emerging or mature• whether high-tech or low-tech• whether regulated or unregulated


Industry Profitability Determined by…

In Short term• A myriad of factors• The weather (severe cold

weather deters trips to shops)

• The business cycle (products at end of PLC vs new products – think of Video Game Consoles)

In Medium/Long Term• Industry structure as

manifested in the competitive forces


Why is it essential to understand the forces?

1. These reveal the roots of an industry’s current profitability

2. They also provide a framework for anticipating and influencing competition (and profitability) over time

3. Essential for strategic positioning – Need to defend against the competitive forces– And to shape the forces to the company’s advantage


Industry Analysis: Example 1: Commercial Aircraft

Factor Evaluation

Intensity of Rivalry Strong Force (albeit only two key players – Airbus and Boeing)

Buyer Power Strong force (airlines placing huge orders eg. Singapore Airlines)

Supplier Power Benign

Threat of Substitute Products Benign (I would suggest that this has become a stronger force due to extension of journey time due to security concerns and technological advances in substitutes such as rapid trains)

Threat of New Entrants Benign


Key Point

“The strongest competitive force or forces determine the profitability of an industry and

become the most important force for consideration in strategy formulation”

Porter, 2008, Harvard Business Review


Photographic Film Industry

• Low returns are due not so much to rivalry (i.e. between Kodak and Fuji)

• But due to the advent of a superior substitute product (i.e. digital photography)

• Hence coping with this substitute product emerges as the top or number one strategic priority

The Five Forces in-depth


FIRST FORCE: THREAT OF NEW ENTRANTS


Threat of Entry

• New entrants increase industry capacity and want to win market share

• This leads to pressure on prices, costs and the rate of investment required to compete

• New entrants that emerge from other markets can have a major impact as they can leverage existing capabilities and cash flows to shake up competition:


Threat of Entry: Recent Examples

• Google with Android in smart phones;• Apple with iPad in eReader;• Pepsico entering bottled water and other

beverage segments;• Amazon with Online entertainment


Threat of entry

Is High

Demands a response from

incumbents

They must hold down their

prices

Or boost investment

(erect barriers)

Deters New Entrants


What determines level of Threat of Entry?

1. The height of entry barriers (i.e. the advantages that incumbents have relative to new entrants)

2. The reaction new entrants provoke from incumbents


Barriers to Entry: Seven Major sources

Nature of Barrier Comment/Explanation

1. Supply-side economies of scale Firms producing in large quantities enjoy economies of scale and so new entrants can only compete if they enter and they too are prepared to compete on scale, otherwise they suffer a cost disadvantage.

Scale economy benefits arise in almost every activity of the value-chain.

2. Demand-side benefits of scale Basically, buyers’ willingness to buy from a company increases with the number of other buyers the company has.

Buyers have higher trust in larger companies.




3. Capital requirements The need to invest substantial financial resources in order to compete can deter new entrants;

Where capital requirements are modest, many potential entrants exist;

However, lenders can be found to provide large sums of capital when risks are low and growth opportunities are strong.

4. Incumbency advantages independent of size

Regardless of size, incumbents may possess cost or quality advantages unavailable to potential rivals.

Advantages may include proprietary technology; preferential access to raw materials; entrenched in most attractive locations; brand identities etc.




5. Customer-switching costs Switching costs are fixed costs that buyers face when they change suppliers;

The greater the switching costs, the higher the barrier to entry;

6. Unequal access to distribution channels

A new entrant needs to secure distribution, so the more limited the choice of channels the greater the entry barrier.

Similarly, the more that incumbents control or have tied up distribution channels, the greater the entry barrier.

When such barriers are high, the new entrant must bypass distribution channels altogether or create their own.




7. Restrictive Government Policy

Government policy can impede or aid new entry directly;

It can also exaggerate or minimize other entry barriers


Barriers to Entry: Seven Major sources and a practical perspective

Nature of Barrier Consider these Barriers to Entry for Developed Country Multinational Corporations (MNCs)

and the China Market1. Supply-side economies of scale

2. Demand-side benefits of scale

3. Capital requirements

4. Incumbency advantages independent of size5. Customer-switching costs

6. Unequal access to distribution channels7. Restrictive Government Policy

Now consider the extent of these barriers to companies such as Apple, Dell, Google, RIM (ie Blackberry in China)


Barriers to Entry: Seven Major sources and Google in China

Nature of Barrier Extent of Barrier

1. Supply-side economies of scale High

2. Demand-side benefits of scale High

3. Capital requirements Low

4. Incumbency advantages independent of size

High

5. Customer-switching costs High

6. Unequal access to distribution channels

High

7. Restrictive Government Policy Very High

Could Google possibly ever succeed in China?


Big Challenge in Emerging Markets

You may be seduced by the opportunities, but often the barriers to entry are very

high.

