Porter’s Five Forces Analysis is based on the concept that the key objective for any organization should be to gain advantage over its competitors, it is not the industry that an organization is in that counts, but where it wants to compete in terms of the nature of the competition. This competition is provided by the nature of the rivalry between existing firms, the threat of potential entrants and substitutes and the bargaining power of both the suppliers and buyers (Lowson, 2002).
The five-forces model is extremely helpful in systematically diagnosing the principal competitive pressures in a market and assessing how strong and important each one is. This straightforward approach is the most widely used technique of competition analysis. The rivalry among competing sellers. The most powerful of the five competitive forces is usually the competitive battle among rival firms. How vigorously sellers use the competitive weapons at their disposal to jockey for a stronger market position and win a competitive edge over rivals shows the strength of this competitive force.
Competitive strategy is the narrower portion of business strategy dealing with a company’s competitive approaches for achieving market success, its offensive moves to secure a competitive edge over rival firms, and its defensive moves to protect its competitive position. As noted by Fleisher and Bensoussan (2003), Porter’s fifth force, competitive rivalry, is also an element addressed by the strategic group analysis where it considers competitive rivalry and how this force both impact and it is impacted by other four forces.
Porter (1980, taken from Bowman, 1998) suggests that the level of rivalry, the actual competition between existing producers, varies according to a number of factors. The market structure for example will be a major determinant in the intensity of rivalry. In a monopolistic market for example, where one firm has the total control of the market, quality, availability, price but mainly product differentiation will be a priority.
In relation to this it must be noted that an article by Business World (2005) suggests that the law concerning the abuse by companies of dominant market positions will be reviewed and ultimately changed in the near future. On the other hand, firms operating under conditions of oligopoly may find considerable variation in the identity, number and size distribution of competitors internationally, as for example Burger King and McDonald (John et al, 1997).
The slow growth of demand, or a declining demand, the high fixed costs involved that do not vary with the level of outputs, are also factors which will ultimately impact on the level of rivalry. The competitive force of potential entry. New entrants to a market bring new production capacity, the desire to establish a secure place in the market, and sometimes substantial resources with which to compete. How serious the threat of entry is in a particular market depends on two factors: barriers to entry and the expected reaction of incumbent firms to new entry.
A barrier to entry exists whenever it is hard for a newcomer to break into a market and/or economic factors put a potential entrant at a disadvantage relative to its competitors. Even if a potential entrant is willing to tackle the problems of entry barriers, it still faces the issue of how existing firms will react. Will incumbent firms react passively, or will they aggressively defend their market positions with price cuts, increased advertising, product improvements, and whatever else will give a new entrant (as well as other rivals) a hard time?
A potential entrant often has second thoughts when incumbents send strong signals that they will stoutly defend their market positions against entry and when they have the financial resources to do so. A potential entrant may also turn away when incumbent firms can use leverage with distributors and customers to keep their business. The best test of whether potential entry is a strong or weak competitive force is to ask if the industry’s growth and profit prospects are attractive enough to induce additional entry.
When the answer is no, potential entry is not a source of competitive pressure. When the answer is yes (as in industries where lower-cost foreign competitors are seeking new markets), then potential entry is a strong force. The stronger the threat of entry, the greater the motivation of incumbent firms to fortify their positions against newcomers to make entry more costly or difficult. the threat of entry changes as industry prospects grow brighter or dimmer and as entry barriers rise or fall.
For example, the expiration of a key patent can greatly increase the threat of entry. A technological discovery can create an economy of scale and advantage where none existed before. New actions by incumbent firms to increase advertising, strengthen distributor-dealer relations, or improve product quality can erect higher roadblocks to entry. In international markets, entry barriers for foreign-based firms ease when tariffs are lowered, domestic wholesalers and dealers seek out lower-cost foreign-made goods, and domestic buyers become more willing to purchase foreign brands.
Barriers to entry, identified as one of the five forces, presents five structural determinants that affect a company’s ability to enter new markets; economies of scale and product differentiation. The economies of scale, which is a benefit gained from large scale production will keep costs down and ultimately low prices too. Product differentiation will allow keeping customers loyalty and switching costs and an appropriate example of this would be the new electric car introduced by Toyota.
It can also be suggested that advertising campaigns may also be considered as an entry barrier. The existing markets will be able to raise product awareness while new entrants will less likely be able to meet the costs involved in doing so. Backwards vertical integration may also be identified as a possible entry barrier. The competitive force of substitute products. Firms in one industry are, quite often, in close competition with firms in another industry because their respective products are good substitutes.
The competitive force of substitute products comes into play in several ways. First, the presence of readily available and competitively priced substitutes places a ceiling on the prices companies in an industry can afford to charge without giving customers an incentive to switch to substitutes and thus eroding their own market position. This price ceiling, at the same time, puts a lid on the profits that industry members can earn unless they find ways to cut costs. Second, the availability of substitutes invites customers to compare quality and performance as well as price.
Another determinant of whether substitutes are a strong or weak competitive force is whether it is difficult or costly for customers to switch to substitutes. If switching costs are high, sellers of substitutes must offer a major cost or performance benefit to steal the industry’s customers. When switching costs are low, it’s much easier for the sellers of substitutes to attract buyers. For example, Apple Inc introduces the new iPod touch in new version but with the same price with the old version. The new version has extra function like camera but in the same price. The power of suppliers.
