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Porters Five Forces: A Model for Industry Analysis

in Small Business

industry analysis

I figured we would switch it up for the next couple posts on start up loans. We talk so much about existing businesses and finance because that’s what this blog aims to do. What about the folks who are just now getting into business? We should talk about some things like industry analysis and marketing. So with that thought in mind, these next couple posts are going to be along those lines.

Porters Five Forces

The model of competition by nature, implies that rates of return should be constant across all niches and industries. The truth is that different industries can sustain different heights of profitability. Industry structure has a lot to do with that. Once upon a time, a man named Michael Porter provided a go-to outline that models an industry as being influenced by five forces (ala Porters Five Forces). You, as a business owner or manager can use this framework to better understand your industry and develop an edge in your market place. Let’s take a look at the forces and go over each one briefly and look a diagram to illustrate the forces at work.

porters five forces

A Diagram of Porters Five Forces

Rivalry

Almost always, and most definitely in the traditional economic model, competition amongst firms will inevitably drive profits to the ground.  But competition is not perfect and [successful] companies are not hick, lay on your back, price takers. Instead, companies take the angel for a competitive advantage over their rivals. The intensity of rivalry among businesses varies greatly across industries. If rivalry among companies in a particular industry is low, the industry is considered to be disciplined. Just as the name of this point suggest, when rivals act there develops a heated battle and the winner is the one with the competitive advantage. So what are some things that give you a competitive advantage?

  • Changing Prices
  • Improving your product or it’s differentiation
  • Creatively using your distribution channels
  • Exploiting suppliers to meet higher demands

Buyer Power

Buyers have an impact on every industry. Fore the most part, when buyer power is very strong, the relationship to the producing industry is a market in which there are many, many, many suppliers and one type of buyer. Under those market conditions, the buyer actually ends up setting the price. They decide what a product or service is worth. A good example is to think of the Department of Defense; They have a lot of buyer power because they are pretty much the only ones who buy weapons from defense contractors. Make sense? Good!

Supplier Power

Any given producing industry will require some kind of raw material, whether it’s man power, some specific supply or another.  Because of that, this requirement will lead to a buyer-supplier relationship between the industry and the businesses that supply the raw material. Suppliers, when in full, can push an influence on the industry. They can push a product/service at a higher price to reap in all the markets profits.

Threat Of Substitutes

Substitute products refer to products in other industries. Substitutes exists when a specific product or service’s demand is affected by the price change of a substitute.When substitution occurs the product or services price becomes elastic, because the consumer now has many more options and different avenues. The problem lies in when a close substitute product enters the market, because it will constrain the ability of businesses in an industry to raise prices.

While this sounds terrible and there is a very real threat in every market with a substitute product, it will typically impact an industry through price competition. That then breads more diversified pricing and product options for consumers. Entertainment mediums are a great example of substitution (TV- network television, cable, satellite, etc).

Barriers to Entry (Threat of Entry)

Everyone has heard of a barrier to entry or a threat of entry. Not only do the existing rival companies post a threat to one and others profits, but the threat of new beasts entering the industry is very real. In a perfect world, any company should be able to enter and exist a market. If those free exists do in fact exist, then the profits in that given industry should always be low. In real life, however, some industries contain certain characteristics that actually PROTECT high profits and PREVENT rivals from entering the industry!!! These my friends, are barriers to entry.  Some of the most common are things like:

  • Government influence (think banks)
  • Patents and proprietary software/service/product (think Apple vs HTC/Google/Microsoft circa 2010 and the battle for smart phone operating system control)
  • Internal Economies of Scale (think phone service providers)
  • Asset requirements inhibit entry into an industry (think microchips)

Conclusion

Analyze your industry prior to taking the leap, use things like Porters method and other frameworks that are tried and true. Like I always say, I don’t need to be the best or the brightest, I just need to learn from them.

By no means am I saying don’t ever just jump right in. Sometimes you have to get wet to know if you can swim. Stay tuned for more great articles coming this week and next from all of us here at startuploans.org!

If rivalry among firms in an industry is low, the industry is considered to be disciplined.
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