Should a company enter a market where the barriers are so high that it is either peripheral

or confined to being a niche player?


What determines level of Threat of Entry?

1. The height of entry barriers (i.e. the advantages that incumbents have relative to new entrants)

2. The reaction new entrants provoke from incumbents


Expected Retaliation by Incumbents

Retaliation

Strong

Reduces profit potential

Deters new entrants

Weak Encourages new entrants


Reasons to Fear Retaliation

• Incumbents have a history of mounting strong defence against new entrants

• Incumbents have the resources to fight back: – Cash– Production capacity– Clout with distribution channels and customers

• Incumbents will cut prices to protect market share and/or have high fixed costs

• Industry growth is slow so the only way for new entrants to gain volume is at the expense of an incumbent


1. Threat of New Entrants

• Vital to stress that it’s the mere threat, not actual entry that holds down profitability

• When threat is high, incumbents need to hold down prices or boost investment to deter entrants

• Threat of entry is high and profits are moderated when entry barriers are low and newcomers expect little retaliation from incumbents


SECOND FORCE: THE POWER OF SUPPLIERS


2. Bargaining Power of Suppliers

• Supplier are more powerful when:• They sell to an industry less concentrated than their

own• The supplier is not heavily dependent on the industry

for its revenues• Switching costs for industry participants are high• Suppliers offer differentiated products• No substitutes are available• Suppliers could undertake forward integration


THIRD FORCE: THE POWER OF BUYERS


3. Bargaining Power of Buyers

• Powerful buyers can:– force down prices;– Demand better quality or more service (thus driving up

costs);– and can play industry participants off against each other

• These all result in a reduction of profitability for those catering to these buyers


Bargaining Power of Buyers is Strong when….…

• There are few buyers;• Or when each buyer purchases in volumes that are

large relative to the size of a single vendor;• Buyers perceive vendors products as standardized or

lacking in differentiation, so they perceive no advantage in buying from a particular vendor;

• Buyers have low switching costs in changing vendors;

• Buyers can credibly threaten backward integration and produce the vendor’s product themselves


Bargaining Power of Buyers is Weak when….…

• There are many buyers;• Or when each buyer purchases in volumes that are

small relative to the size of a single vendor;• Buyers perceive vendors products as differentiated, so

they perceive no advantage in buying from a particular vendor;

• Buyers have high switching costs in changing vendors;• Buyers cannot credibly threaten backward integration

and produce the vendor’s product themselves


Let’s Sum Up the Previous Two Slides

Factor Trait when Buyer Power is Strong

Trait when Buyer Power is Weak

Number of buyers Few Many

Volume of purchase relative to size of single vendor

Large Small

Nature of Vendor’s Product Standardized or lacking differentiation

Strong differentiation

Buyers and switching costs Low Costs High Costs

Threat of backward integration by vendor

Strong Weak


Spotting Price Sensitive Buyers

A buyer group is price sensitive when:• It buys a product from the industry that

represents a high percentage of its cost structure– E.g. imagine a company buys just one particular component that accounts for

30 per cent of its total cost structure – the company will be very price sensitive and seek to lower cost of that component as much as possible



A buyer group is price sensitive when:• It earns low profits, is strapped for cash, or is under

pressure to reduce purchasing costs;• Its own products/services are not greatly affected by

the quality of the vendors’ products/services– E.g. let’s assume that the ducting used in a Dyson hose is

not critical to the quality of Dyson would be a very price-sensitive buyer of such ducting;

– However, the motor may be very important, so for that product Dyson would be much less price sensitive



A buyer group is price sensitive when:• The industry’s product has little effect on the

buyer’s other costs– E.g. an automobile producer may be very price

sensitive when it comes to purchase of lights in vehicles, but not at all price-sensitive in choice of CNC machinery


Just Think of Yourself as a Consumer!

When are you a price sensitive buyer?

• When you are buying products that lack differentiation;

• When you are buying products that are relatively expensive to you;

• When product performance is not a major concern


FOURTH FORCE: THE THREAT OF SUBSTITUTES


Substitute Products

• When the threat is high, industry profitability suffers

• The existence of substitute products/services limits an industry’s profit potential by placing a ceiling on prices

• Therefore an industry needs to reduce the appeal of substitutes through product performance, marketing etc– E.g. golf club companies seek to reduce appeal of previous

generations of product by regular new product launches and claims of improved performance


Substitute Products

• In Emerging Markets, industries that may have expected to reap the benefits of economic development miss out due to substitute products– Rather than subscribe to a wired telephone line,

they rely exclusively upon wireless telecommunications


The threat from substitute products is high if….

1. it offers an attractive price-performance trade-off to the industry’s product– Imagine paying $200 for a set of rarely used golf clubs

that retailed for $1,200 only 12 months earlier;– People use Skype and Vonage rather than

conventional service providers for long-distance calls;– TV cable companies in 2010 have seen largest drop in

subscriber numbers as people rely on Online services such as Hulu, Netflix and YouTube.


