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When a business understands the forces that make and break all companies, it can make better decisions as it moves forward. Porter’s Five Forces is a framework that can help any business leader understand the factors impacting their company. Developed by Michael Porter, the concept of five forces is a way to analyze a market or industry’s competitive environment and understand how much influence its suppliers and customers have over it.
Key Points
• Porter’s Five Forces framework — developed by Harvard Business School professor Michael Porter in 1979 — helps businesses analyze competitive environments and make informed strategic decisions.
• The five forces are: competitive rivalry, threat of new entrants, supplier bargaining power, buyer bargaining power, and the threat of substitute products or services.
• Competitive rivalry drives innovation but can also trigger marketing wars that reduce profits for all companies competing in the same market.
• Conducting a Porter’s Five Forces analysis involves defining your industry, evaluating competition, assessing entry costs, examining supplier and buyer options, and determining substitute threats.
• While the framework can be an excellent tool for small businesses, its limitations include an overemphasis on external factors and reduced effectiveness for complex or emerging industries.
What Is Porter’s Five Forces?
Porter’s Five Forces is a framework to help determine how external forces are impacting a market or industry – which can, in turn, help companies determine how viable they may be. By analyzing the existing market, they can strategize ways they could pivot to become or remain a strong key player in their field. It’s one of many business growth strategies, but can also be seen as a critical thinking tool to help company owners analyze their business in context.
History and Background
The five forces framework was developed by Harvard Business School professor Michael Porter. He first wrote about it in the Harvard Business Review in 1979 because he felt that the models used in the curriculums of most business schools were off target and largely unrealistic.
In a typical curriculum at the time, the assumption was that businesses each had an equal shot at acquiring customers and no entity possessed a pricing advantage or influence over the market. Porter’s article took issue with this standpoint because it presented a model that students were unlikely to encounter in the real world.
To remedy this, Porter wrote about what he considered to be the five forces at play in the market at any given time. For a company to be competitive, he argued, it must consider each and every one of them before making an important strategic decision.
The Five Forces Explained
Here’s an overview of each of the five forces:
Competitive Rivalry
How fierce is the competition? Competition can be seen as any other companies that offer the same products or services and that customers can switch to if they choose. Who is the competition and how many other businesses is your company up against?
In a robust capitalist economy, it’s not uncommon for every company to have at least one rival, such as:
• Lowe’s vs. Home Depot
• Playstation vs. Nintendo
• Microsoft vs. Apple
• CVS vs. Walgreens
• Coke vs. Pepsi
Rivalries, however, keep companies from growing complacent, and that, in turn, leads to innovation. Of course, it can also lead to marketing wars, which can result in a mutual loss in profits.
Threat of New Entrants
How easy is it for new companies to rise up as competition? Many things can factor into entry costs, such as regulations, patents, economies of scale, and capital requirements. Industries with lower initial costs tend to face more pressure from newcomers than those with higher costs.
The easier it is for a new entrepreneur to dream up a new angle, obtain a startup business loan or other funding, and launch their business in your industry, the higher the threat of new entries – and new competitors – will be.
Bargaining Power of Suppliers
The power of suppliers refers to the ability of suppliers to influence your business. Whether they’re affecting the prices you have to charge or your ability to make your product at all, suppliers can have a lot of sway over a company.
Their power is even greater when there aren’t that many of them or it’s difficult to switch from one to another. Plus, they can create a catastrophic scenario if they decide to enter the arena themselves, since they already have much of what they’d need to manufacture products.
Bargaining Power of Buyers
Buyer power refers to the ability of buyers to influence a product or its price. A few variables can affect just how powerful it is. For example, can the customer save money by going to a big box retailer or by buying in bulk? Or can they save simply by switching over to another company?
Identifying your customers, their habits, and their motivations is one of the ten steps to starting a business.
Threat of Substitutes
An alternative product that satisfies the same need is a threat to any company’s sales. If there is no brand loyalty and no clear reason for the customer to stay if they can save or get better value by going elsewhere, then the company’s long-term viability may be at risk.
How To Conduct a Porter’s Five Forces Analysis
To conduct a Porter’s Five Forces analysis, companies generally follow these steps:
• Define the company’s specific industry. Be as precise as possible.
• Evaluate how much competition the company’s rival really represents. Is it truly a threat? Or is it just bluster?
