The “forces” you need to understand to have a profitable business.
In this article I’m going to look at Professor Michael E. Porter’s strategy model that provides a way of examining the pressures that influence and constrain a company’s strategy. Using this model’s approach to thinking about strategy can help you to react to likely developments that could affect your organisation.
In 1979, Porter came up with his view of the competitive environment that faces every company to some extent or other. It provides a useful way to model the market in which you are operating and can give you vital hints about the threats and opportunities that may, or do, affect your organisation. When we think of competition facing a company, we tend to think quite narrowly, looking just at those competitor companies in the same market, such as sports clothing manufacturers, rather than the wider suite of competitive forces that may apply.
Porter’s model expands our vision to look more holistically at the situation that applies to the organisation.
The basic model is beguilingly simple in its approach, with just five elements that combine to show the operating environment, but the power of the technique is twofold; firstly, it gives you a picture of the structural factors that affect an organisation and secondly gives you further insight as you decompose the five elements to a greater extent to improve your situational awareness.
The five elements show different aspects of how competition drives activity in the marketplace.
Competition between market participants
We’ll start with the central hub of the model. This central node represents the rivalries between competing peers in the market. Here competitive forces drive incumbents to try and take market share from each other and drive them to create new products and services that can maximise their position in the market. Incumbents are forced to watch each other, maintaining parity in terms of market offering, and maintaining competitive prices in relation to each other, constraining their desire to charge more.
In the soft drinks industry, Coca Cola and Pepsi Cola compete against each other, and lesser brands, to be the dominant cola company. New products are introduced, such as “Max”, “Zero” and “Sugar Free” and advertising campaigns, such as Pepsi’s famous blind testing stunts, encourage consumers to change brand, or at least to try their alternative!
Factors in this part of the model include the number of competitors, brand loyalty, switching costs, contractual ties and the contraction or expansion of the market that the players co-exist within.
Bargaining power of suppliers
On the left of the model, we see the bargaining power of suppliers exerting their pressure on the companies in the market. Suppliers want to make their own profits and so will constantly seek to advance their position in terms of market share and price by extracting more money from their buyers.
Where the items being supplied are highly commoditised, for example, house bricks, we expect suppliers to have limited ability to edge prices upwards, but should they be in a good position, perhaps as a sole supplier of a specialised finished product, then their power will be strengthened. In this context we’re talking about a wide definition of “supplier”, meaning pretty much any input into the creation of the end product.
Let’s look at the differences in the supply of labour into the UK rail and the on-demand delivery industries. The rail industry has a heavily unionised and skilled labour force, which exercises its right of collective bargaining and has the power to bring the industry to a halt by withholding its labour. On demand delivery companies tend to treat their workforce as many individual suppliers, each of whom has very weak bargaining power and who can be replaced very easily; therefore, the delivery drivers tend to have much less bargaining power than the rail employees and the competitive force is less.
Factors in this part of the model include the number of suppliers, how dominant they are in their market and the interchangeability of the supplied products with alternatives.
Bargaining power of buyers
Exerting price pressure from the right-hand side of the model is the bargaining power of buyers. This is the power that consumers have when making their purchasing choices. Whether it’s an individual consumer choosing to withhold their money, or a keenly negotiated contract negotiation for a multi-million-pound contract, the pressure of the end customer tends to push the price that can be demanded for any given product or service downwards.
The same dynamic works here as did for the bargaining power of suppliers, if the organisation is supplying an exclusive product, they will be less exposed to the consumer’s bargaining power than if they are supplying a commoditised product.
The factors at play in this part of the model are similar to that on the suppliers-side, with factors such as how many consumers exist, how big their purchases are, their ability to access price information, their sensitivity to those prices and their ability to switch their purchasing power all playing a part.
The threat of new entrants
The top of the model deals with the threat of new entrants. If incumbents in the market seem to be making abnormally large profits, if they appear to be inefficient, or if they fail to innovate, then new entrants will be tempted into the market by the promise of making abnormal profits themselves.
New entrants will perhaps be happier with a lower level of profits and will steal market share away from the incumbents, forcing the general level of profit downwards. If the incumbent is inefficient, new entrants may simply provide a more efficient process and drive the more inefficient companies out of business. Finally, innovative new entrants may have fresh idea on how they can deliver the products and services, redefining the market. Here we can imagine that companies that leverage artificial intelligence effectively may be able to reduce their cost base compared with incumbents who do not innovate in this direction.
A classic industry that constantly attracts new entrants is the airline industry, here a whole host of low-cost airlines spotted the opportunity to take large chunks of the market away from the traditional national carriers. The result was EasyJet, Ryan Air and others taking profitable short haul routes away from their larger competitors.
Factors affecting the ability of new entrants to enter the market include barriers to entry, such as technical, scale, distribution and regulatory barriers.
The threat of substitution
The final force dealt with in the model is the threat of substitution. There is often more than one way to achieve an end and this variable shows this dynamic in action. Where the market can be substituted, it often will be, especially if consumers become disenchanted with the incumbents’ products and services. Here we see products and services that overlap in the problem they solve being substituted for the original services.
Theatres lost market share to cinemas as the silver screen came of age with cost and availability driving adoption of an alternate form of entertainment. Theatres continued to provide their services, but now knew they were competing with the cinema alternative. If restaurants fail to provide compelling reasons to eat out, there are plenty of takeaways willing to provide a tasty curry. Over-priced rail journeys can be easily substituted for bus transport, or even air travel for longer journeys.
Factors affecting substitution include consumers’ ability and desire to use alternate products and services, the costs of switching and the cost/performance of substitutes.
So, this is all well and good, we can take any organisation and use the five forces model to understand the forces that may affect, drive and constrain behaviour in the market, but how can companies use the model to improve their position in the market?
In the next article, we’ll take a look at how the model can be used to leverage competitive advantage.