Michael Porter's Five Forces

Summarized by Sam Mishra

The five forces which one must consider to analyze any industry are the rivalry between the firms within the industry being analyzed, the bargaining power of buyers, the bargaining power of suppliers, the threat of substitute products or services, and the threat of new entrants (also known as barriers to entry). Each of these five forces is analyzed in further detail in their respective links above. They are also shown in the diagram below. Initially propounded by Harvard Business School Professor Michael Porter, the Five Forces framework has been accepted as a strategic framework which one can apply to analyze any industry. In this article, three industries have been chosen to illustrate applications of this framework: the IT (information technology) industry; the auto industry; and the Internet which has emerged as a threat to traditional media like print, radio, and TV. To deepen the analysis, a three by three buyer-supplier matrix has also been provided which depicts the interplays between buyers and suppliers, two of the Porter five forces.

Let's consider rivalry within the industry first. It is common sense to assume that if the rivalry is intense, average profitability will reduce. In other words, to increase profitability, firms within an industry may have to coordinate for collective good. For example, if the firms want to avoid costly price wars which will ultimately reduce profits for all firms (also see Game Theory), firms need to coordinate. However, this is easier said than done. Frequently, in an industry comprising of firms large and small, smaller firms tend to lower prices to increase market share, and ultimately larger firms follow. A good example is the IT (Information Technology) Consulting industry. When mid-sized Indian consulting firms like TCS and Wipro introduced off-shoring by charging lower prices per consultant, big IT consulting houses like IBM and Accenture had to hire IT professionals in India and charge similar prices per consulant. At the time of this writing (2006 - 2008), other big IT consulting firms like EDS who had not been aggressively hiring in India could not compete as effectively in terms of pricing, because they did not enjoy the labor arbitrage which firms having a large number of consultants in India enjoyed.

Bargaining power of suppliers and customers always needs to be considered, while analyzing any industry. Let's take the IT industry, for the sake of analysis. IT has always been a cost center in a business. Once the Y2K hype was over and we entered the new millennium, it became clearer that the buyers of IT consulting services had the upper hand, as opposed to the suppliers of these services. Consequently, the suppliers had to hire overseas, particularly in India, and succumbed to the off-shoring trend currently underway. The following buyer supplier matrix portrays who has how much power in business negotiations. For example, the IT industry scenario discussed here falls under the middle left zone depicting higher buyer power. The other eight zones in the following matrix are similarly self explanatory.

The threat of substitutes is important while analyzing an industry. Currently, with the onslaught of the Internet, traditional media like print and TV are under attack. Online advertisers like Google and Yahoo!, two well known Internet companies, are ensuring that more and more advertising move to the World Wide Web, at the cost of print and TV advertising. In short, the Internet and the mobile Internet have emerged as real substitutes to reading newspapers and magazines and watching TV. Kids who grew up playing Gameboy are extremely comfortable watching streaming video using iPods and iPhones, and will never watch as much TV as the baby boomers did when they were teenagers. So, what does a business in the traditional media industry like print do? Adopt the substitute as part of its industry, and adapt to the changes rapidly. All big newspapers and magazines have an online presence today, directly as a result of this threat from the Internet. Some of them like USA Today even compete with the likes of Google (see next paragraph) in actively soliciting Internet advertising.

Finally, let us consider barriers to entry as the fifth Porter force, which one needs to analyze. Typically, when an industry is emerging, barriers to entry can be medium to low. An example is the Internet industry, where companies like You Tube (which got acquired by Google for close to 1.6 billion dollars) can enter and establish themselves in less than two years. On the other hand, for an established industry, barriers to industry will be high to very high. For example, who would want to enter the American auto industry? On one hand, there is low profitability because of intense rivalry: Ford is making losses; GM has lost its number one position to Toyota, the Japanese auto juggernaut; Chrysler was acquired a few years ago by Daimler, the German auto giant. On the other, barriers to entry remain high in terms of high capital costs of building auto plants, establishing a brand name similar to a Mercedes or a Toyota, bringing in lean manufacturing practices of the Koreans and the Japanese to auto plants in Kentucky, Tennessee, and Ohio, etc.

In addition to the above analyses, another way to appreciate the value of this strategic framework is to see an actual application of the framework in the context of a real life business situation. Our Cash in Gas and other Solved Cases apply this framework while analyzing the industry as part of crafting a profitable strategy. Also, please browse the book below (currently a prescribed text-book for a management course in UNLV - University of Nevada, Las Vegas):