Monday, April 27, 2009

Michael E. Porter's Five Forces - Industry Competitive Analysis

While an index like the Herfindahl-Hirschman Index (HHI) might give you a nice quantitative number describing the level of competitiveness in a given industry, a framework such as Porter's Five Forces will start to explain why this is the case.

Porter's five forces analysis looks at:
Another way of looking at this is a 360 view around your company's position in an industry. This includes your supply chain (vertical view of suppliers and customers) as well as within your market (horizontal view of entrants and substitutes). Each of Porter's four mutually exclusive forces contribute to the over all competitive rivalry in an industry.

This helps you answer the question, "Should we start a new venture in this industry?"

Let's have a closer look at each category:

The threat of substitute products The greater the number and the closer substitute products imply an increase the propensity of customers to switch between alternatives (high elasticity of demand).
  • buyer propensity to substitute
  • relative price performance of substitutes
  • buyer switching costs
  • perceived level of product differentiation
Example: Coke and Pepsi are (propensity to substitute, "brand loyalty" aside) cost about the same. In a convenience store, there is no cost to switch from one to the other and there may be some small differentiation between brands. The threat of substitution is high. Test this by going into a restaurant that only serves Pepsi and ask for a Coke. Chances are your server will ask "Is Pepsi, ok?" (if they ask at all)

The threat of the entry of new competitors Inefficient or overly profitable markets will attract more firms and capacity investment. More capacity results (for under served markets) results in decreasing profitability. The markets will always seek equilibrium even if that equilibrium is artificially imposed by barriers.
  • the existence of barriers to entry (patents, rights, etc.) - Note the expiry of patents can trigger new a equilibrium and competition rivalry movements in the industry
  • size - capital requirements and economies of scope
  • brand equity
  • access to distribution
  • learning curve advantages - required skill
  • government policies, regulations and licensing requirements
Example: Although the mass production of juice might require specialized equipment for economies of scale, individual producers (lemonade stand) are not prevented from entering the market with smaller equipment investments. Threat of new competitors is high. Other than standard food and health regulations (FCC), there are no licenses required to produce juice.

The bargaining power of customers Also described as the market of outputs. The ability of customers to put the firm under pressure and it also affects the customer's sensitivity to price changes.
  • buyer concentration to firm concentration ratio
  • degree of dependency upon existing channels of distribution
  • bargaining leverage, particularly in industries with high fixed costs
  • buyer volume
  • buyer switching costs relative to firm switching costs
  • ability to backward integrate - can customers do this themselves?
  • availability of existing substitute products
  • buyer price sensitivity
  • differential advantage (inimitable characteristics) of industry products
The bargaining power of suppliers Also described as market of inputs. Suppliers of raw materials, components, labor, and services (such as expertise) to the firm can be a source of power over the firm. Suppliers may refuse to work with the firm, or e.g. charge excessively high prices for unique resources.
  • supplier switching costs relative to firm switching costs
  • degree of differentiation of inputs
  • presence of substitute inputs
  • supplier concentration to firm concentration ratio
  • employee solidarity (e.g. labor unions)
  • threat of forward integration by suppliers relative to backward integration by firms
  • cost of inputs relative to selling price of the product (profit margins)
Example: Bread inputs include flour, eggs, etc (highly fungible and cheap base commodities). Supplier concentrations of these inputs to firm is very high. Individual suppliers do not dominate the market and will probably not forward integrate (an egg distributor / farmer) will generally have no interest in making and selling bread.

The intensity of competitive rivalry For most industries, this is the major determinant of the competitiveness of the industry. Sometimes rivals compete aggressively and sometimes rivals compete in non-price dimensions such as innovation, marketing, etc.
  • number of competitors
  • rate of industry growth
  • intermittent industry overcapacity (like the service industry)
  • exit barriers
  • diversity of competitors
  • informational complexity and asymmetry
  • fixed cost allocation per value added
Example: Cellular carrier companies (Canada: Rogers, Bell, Telus. US: Verison, Sprint, AT&T) requires large economies of scale for infrastructure. Industry suffers from over capacity at off peak hours. There also also high exit barriers (selling cellular infrastructure). Competitors are not particularly diverse and informational complexity is fairly low. Cellular billing (cost per minute) is fairly fixed. Competitiveness is generally high.

Each of these sections are scored and collectively analyzed to understand the competitive forces in any given industry. This framework highlights the key factors which determine any industry's overall competitive rivalry (and attractiveness). Industries which are not competitive may be attractive for other companies to enter (or increase investment), industries which are overly competitive may force out weaker companies and would generally be unattractive for new ventures.


Alan S Michaels said...

Good analysis, thanks!

(Minor point.... substitutes for sodas like Coke and Pepsi = water, juice, milk, or drinking less soda)

Joshua Wong said...

Thanks! Actually, I was speaking with representatives from Anheuser-Busch InBev and they were commenting on how sodas are substitutes for alcoholic beverages as well.

I guess you can even add beer and alcoholic beverages to your list (for the right demographics in the legal drinking age of course).

Ian Pratt said...

Hey, great analysis. It is always good to read examples to illistrate a point. From my timber milling days, I like to look at the example of seel frames as a substitute for Timber frames in domestic housing.


Joshua Wong said...

Thanks Ian, like your blog! I also recently put up a post about elasticity on my blog directly related to your idea of bargaining power!

charlottefox said...

Hi, I know you posted this a long time ago, but I found it on google and liked your colourful picture.. Bit of a weird question - I'm trying to write a report on the hotel that I am currently working in, can I use Porter's 5 forces on a single business or is it more commonly used to analyse a chain or industry? Thanks!