Harvard Business School professor, Michael Porter, identified five forces that can disrupt potential sales:
Knowledgeable Customers - forcing prices down by comparison shopping
Supplier Power - driving down profits by raising supply costs
Competitors — stealing customers
New Market Entrants — stealing potential investment capital
Substitute Products — stealing customers
Entrepreneurs use this model to analyze the competitive environment in which a company operates to determine the profitability of an industry. If an entrepreneur can identify opportunities, competitive advantages, and competitive intelligence then they have the ability to proactively address potential issues.
Items to consider include:
Number of customers
Sensitivity to price
Size of orders
Difference between competitors
Availability of substitute products
When the buyer power is high, customers can end up forcing a business and its competitors into a bidding war driving prices down. Companies can lower their risk of buyers driving down prices by manipulating switching costs.
Switching costs consists of the “pains” consumers have to deal with when switching to a competitor. Banks make it harder for you to switch by ensuring you have multiple product lines with their companies; checking account, savings account, credit cards, car loans, etc.
Companies also use loyalty programs to reduce buyer power. Consumers are likely to keep using your services if they receive incentives.
Suppliers can influence prices for supplies (i.e. materials, labor, and services) using the following factors:
Number of suppliers
Size of suppliers
Uniqueness of services
Availability of substitute products
When supplier power is high, suppliers can influence the industry standards by:
Charging higher prices
Limiting quality or services
Shifting costs to industry participants
Companies typically pass on the increase in supplies to consumers by raising the price of the end product. Some industries, like pharmaceutical companies, can determine the market price for an entire industry since substitutes can be limited and the actual product is critical to the consumers like a cancer saving drug.
Substitute Products and Services
Are there alternatives in your industry available? There are strategic ways a company can add value thereby reducing their risk of substitute products entering your market. A company can increase their product availability by selling online with their website, using Amazon, Ebay, vending machines, virtual meetings, etc. Technology has increased the ability for companies to get creative in adding value consumers want.
For Example: Smartphones not only let you make calls, but you can download games, videos, music, business apps, and more making it more than just a phone. It adds value to consumers reducing their need to switch to another company.
Threats of New Entrants
If it is easy for a competitor to enter a market, then the threat of new entrants is high. Companies can reduce their risk by establishing entry barriers which is simply a feature or product that consumers have become accustom to having so new competitors require any new entrants to have the same.
For Example: A bank must offer ATM’s, online bill pay, online services, etc. making it difficult for a new competitor to enter the market unless they offer the same array of services.
Rivalry Among Existing Customers
Every industry has competition in one sense or another, but there are strategic ways to beat your competitors like product differentiation. This occurs when a business is able to develop unique differences in their products or services causing a competitive advantage.
A Five Forces analysis can help companies assess industry attractiveness, how trends will affect industry competition, which industries a company should compete in—and how companies can position themselves for success. Every industry is different, but the underlying drivers of profitability are the same in every industry.