Michael Porter, a renowned Harvard Business School professor and expert in business strategy, devised a framework called the "Five Forces Model," which has become a foundational concept for aspiring product managers. In three of my courses at Carnegie Mellon – Product Management, Foundations of Software Management, and Integrated Thinking for Innovation - this framework was referenced, making me realize how essential it is for product managers to understand. This inspired me to write a blog about it.
At its core, it revolves around profits and competition.
Introduction to Porter's Five Forces
Michael Porter's groundbreaking 1979 article in Harvard Business Review, "How Competitive Forces Shape Strategy," revolutionized the way businesses approach strategy formulation.
Industry structure goes beyond merely identifying competitors. It includes a broader view of competition and various forces shaping the competitive market. By analyzing these structural elements, companies can gain insights into the underlying economics of their industry and identify the sources of competitive pressure.
The importance of industry structure in strategy formulation cannot be overstated:
Know what challenges they face
Get ready for changes
Find the best way to compete
Guess how much money they might make
Decide if they should enter new markets
By understanding industry structure, companies can move beyond simplistic notions of competition based solely on market share battles, and develop strategies that address the full complexity of their competitive environment.
Image credits: How Competitive Forces Shape Strategy
Overview of the five competitive forces
Porter's framework identifies five fundamental competitive forces that shape every industry:
Threat of New Entrants: This force considers how easy or difficult it is for new competitors to enter the market. High entry barriers help protect established companies and allow them to keep making strong profits over time.
Bargaining Power of Suppliers: This force looks at how much influence suppliers have to raise prices or lower product quality. When suppliers have a lot of power, they can reduce the industry's overall profitability.
Bargaining Power of Buyers: This force looks at the ability of customers to drive prices down or demand higher quality or better service. Strong buyer power can also erode industry profitability.
Threat of Substitute Products or Services: This force considers how easily customers can switch to a competitor's product or service, or find an alternative solution to their needs. Strong substitutes can limit an industry's profit potential.
Rivalry Among Existing Competitors: This force examines the intensity of competition among existing firms in the industry. High rivalry can lead to price wars, increased advertising expenditure, and other competitive actions that erode profitability.
These five forces work together to determine the overall intensity of competition and profitability within an industry. The stronger these forces, the more challenging it is for companies to raise prices and earn greater profits. Conversely, weaker forces allow for greater potential profitability.
Implications of the Five Forces
As stated in the document - "The collective strength of these forces determines the ultimate profit potential of an industry. It ranges from intense in industries like tires, metal cans, and steel, where no company earns spectacular returns on investment, to mild in industries like oil field services and equipment, soft drinks, and toiletries, where there is room for quite high returns."
For example:
Strong threat of new entrants reduces profitability by putting downward pressure on prices and upward pressure on the investment required to compete.
Powerful buyers or suppliers can capture more of the value for themselves, leaving less profit for the companies in the industry.
Intense rivalry among existing competitors can lead to price wars, increased marketing expenses, and other costly competitive actions that erode profits.
The presence of close substitutes limits the price companies can charge without losing business to the substitute.
Identifying strengths and weaknesses
As Porter states in the document:
"Once the corporate strategist has assessed the forces affecting competition in his industry and their underlying causes, he can identify his company's strengths and weaknesses. The crucial strengths and weaknesses from a strategic standpoint are the company's posture vis-à-vis the underlying causes of each force."
This analysis helps companies in several ways:
Positioning: It allows a company to position itself where the forces are weakest. For instance, the document mentions how Dr. Pepper positioned itself to avoid direct competition with Coca-Cola and Pepsi by focusing on a unique flavour and piggybacking on their distribution networks.
Exploiting change: By understanding the forces, a company can better anticipate and exploit shifts in the competitive landscape. The document notes: "Anticipating shifts in the factors underlying the forces and responding to them, with the hope of exploiting change by choosing a strategy appropriate for the new competitive balance before opponents recognize it."
Shaping industry structure: Companies can take actions to influence the balance of forces in their favour. For example, increasing product differentiation can reduce the threat of substitutes and new entrants.
Identifying critical strengths and weaknesses: The framework helps companies focus on the aspects of their business that are most crucial given the industry structure. For instance, in an industry with powerful buyers, strong sales and marketing capabilities might be critical.
Guiding strategic decisions: Understanding strengths and weaknesses in relation to the five forces can guide decisions about diversification, vertical integration, or major capital investments.
