Business (9625) | Analysing the industry environment

Analysing the Industry Environment: Porter's Five Forces

Hello future Business Strategists! This chapter is one of the most important tools in your strategic toolkit. Why? Because before a business decides what to do, it needs to know what it can do. The profitability of a business is heavily influenced by the nature of the industry it operates in.

Here, we will learn how to analyze an industry's structure using Porter's Five Forces model. Don't worry if this sounds complex—we'll break it down into five simple questions that every successful manager asks!

Introduction: Why Analyze the Industry?

Imagine you want to open a new café. You wouldn't just look at your own ideas; you'd look at the street you're on, the other coffee shops, and how many people walk by. Analyzing the industry is the formal way of doing this on a large scale.

The core goal of using this analysis is to determine the attractiveness of an industry.

Quick Rule: The higher the pressure from these forces, the less attractive (less profitable) the industry will be for existing businesses.

The model was developed by management expert Michael Porter and is one of the most famous frameworks in business strategy.

The Core Tool: Porter's Five Forces

Porter identified five crucial forces that determine the competitive intensity and therefore the long-run profitability of an industry. Businesses must understand these forces when making strategic decisions, such as entering a new market or launching a new product.

Memory Aid: The Five Forces (R-SEBS)

To remember the forces, you can use the acronym R-SEBS:

Rivalry
Substitute threat
Entry threat
Buyer power
Supplier power

1. Threat of New Entry (Entry Threat)

This force measures how easy or difficult it is for a new company to start competing in the industry. If it’s easy, existing businesses face pressure to keep prices low and investment high.

The main factor here is Barriers to Entry. When barriers are high, the threat of new entry is low, which is good for established firms.

Key Barriers to Entry:

• Economies of Scale: Existing businesses already operate on a massive scale (e.g., car manufacturing), making their average costs very low. A new entrant cannot match these costs immediately.
• Brand Loyalty: Customers are loyal to established brands (e.g., Apple). A new entrant must spend huge amounts on marketing to persuade customers to switch.
• Capital Requirements: High financial investment is needed (e.g., setting up a new airline requires billions for planes and infrastructure).
• Government Regulation: Licensing requirements or strict quality controls can restrict entry (e.g., pharmaceutical drugs).
• Access to Distribution Channels: Existing firms might have exclusive deals with key retailers, making it hard for new firms to get their product on the shelves.

Example: Starting a new social media platform (like Instagram) is difficult because the barrier of "network effects" is so high—everyone else is already using the established platform.

2. Bargaining Power of Buyers (Buyer Power)

This force examines how much control or leverage customers (buyers) have over the businesses in the industry. If buyers have high power, they can demand lower prices, better quality, or more services, squeezing the business's profits.

Buyer Power is High When:

• Few Large Buyers: The buyers purchase huge quantities. (e.g., a major supermarket chain negotiating with a small local vegetable farm).
• Standardised Products: The product is very similar across all suppliers (a commodity). If one business raises its price, the buyer can easily switch.
• Low Switching Costs: It costs the buyer very little time or money to switch to a competitor.
• Buyers are Price Sensitive: The product represents a significant part of the buyer's cost, so they care deeply about the price.

Analogy: Think about buying a unique custom-made suit (low buyer power) versus buying a generic USB cable (high buyer power, as you can easily switch brands).

3. Bargaining Power of Suppliers (Supplier Power)

This force examines how much control suppliers of inputs (raw materials, labour, or components) have over the business. Powerful suppliers can raise their prices or reduce the quality of the goods they supply, pushing up the business's costs and lowering its profits.

Supplier Power is High When:

• Few Suppliers: There are very few businesses supplying a specific input (e.g., specialized rare earth minerals).
• Critical Input: The input is essential, and no good substitutes exist.
• High Switching Costs: It is expensive or complicated for the business to switch suppliers (e.g., changing complex software systems).
• Suppliers Can Integrate Forward: Suppliers could potentially start competing directly with the industry they supply (e.g., a microchip producer starts making computers).

Did you know? If a business finds that both Buyer Power and Supplier Power are high, they are essentially stuck in the middle, facing pressure on both costs and prices, which severely limits profit potential.

4. Rivalry Among Existing Competitors

This is the intensity of the competition between the companies currently operating in the industry. High rivalry leads to price wars, costly advertising campaigns, and frequent product launches, all of which erode profit margins.

Rivalry is High When:

• Many Competitors of Similar Size: No single company dominates, leading to constant fights for market share.
• Slow Market Growth: If the market isn't growing, the only way to increase sales is to steal customers from rivals (a zero-sum game).
• High Exit Barriers: It is difficult or costly for firms to leave the industry (e.g., due to highly specialized assets or legal obligations). Firms stay and fight, even if they are losing money.
• High Strategic Stakes: If succeeding in this industry is crucial for a larger parent company (prestige or scale).

Example: The global smartphone market (Apple vs. Samsung vs. Xiaomi). Competition is intense, leading to large R&D spending and frequent aggressive marketing.

5. Threat of Substitute Products or Services

A substitute product is something *outside* the industry that fulfills the same basic customer need. This is a vital distinction from rivalry, which is competition *inside* the industry.

If the threat of substitutes is high, businesses must keep their prices competitive and continually improve quality to prevent customers from switching to the alternative product.

Threat of Substitutes is High When:

• Attractive Price-Performance Trade-off: The substitute is significantly cheaper or better than the industry product.
• Low Switching Costs: It is easy for customers to move from the industry product to the substitute.

Example of a Substitute: The airline industry's main substitute is high-speed rail. If the train becomes much cheaper and almost as fast, the threat of substitution increases, putting pressure on airlines to lower prices.

Application and Implications for Business Strategy

Assessing the Implications for Decision Making and Profits

The entire point of using Porter's Five Forces is to assess how a strategic decision (like a new entry or diversification) will be affected by the industry structure, and what the potential profit implications are.

1. Profit Potential and Industry Attractiveness

• Unattractive Industry: If all five forces are strong (high pressure), profit potential is low. The business should consider avoiding this industry or developing a strategy to shield itself from these pressures.
• Attractive Industry: If all five forces are weak (low pressure), profit potential is high (e.g., specialized software with high entry barriers and low substitute threats).

2. Analyzing Changes in the Forces

Students must be able to analyze *how* and *why* these forces might change over time, and the impact of that change on profit.

Example of a change: The development of digital printing technology drastically lowered the capital required to start a publishing company.
Implication: This lowered the Barriers to Entry, increasing the Threat of New Entry, making the traditional publishing industry less profitable.

3. Strategic Response

The analysis helps a business formulate strategies to either:

• Influence the Forces: A business can try to lower the power of a force. (e.g., spending heavily on R&D to create unique features, thereby raising switching costs for buyers and lowering buyer power).
• Position Itself: A business can choose a market niche where the forces are weaker. (e.g., competing in the high-end luxury segment might lower buyer price sensitivity).

Encouragement: Analyzing these forces allows a business to be proactive, rather than reactive. By understanding the battlefield, you can choose the right weapons!

Key Takeaway: The Strategic Value of Porter's Analysis

The Five Forces model is a dynamic framework that helps managers look beyond immediate competitors. It reminds them that profit is determined not just by price wars (Rivalry), but by the power structures relating to new entrants, customers, suppliers, and alternative solutions (substitutes). A strategy that ignores these forces is unlikely to succeed in the long run.