• Determine the cost of entry for new competitors. How easy is it for a new company to throw its hat into the ring?
• Assess how much influence suppliers have over the company. Does the company have only one supplier for an essential product? Or does it have multiple options for its supplies?
• Evaluate how much influence the buyer has over the company. Buyers have strong purchasing power when they can easily switch over to another company’s product. Their power is weaker when there are few choices in the marketplace.
• Determine whether similar products or services are available. If customers can go elsewhere, compare and contrast the products. What advantages and disadvantages does each have?
• Once the five forces have been analyzed, determine what steps need to be taken to ensure your company’s profitability and long term growth.
Porter’s Five Forces is partly about understanding where a company is vulnerable, but that understanding also provides insight into its opportunities to strengthen its position in local, national, and global markets.
When used in conjunction with small business financial ratios and financial projections, Porter’s Five Forces can help a company decide when it should take on additional debt to expedite growth so it can surpass its competition. It may need a single small business loan, or it may benefit from a business line of credit to capitalize on opportunities as they arise.
Porter’s Five Forces Example
Let’s take a closer look at this framework with a hypothetical situation.
Imagine that an entrepreneur is considering whether to open their own pizza restaurant in a busy urban area. Using Porter’s Five Forces, here’s what that business owner might determine.
• Competition: There are many pizza restaurants both within the city itself and the surrounding suburbs, so competition is high.
• Threat of new rivalry: The threat of a new pizza restaurant with delivery is high because the cost of entry is very low compared to other business models.
• Supplier power: The owner can obtain the necessary ingredients and packaging from multiple suppliers all over the country and abroad if necessary, so supplier power is very low.
• Buyer power: Customers have a lot of choices when it comes to pizza restaurants, which means they have a lot of power. Both the product and customer service must be top notch.
• Threat of substitutes: This is also high. If customers wish, they can make pizza themselves, get frozen pizza at the grocery store, or simply go to another provider. They can also choose to eat something else completely, like burgers, enchiladas, or poke bowls.
With so many variables stacked up against it, opening a pizza restaurant may not be a great idea. It’s easy for new competition to enter and customers already have a lot of choices, both for pizza and other options.
Benefits and Limitations of the Five Forces Model
Porter’s Five Forces is simply a framework for business owners to understand their enterprise’s strengths and weaknesses either as an existing company or as a potential startup.
Benefits
• May encourage business owners to come up with innovative ways to stand out
• Helps identify the level of outside threats
• Helps identify areas where the business can improve
• Is a good framework for new businesses to use when strategizing about external threats
Limitations
• May overemphasize outside factors
• Does not give enough importance to internal factors that affect the business
• Isn’t appropriate for new, emerging industries
• May be too simplistic for complex business structures
The Takeaway
Porter’s Five Forces is a solid framework that businesses can utilize to understand the variables that impact their success. While it may be too simplistic for a large, complex company, it’s an excellent tool for small businesses that want to determine areas of improvement and potential issues they should guard against.
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FAQ
Who created Porter’s Five Forces model?
Michael Porter created the five forces model when he was a professor at the Harvard Business School. The framework first appeared in the Harvard Business Review, but was also discussed in his book “Competitive Strategy: Techniques for Analyzing Industries and Competitors.”
How is Porter’s Five Forces different from a SWOT analysis?
The five forces framework analyzes outside factors. SWOT, on the other hand, looks at a company’s strengths, weaknesses, opportunities, and threats, focusing on both external and internal forces that affect the business’s performance.
What industries is Porter’s Five Forces most useful for?
Porter’s Five Forces can be used by any industry at any time. It may be particularly useful for new businesses, but any business of any age or type can utilize it as a framework to assess the factors at play that are affecting it.
How often should a business conduct a Five Forces analysis?
There are no rules about this. Completing the process once a year would illuminate factors at play, but if market conditions are changing day to day, a more frequent analysis may be a good idea. If they’ve internalized the framework, savvy business owners may immediately recognize when changes are occurring and how those changes will affect them.
What are the limitations of Porter’s Five Forces?
Porter’s Five Forces is not an ideal model for recognizing internal factors that are affecting performance, and may also not be optimal for new industries or companies with large, complex revenue structures.
Photo credit: iStock/fatihhoca
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