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What is Porter's 5 forces model?

Written By

Pantelis Peter Retzepis, CFA, FRM

Partner, Mercury Financial, LLC

Briefly Speaking

Porter's 5 forces model is an excellent tool for corporations for the analysis of their competition and to determine their market strategy. The model was formed by Michael Porter of Harvard Business School in 1979. The five forces are: 1. Rivalry among existing firms, 2. Threat of New Entrants, 3. Threat of Substitute Products or Services, 4. Bargaining Power of Suppliers, and 5. Bargaining Power of Buyers.
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The strength of each one of the five forces is a separate function of the the industry structure, but considered together affect prices, levels of investment for competitiveness, market share, potential profits, profit margins, and industry share. The key to success in an industry is to analyze the dynamics and the constant flow of changes within each of these five forces in Porter's 5 forces model.

Analytically:

1. Rivalry Among Existing Firms

Here we have to examine the structure of the competition. If there are a lot of small and similar size companies the rivalry will be more intense in contrast to the case of a large company which is the market leader. Other factors that affect competition amongst firms in the same industry are high fixed costs, degree of product differentiation, switching costs and exit barriers.

2. Threat Of New Entrants

The threat of new entrants depends mostly on barriers to enter the industry. Porter identifies as such the following:

a. Capital Requirements (the larger, the more difficult), b. Economies of Scale, which may force the new entrant to enter at a large scale and accept higher risk, c. Access to industry distribution channels, d. Brand loyalty, e. Existing barriers (patents, rights, etc), f. Switching costs, the cost incurred to the buyer to switch suppliers.

3. Threat of Substitute Products or Services

The effect of a substitute product or service in an industry depends mostly on the following factors; a. the quality of the substitute, b. the price and the performance of the substitute, c. Is the buyer willing to switch to a substitute product? and d. the overall cost of switching to substitutes.

4. Bargaining Power of Suppliers

Suppliers have a large effect on an industry since they affect quality and prices. The bargaining power of suppliers depends on their concentration, the branding, their profitability, role of quality and service and switching costs. Labor can be an important factor as well. Two additional factors that affet the bargaining power of suppliers, are a. buyers do not threaten to integrate bacwards into supply and b. suppliers threaten to integrate forward into the industry, as in the case of  a name brand manufacturer threatening to open their own retail locations.

5. Bargaining Power of Buyers

Factors affecting the bargaining power of buyers are:

a. Are buyers concentated in large volumes and subsequently able to demand better quality/prices? b. Are products standardized? or there is large differentiation so a buyer can seek alternate solutions. c. Profitability of the buyers. If their profit marging is low, then they have to negotiate harder for better prices. d. Buyers can also exercise more power if switching costs are low and thus they can easily have other choices. e. as in the case of suppliers, the threat of backward and forward integration in the industry.

In summary, Porter's 5 forces model is a strong tool and a starting checkpoint when analyzing an industry at a line-of-business level. Its major weakness is that it considers buyers, sellers and competitors unrelated to each other and does not cope with synergies that very much likely exist within a large corporation or a holding company. A final criticism about Porter's 5 forces model is that it does not consider government regulation.

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