Detailed Analysis of the Five Forces
Now that you have a general idea of the five forces and the impact they make on profitability let’s dive deeper into a detailed analysis of them.
Barriers to entry
Let’s outline six major sources of barriers to entry:
Economies of scale: Force new entrants to come in at large scale or accept a cost disadvantage.
Product differentiation: Brand identification creates a barrier by forcing entrants to spend heavily to overcome customer loyalty.
Capital requirements: Large financial investments are needed to compete, especially for unrecoverable expenditures in up-front advertising or R&D.
Cost disadvantages independent of size: Established companies may have advantages not available to potential rivals, such as proprietary technology, favourable locations, or learning curve advantages.
Access to distribution channels: New entrants must secure distribution of their product or service, which can be difficult if existing competitors have ties with distributors.
Government policy: Regulations, license requirements, and limits on access to raw materials can create significant barriers.
Expected retaliation
The document mentions that a potential entrant's expectations about retaliation from existing competitors also influence the threat of entry. Factors that deter entry include:
Incumbents with substantial resources to fight back
Incumbents likely to cut prices to keep market share
Slow industry growth, affecting the industry's ability to absorb new entrants
Bargaining Power of Suppliers
The article states that powerful suppliers can exert bargaining power by raising prices or reducing the quality of purchased goods and services. A supplier group is powerful if:
It doesn't depend heavily on the industry for its revenues. If a supplier has a diverse customer base across multiple industries, it's less dependent on any single industry for its revenues
Industry participants face switching costs in changing suppliers
Suppliers offer products that are differentiated
There is no substitute for what the supplier group provides
The supplier group can credibly threaten to integrate forward into the industry
Bargaining Power of Buyers
Powerful buyers can force down prices, demand higher quality or more service, and play competitors against each other. A buyer group is powerful if:
It is concentrated or purchases in large volumes; hence, they gain bargaining power.
The products it purchases from the industry form a significant part of its costs or purchases
It earns low profits, creating an incentive to lower purchasing costs
The buyer has full information about demand, actual market prices, and supplier costs
Threat of Substitute Products or Services
Substitutes limit the potential returns of an industry by placing a ceiling on the prices firms can profitably charge. Porter states:
"The more attractive the price-performance trade-off offered by substitute products, the firmer the lid on industry profits."
Substitutes that deserve the most attention are those that:
Are subject to trends improving their price-performance trade-off with the industry's product
Are produced by industries earning high profits
Rivalry Among Existing Competitors
Rivalry among existing competitors takes the form of jockeying for position using tactics like price competition, advertising battles, product introductions, and increased customer service. Intense rivalry is related to the presence of several factors:
Numerous or equally balanced competitors. Diverse competitors with different strategies and origins
Slow industry growth
Lack of differentiation or switching costs
High exit barriers
Conclusion and Recap
Michael Porter's Five Forces Model is still very important for product managers and business leaders. It helps them understand how companies compete with each other. By using this model, we can see what makes some industries more profitable than others.
Let's recap the key points:
The Five Forces:
Threat of New Entrants
Bargaining Power of Suppliers
Bargaining Power of Buyers
Threat of Substitute Products or Services
Rivalry Among Existing Competitors
Industry Structure: Understanding these forces helps companies comprehend the underlying economics of their industry and identify sources of competitive pressure.
Strategic Implications: This framework enables businesses to:
Position themselves where competitive forces are weakest
Exploit industry changes
Shape industry structure in their favour
Identify critical strengths and weaknesses
Guide strategic decisions
Profitability Impact: The collective strength of these forces determines an industry's profit potential, ranging from intense (low profitability) to mild (high profitability).
Detailed Analysis: Each force has multiple factors that influence its strength, from barriers to entry for new competitors to the price-performance trade-off of substitute products.
By understanding Porter's Five Forces, product managers can make better plans. They can see problems coming and find new ways to do well in their market. This model helps them understand what's happening now and guess what might happen in the future.
Even though business keeps changing, the Five Forces Model is still useful. It works for new types of businesses too. If you want to be a good product manager, it's really important to understand this model. It will help you make smart choices about your products and how to compete with other companies.
To learn more about the strategies for dealing with the Five Forces, their limitations, and an in-depth case study, read my blog: 'Porter’s Five Forces: Strategic Analysis, Case Study, and Limitations.' (coming soon)
Next read:
Porter’s Five Forces: Strategic Analysis, Case Study, and Limitations (coming soon)
Questions Every PM Must Answer Before Writing a Market Requirements Document (MRD)