Week 4: Clear

Porter's Five Forces 

Sun Tzu (544 BC - 496 BC) a Chinese general and military strategist, and philosopher once said:

Graphic 1: Quotation of  Sun Tzu

Graphic 2: Sun Tzu

With this saying he meant that strategy is the way how you can get to know yourself, the enemies you are facing and the terrain you are fighting on. This cannot only be applied to war affairs but also to economics and today’s business world. So, no matter which kind of business you run or work for, it is essential to have a strategy and to know the industry or business field you are being part of.

But how do you set-up a strategy?

And how do you get to know the industry you are working for?

Graphic 3: Michael Eugene Porter

In order to provide help and a basis to start with, Michael E. Porter a professor at Harvard Business School, developed a framework for business strategy development and industry analysis widely known as “Porter’s Five Forces” in 1979.

This framework (see Graphic 4) helps to analyze the attractiveness of industries and takes five different forces into account affecting companies in every kind of industry, namely:

1)  Bargaining Power of Suppliers

2)  Bargaining Power of Customers

3)  The Threat of New Entrants

4)  The Threat of Substitute Products

5)  Competitive Rivalry within an Industry

Graphic 4: Five Forces Framework

Attractiveness in this specific context alludes to the general industry profitability. An industry is unattractive if its main focus is just on competition and how to drive the competitors down, as this results in an zero-sum game.

So, let’s have a closer look at the five forces...

Bargaining Power of Suppliers – When there are only few substitutes existent, suppliers of any kind can be a possible source of power over a company. Hence, if a company relies heavily on one or few suppliers, these suppliers experience high bargaining power and the company itself is therefore disadvantaged. Thus, companies should investigate their suppliers closely and try to mitigate the risk by relying on more than one or a few suppliers if possible.

Bargaining Power of Customers – The bargaining power of customers can be described as ability to exert pressure on a company. If customers have the power to force down prices, play participants off against one another or demand better quality or more service, the bargaining power of customers is high. This is often the case when there are only few buyers or if the buyers purchase large volumes, if the offered products are standardized and low switching costs exist. Thus, companies should examine their customer base conscientiously and try to differentiate their products and service to become essential and irreplaceable. 

The Threat of New Entrants – When industries are highly profitable and provide high returns, they are attractive and allure many new potential entrants. If these companies enter the market, profitability for all companies might go down as “the pie has to be shared” by more parties. In order to avoid or mitigate this risk, it is beneficial for companies to create high barriers of entry in order to deter potential entrants from entering the industry.

The Threat of Substitute Products – Services or products are substitute of one another if they perform the same or similar functions. Substitutes are regarded as threat as customers might turn away from the company’s products or services in order to purchase substitute products or services which satisfy the same need e.g. more effectively or efficiently. Thus, it is not enough just to regard direct competitors as rivals, but one also has to think of indirect competitors selling substitute products or services, in order to get the whole picture.

Competitive Rivalry within an Industry – This force is the most straight forward one. As soon a company does not hold the monopolistic stake in an industry, it faces competitors. Hence, a company must always keep an eye on its rivals in order to anticipate their actions and to mitigate the risk coming from competitive rivalry.

In order to know which kind of strategy a company should pursue and to know how to position itself in an industry, a company should always conduct an industry analysis. This should not just happen before entering the industry or while entering it, but it is important to investigate the industry continuously to avoid losing track. To get a basis to start from, Porter’s Five Forces Framework is a valuable tool.

Graphic 1 by Nina Maria Scherl

Graphic 2 by FrankWilliams on commons.wikimedia.org

http://commons.wikimedia.org/wiki/File:Sun-tzu.jpg

Graphic 3 by World Economic Forum from Cologny, Switzerland on commons.wikimedia.org

http://commons.wikimedia.org/wiki/File:Michael_Porter.jpg

Graphic 4 by Grahams Child on commons.wikimedia.org

http://commons.wikimedia.org/wiki/File:Porters_five_forces.PNG