What is Porter’s Five Forces Model
In any market, there are fundamental interactions at play that drive supply and demand: between buyers and sellers, between vendors and buyers, between competing products and between companies targeting the same customers.
The dynamics at play in these interactions sometimes get in the way of an effective conversion of the value created by a company into profits, and must be taken into account when creating your business strategy.
Harvard Business School’s Professor Michael E. Porter, through his Harvard Business Review article How Competitive Forces Shape Strategy published in March 1979, and his books Competitive Strategy and Competitive Advantage, provided a robust framework to understand the fundamental forces that affect the ability of an organization to produce and protect its profitability within a given industry.
Porter identified the Bargaining Power of Buyers, the Bargaining Power of Suppliers, the Threat of New Entrants, Substitute Products and the Rivalry Among Competitors, as the
In short, Porter’s model establishes that the stronger these forces are, the more they can limit the profits a business can make in an industry.
If you look deeper, you realize how Porter’s five forces is in essence a categorization of the different types of “competition” that a company could face within a given market.
In other words, the forces are the five categories of companies that will try to compete with you for the same “profits”, and based on how well-positioned your company is to fight for a bigger share of the interaction with these companies, your profitability could be predicted.
Powerful buyers, for example, will try to use their power to pay less for products, while powerful vendors will try to get paid more for theirs, so in essence, the five forces model describes a power play where industry participants compete with each other to claim a bigger piece of the pie, and each player’s success depends on how well it is positioned in its respective industry.
The model also explains how products coming from different industries, specifically substitutes and complements, can also influence the ability of a company to claim a piece of the value the industry creates.
Substitute products, for example, i.e. products of different nature that offer the same benefit and functionality, set a limit on the prices that an industry can charge for its products.
The rates that ride-sharing services like Uber and Lyft charge, for example, put a cap on the prices that conventional taxis can charge for services. If taxi services are priced too high, more people will switch over to ride-sharing alternatives, and vice versa.
In a similar tune, the “threat” that powerful outsiders could enter the industry if it looks too profitable from the outside limits the profitability of the incumbents who will be happy to invest in creating barriers to block or deter the entry of such players.
Interestingly, we also added a new force to Porter’s quintet which we call Complementary Products or just “complements”. These are products used in combination with or as a consequence of using your products or services, but because of that interrelation they could limit the profitability of your own products and services.
The five forces described in Porter’s framework are present in any industry since they result from predictable choices its players make to maximize profits.
A subtler observation, however, is that those forces are actually interacting with our industry in response to what is happening in their respective markets. Vendors, for example, are competing with other companies in their own market, and their interaction with our industry is influenced by the five forces acting on their industry.
A price war or lack of differentiation in your vendors’ industry will be reflected as lower costs in yours, and will give you more bargaining power when negotiating with them.
Similarly, if some of your customers are competing with other companies on the quality or performance of their products, you may be able to charge them higher prices in exchange for features that can help them compete along those dimensions.
The same forces that are at play in your markets are also acting, although in different proportions, in the forces’ markets. Understanding this context can help you position your businesses better and take advantage of opportunities that may arise as conditions in those adjacent markets change.
In fast-paced industries, you may (and probably should) narrow the scope of the five forces analysis to understand the profitability of a particular market within an industry, or a particular opportunity within a market.
For example, within the automobile industry, Kia and Porsche serve different markets, and in serving each they will face a different set of forces, therefore executives can use the model to understand the behavior of the players and the profitability within that particular market.
Porter’s Five Forces Example:
As an example, let’s take a look at the solar industry which, through the lenses of Porter’s five forces model is a zero-star industry.
Powerful Buyers: Companies developing and operating solar projects face powerful customers who can buy clean energy from many other sources at very low prices. From the largest utilities to the smallest individual homeowners, they all have plenty of options to choose from when looking for vendors of solar energy solutions.
Serious Threat of New Entrants: In the solar industry, competition is coming from companies of all sizes including aggressive, deep-pocketed players, large power corporations and even oil majors now jumping on the wagon. The technology and the economics of solar power is well-known by now, so there’s nothing preventing serious players from entering the space.
Solid Substitutes: The final product, solar energy, also faces serious and credible substitute products such as wind power and clean-fuels-based generation. Solar power is becoming so cheap that many utilities are trying to de-incentivize its installation to prevent the instability problems that a large proportion of intermittent energy resources could create in the power grid.
Power Vendors: Move one slot upstream in the solar value chain, and you’ll face the most aggressive market – in the manufacturing of the solar modules. Many of these companies, mostly from Asia, have been working in the red (at losses) for years hoping that it will get better at some point.
In the meantime, the panel manufacturing industry is inundated with excess capacity and sunk costs, imposing bitter exit costs. Incumbents prefer to stay in the fight, waiting and hoping that consolidation and bankruptcies will clear the space at some point.
Fierce Rivalry: Prices for solar panels have been consistently declining for the last 20 years with an accelerated decline over the last decade. Analysts predict that prices will continue to drop an additional 20 percent annually over the next 5 years.
The price of solar panels has been dropping so fast that project developers won’t place their orders until the time of installation (usually a few months after beginning of construction), afraid that ordering too early would leave money on the table.
But none of this has stopped aggressive competitors that still seek to grow fast in this market, even if that means taking lower returns on new projects. In fact, companies in this space are reportedly making low one-digit returns, sometimes under 5 percent.
Solar developers are clearly playing the scale game, trying to build huge portfolios that create sufficient economies of scale through centralized operations, in the hope that it will reduce unit costs in the long term. However, this decision comes at a huge financial cost in the short term and creates a lot of uncertainty for the people involved in those efforts.
This article has been extracted from Sun Wu’s book Strategy for Executives which can now be downloaded for free here.
Porter, Michael E. Competitive Strategy: Techniques for Analyzing Industries and Competitors. Free Press. Kindle Edition.
Magretta, Joan. Understanding Michael Porter: The Essential Guide to Competition and Strategy. Harvard Business Review Press. Kindle Edition.