The threat from substitute products is high if….

2. The buyer’s cost of switching to the substitute is low

– Consumers may switch at minimal cost from branded products (e.g cereals, drugs) to generics


Substitute Products

• Changes in other industries may render them attractive substitutes when they were not before

• Consider some examples:– Steel may be replaced by plastics as the latter

innovates;– Nuclear power may be replaced by renewable

energy sources as the latter innovates


Threat of Substitute Products

• A substitute performs the same or similar function as an industry’s product by a different means– video conferencing is a substitute for travel;– Plastic for aluminum– Email for fax/letters– Facebook for email


Threat of Substitute Products

• Substitutes are always present…though they can often easily be overlooked;

• Valentine’s Day is approaching so think of the range of substitute products– Think of what you may choose to buy for your partner –

that ‘list’ of potential purchases are in fact all substitute products

– Consider your gift purchases at Christmas time – the options that you faced in each purchase again highlights the nature of substitutes


It is a substitute to…

• do without – you may decide not to make a purchase (e.g. buy a car; book a vacation)

• buy used (so this can be a strong substitute for cars, sports equipment, books etc – internet and ecommerce has perhaps increased the strength of this force)

• do it yourself (e.g. remodel yourself rather than employ a contractor; wash your own car rather than go to commercial carwash)


FIFTH FORCE: INTENSITY OF RIVALRY


Think of How Rivals Compete

• What do auto companies do in order to win sales?

• What do mobile phone service carriers do in order to win subscribers?

• What do retailers to in order to attract customers?


Rival’s Means of CompetingAuto

CompaniesFast Food

RestaurantsMobile Phone

Service Carriers

Retailers

Price Discounts on Original Purchase PriceLow Maintenance Costs (eg Warranty)Advertising

New Product IntroductionsService ImprovementsOther


High Rivalry Limits The Profitability of the Industry

Industry’s Reduced Profitability

determined by….

Intensity of Rivalry

Basis on which they compete


Intensity of RivalryGreatest if……….. Implications of trend

Competitors are numerous, or are roughly equal in size and power

Rivals struggle to avoid poaching business from each other;In the absence of an industry leader, there is no ‘enforcer’ of practices best suited to the industry

Industry growth is slow Leads to fights for market share

Exit barriers are high… Companies cannot exit easily as their assets are highly-specialized;Often management have an emotional commitment to the industry and only its removal results in exit from the industry

Rivals are highly committed to the business and seek market leadership

Often results in all competing on the same dimensions, and this damages prospects of profitability


Price Competition is most likely if…

Trend Comment

Products or services of rivals are nearly identical and few switching costs to buyers

This encourages rivals to cut prices to secure new customers

Fixed costs are high and marginal costs are low

Again intensifies pressure for rivals to cut costs below their average costs

Capacity must be expanded in large increments to be efficient

Can lead to excess capacity issues and price-cutting

The product is perishable Intensifies pressure to cut prices whilst product has some value;Fruit may rot; electronics may become obsolete; services are perishable – an unsold hotel room can never be recovered


Common Errors in Industry Analysis:Factors Not Forces

Common Error

Fast-growing industries are always attractive

Fast growth can make suppliers powerful;High growth with low entry barriers will draw in entrants;Even without new entrants, customers may be powerful or substitutes are attractive, reducing profitability opportunities.

Technology and Innovation make an industry attractive

Often industries with low technology can be more profitable than technology-intensive industries (eg software)

Government Can affect the forces, but is not a force per se


Intensity of Rivalry

• In addition to the dimensions of rivalry, intensity increases when firms compete on the same dimensions

– Firms aim to meet the same needs– Or compete on the same attributes


The Five forces

• In an ideal world what would the analysis conclude for an organization competing in a particular industry?

• What would be the worst case scenario?

• Does the ideal scenario ever exist in a free market economy?


The Five Forces in Operation

• Let’s identify an industry/industries and examine it using the five forces model

• Often students are confused by this tool

– They talk of ‘substitutes’ when they mean ‘rivals’– They are not clear on who the suppliers are– Or do not distinguish between different types of buyers


Porter’s Five Forces Model• It is vital that you grasp this concept and can apply it any context

• It needs to be applied at the SBU level of the organization

• It reveals the nature of competition in the present, but also needs to be employed to consider the nature of each force in the future

• This future orientation allows the organization to develop strategies to deal with each force in the future

• Changes in the remote environment can exert enormous impact upon the nature of a particular force

i n d u s t r y a n a l y s i s a n d t h e f i v e f o r c e s m o d e l

Documents

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industry analysisassess

industry analysis20www

point of industry analysis

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controlling forces

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