The External Analysis framework, also known as Porter’s five forces, is one the fundamental business models widely used by businesses and managements consultants. Originally created by Michael Porter, it is applied for assessing market forces within an industry and developing strategic recommendations. PORTER’S FIVE FORCES Michael Porter had outlined the following 5 key external market forces: Supplier and Buyer Powers, Threat of New Entry, Threat of Substitutes and Industry Rivalry.
The structured analysis of external forces within an industry allows for identifying weak links in company’s strategy going forward. At the same time, it allows for strengthening company’s positions and developing a new strategy, better equipped to withstand external pressures. Moreover, it is essential to track the dynamics of these forces through time. For instance, industry rivalry in one’s market may seem low at the moment but may increase in the future due to a high threat of new entry.
Industry Rivalry. Encompasses market concentration, diversity of competitors, product differentiation, excess capacity and exit barriers and cost conditions. The analysis of the above factors should lead to development of sound recommendations. For instance, a company operating in an industry with little product differentiation may decide to create a unique product line to capture a bigger share of the market. Excess capacity and high exit barriers (e. g. in the pulp and paper industry) may lead to higher competition and price dumping by existing players.
A company may choose to diversify or horizontally integrate to safeguard itself from intensifying industry rivalry. Threat of Substitutes Relates to the existence of alternative products that have a similar utility as company’s products but do not directly compete with them. The two important considerations are buyer’s propensity to substitute and relative prices and performance of substitutes. In the case of the courier delivery industry, regular mail and email are powerful substitutes. Although, the two services do not directly compete in the same market, they nevertheless have a significant impact on the industry.
With the increasing importance of email and other electronic media types, sending original documents often becomes irrelevant as it is much easier and quicker to send a file by email at no cost. Threat of Entry Is a powerful force, predictor of future industry rivalry. When analyzing the threat from new entrants, one should consider the following factors: economies of scale, absolute cost advantages, capital requirements, product differentiation, access to distribution channels, government and legal barriers, retaliation by established producers.
High economies of scale and various legal barriers prevent new players from entering the industry. It may be in the power of an incumbent company to increase these barriers, utilizing government lobbying for protectionist measures or for increasing relevant licensing fees. Online-based businesses often operate in a low entry barrier environment and are often vulnerable in face of new entrants who can easily copy their business model. At the same time, such companies as Facebook can maintain their dominances by leveraging economies of scale and network effects associated with serving a vast customer base.
Buyer Power has two main components: 1) Price sensitivity and 2) Bargaining Power. Price sensitivity is dependent on cost of product relative to the total cost of the project (e. g. a buyer would not pay attention to the cost of new doorknobs when completing a major home renovation project), product differentiation (how differentiated is one’s product in the market place), competition between buyers (is the product demanded and rare OR widely-available? ). Bargaining Power Is dependent on the size and concentration between buyers relative to producers (the bargaining power lies with more powerful market players), buyer’s switching costs (e. . high costs of retraining personnel in the airline industry when carriers switch between Boeing and Airbus). Other factors that increase buyer’s bargaining power are availability of information and buyer’s ability to backward integrate (e. g. grocery chains entering food production). The Supplier’s Power is generally the same as Buyer’s Power only in reverse. Addressing factors presented in the Porter’s five forces model should result in strengthening of company’s positions in its industry. A strong position in a market place, complemented by a thorough value chain analysis, should result in a successful and profitable future for a company.