Whether the suppliers to an industry are a weak or strong competitive force depends on market conditions in the supplier industry and the significance of the item they supply. The competitive force of suppliers is greatly diminished whenever the item they provide is a standard commodity available on the open market from a large number of suppliers with ample ability to fill orders. Suppliers are also in a weak bargaining position whenever there are good substitute inputs and switching is neither costly nor difficult. Suppliers also have less leverage when the butting industry is a major customer.
On the other hand, powerful suppliers can put an industry in a profit squeeze with price increases that can’t be fully passed on to the industry’s own customers. Suppliers become a strong competitive force when their product makes up a sizable fraction of the costs of an industry’s product, is crucial to the industry’s production process, and/or significantly affects the quality of the industry’s product. Likewise, a supplier (or group of suppliers) gains bargaining leverage the more difficult or costly it is for users to switch suppliers.
Big suppliers with good reputations and growing demand for their output are harder to wring concessions from than struggling suppliers striving to broaden their customer base. Suppliers are also more powerful when they can supply a component cheaper than industry members can make it themselves. In such situations, suppliers’ bargaining position is strong until a customer needs enough parts to justify backward integration. Then the balance of power shifts away from the supplier. The more credible the threat of backward integration, the more leverage companies have in negotiating favorable terms with suppliers.
A final instance in which an industry’s suppliers play an important competitive role is when suppliers, for one reason or another, do not have the manufacturing capability or a strong enough incentive to provide items of adequate quality. Suppliers who lack the ability or incentive to provide quality parts can seriously damage their customers’ business. For example, Ayamas is the supplier of the KFC. When the Ayamas increase their price, KFC also must increase their price. The power of buyers. Just as with suppliers, the competitive strength of buyers can range from strong to weak.
Buyers have substantial bargaining leverage in a number of situations. The most obvious is when buyers are large and purchase a sizable percentage of the industry’s output. Buyers also gain power when the cost of switching to competing brands or substitutes is relatively low. Any time buyers can meet their needs by sourcing from several sellers, they have added room to negotiate. When sellers’ products are virtually identical, buyers can switch with little or no cost. However, if sellers’ products are strongly differentiated, buyers are less able to switch without incurring sizable switching costs.
One last point: all buyers don’t have equal bargaining power will sellers; some may be less sensitive than others to price, quality, or service. There are some competitive strategies that must be applied in dealing with competitive pressure. The first one is cost leadership strategy. Produce products and/or services at the lowest cost in the industry. A ?rm achieves cost leadership in its industry by thrifty buying practices, efficient business processes, forcing up the prices paid by competitors, and helping customers or suppliers reduce their costs.
A cost leadership example is the Wal-Mart automatic inventory replenishment sys- tem. This system enables Wal-Mart to reduce storage requirements so that Wal-Mart stores have one of the highest ratios of sales ?oor space in the industry. Essentially Wal-Mart is using ?oor space to sell products, not store them, and it does not have to tie up capital in inventory. Savings from this system and others allows Wal-Mart to provide low-priced products to its customers and still earn high pro?ts. One of the strategies is differentiation strategy. Offer different products, services, or product features.
By offering different, “better” products companies can charge higher prices, sell more products, or both. Southwest Airlines has differentiated itself as a low-cost, short-haul, express airline, and that has proven to be a winning strategy for competing in the highly competitive airline industry. Dell has differentiated itself in the personal computer market through its mass-customization strategy. Third strategy is innovation strategy. Introduce new products and services, put new features in existing products and services, or develop new ways to produce them.
Innovation is similar to differentiation except that the impact is much more dramatic. Differentiation “tweaks” existing products and services to offer the customer something special and different. Innovation implies some- thing so new and different that it changes the nature of the industry. A classic example is the introduction of automated teller machines (ATM) by Citibank. The convenience and cost-cutting features of this innovation gave Citibank a huge advantage over its competitors.
Like many innovative products, the ATM changed the nature of competition in the banking industry so that now an ATM network is a competitive necessity for any bank. In relation to this, it may be added that a PEST and SWOT analysis may also be useful tools to use when analyzing an organization. PEST analysis considers the external political, economic, social and technological factors that will have an impact on the organization, encouraging thinking more broadly about environmental influences on the firm, while the SWOT analysis considers the internal strengths and weaknesses and external opportunities and threats (Bowman, 1998).
As also noted by Recklies (2001) the model is best applicable for analysis of simple market structures. A comprehensive description and analysis of all five forces gets very difficult in complex industries however a too narrow focus on particular segments of such industries, on the other hand bears the risk of missing important elements. Another limitation of Porter’s model is that it assumes that companies try to achieve competitive advantages over other players in the markets as well as over suppliers or customers.
With this focus, it dos not really take into consideration strategies like strategic alliances that in today’s market are very common. As suggested by Thompson and Strickland (2003), not only can alliances offset competitive disadvantages or create competitive advantage but they can also allow firm’s to concentrate more on the mutual rivals than towards one another.