Understanding Porter's Five Forces
Porter's Five Forces is a business analysis model that helps explain why different industries are able to maintain different levels of profitability. The model was published in Michael E. Porter's book, "Competitive Strategy: Techniques for Analyzing Industries and Competitors" in 1980.1 The Five Forces Model is widely used to analyze a company's industry structure as well as company strategy. Porter identified five undeniable forces that play a role in shaping every market and industry in the world, with a few caveats. The five forces are frequently used to measure the intensity of competition and the attractiveness and profitability of an industry or a market.
Porter's five forces are:
1. Competition in the industry
2. The potential of new entrants in the industry
3. Power of suppliers
4. Customer power
5. The Threat of Substitute Products 1
Competition in the industry
The first of the five forces indicates the number of competitors and their ability to undermine the company. The more competitors, along with the number of equivalent products and services they offer, the less powerful the firm will be. Suppliers and buyers seek to compete with the company if they are able to offer a better deal or lower prices. On the contrary, when the competitive rivalry is low, the firm has more ability to charge higher prices and set terms of deals to achieve higher sales and profits.
The potential of new entrants to the industry
The strength of a company is also influenced by the strength of new entrants to its market. The less time and money it costs a competitor to enter the firm's market and be an efficient competitor, the more weak the firm's entrenched position is significantly. An industry with strong barriers to entry is ideal for established firms in that industry because the company would be able to charge higher prices and negotiate better terms.
Power of suppliers
The next factor in the Five Forces model addresses how easy it is for suppliers to increase the cost of inputs. It is affected by the number of suppliers of the main inputs of a good or service, how distinctive those inputs are, and how much it will cost to switch to another resource. The fewer suppliers in an industry, the greater the firm's dependence on the resource. As a result, the supplier has more power and can increase input costs and pay for other advantages in the trade. On the other hand, when there are many suppliers or the costs of switching between competing suppliers are low, the firm can keep input costs low and enhance its profits.
The ability of customers to lower prices or their level of strength is one of the five forces. It's affected by how many buyers or customers a company has, how important each customer is, and how much it will cost to find new clients or markets to produce it. A smaller and stronger client base means that every customer has more power to negotiate lower rates and better deals. A company with many small and freelance clients will have an easier time charging higher rates to increase profitability.
The Five Forces Model can help companies increase profits, but they must constantly monitor any changes in the Five Forces and adjust their business strategy.
Threat of substitutes
The last force of the Five Forces focuses on alternatives. Alternative goods or services that could be used in place of the company's products or services pose a threat. Firms that produce goods or services for which there are no close alternatives will have greater ability to raise prices and have insurance on favorable terms. When close substitutes are available, customers will have the option to forgo purchasing the company's product, and the company's strength can weaken.
Understanding Porter's five forces and how they apply to the industry, can enable a company to adjust its business strategy to better use its resources to generate higher profits for its investors.
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