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Friday, June 8, 2012

PORTER'S FIVE FORCES FRAMEWORK



PORTER’S FIVE FORCES FRAMEWORK


The five forces framework developed by Michael Porter is the most widely known tool for analyzing the competitive environment, which helps in explaining how forces in the competitive environment shape strategies and affect performance. The framework as shown in Figure-I  suggests that there are competitive forces other than direct rivals which shape up the competitive environment. These competitive forces are as follows:

1) The rivalry among competitors in the industry

2) The potential entrants

3) The substitute products

4) The bargaining power of suppliers

5) The bargaining power of buyers




Figure I : Five Forces Analysis




Five Forces Analysis



However, these five forces are not independent of each other. Pressures from one direction can trigger off changes in another which is capable of shifting sources of competition. In the following section each of these five forces are discussed in detail as to understand how each of these forces affect an Industry’s environment so that one can identify the most appropriate strategic position within the industry.

1) Threat of New Entrants

Entry of a firm in and operating in a market is seen as a threat to the established firms in that market. The competitive position of the established firms is affected because the entrants may add new production capacity or it may affect their market shares. They may also bring additional resources with them which may force the existing firms to invest more than what was not required before. Altogether the situation becomes difficult for the existing firms if not threatening always and therefore they resort to raising barriers to entry. These barriers are intended to discourage new entrants and this may be done by organisations, be in any one or more ways, as discussed below:

a) Economies of Scale: Firms which operate on a large scale get benefits of lower cost of production because of the economies of scale. Since the new firm normally would start its operation at a smaller scale and therefore will have a relatively higher cost of production, its competitive position in the industry gets adversely affected. This barrier created through large scale of operation is not only applicable for production side but it can be extended to advertising, marketing, distribution, financing, after sales customer service, raw materials, purchasing and Research and Development as well. For example, you would have noticed in durable industry the kind of investments which players like Samsung and LG do on advertising and promotions normally and specially during events like World Cup cricket match. This makes it nearly impossible for any new third player to launch and sustain such intensive and investment driven maketing attack.  

b) Learning or Experience Effect: The theory explaining the experience curve or the learning curve suggests that as firms produce they grow more efficient and this brings them cost benefits. The efficiency levels achieved is an outcome of the experience, which teaches the organization better ways of doing things. This again keeps any new entrant at a disadvantage. 

c) Cost Disadvantage Independent of Scale: New entrants may face disadvantages which are independent of the operations. It may be on account of the lack of proprietary product knowledge such as patents, favourable access to raw material, favourable locations, existing plants built and equipped years earlier at lower costs, lower borrowing costs etc.

d) Brand benefits: Buyers are often attached to established brands. Differences in physical or mere perceived value make existing products unique and the new entrants have to tire out to beat such brands and change the mindset of the customers.

e) Capital Requirements: High investments required for a start up in any business is another deterrent for new entrants bringing down the possibility of increased competition.

f) Switching Costs: Switching costs, which is nothing but the expenses (financial or psychological) which a customer incurs in switching from one seller to another. Cases where such an expense is higher, new entrants find it difficult to establish or survive. Such costs may be because of a strong brand association or the comfort level a customer may be enjoying or it may be on account of a particular technology like Windows operating systems which most customers use and therefore will find it inconvenient to switch to a system like LINUX so easily.

g) Access to Distribution Channel: Any such critical activity like distribution channel in the business can be a barrier for the entrants when accessibility to them is found to be difficult. Most existing firms in FMCG industry are found to have a strong favourable distribution channels which is very difficult to penetrate. For example in India you can think of HLL which commands a deeply entrenched distribution network.

h) Anticipated Growth: Incumbents in a rapidly growing market are less likely to respond to a new entrant when the market’s growth offers enough opportunities to share. But a new entrant position will be opposite in a slowly growing market. In addition to the above, few general entry barriers exist in each industry’s case, for example, regulatory policies, tariffs and international trade restrictions are few such additional factors.

2) Bargaining Power of Suppliers

Business organizations have a large dependency on suppliers and the latter influence their profit potential significantly. Suppliers’ decisions on prices, quality of goods and services and other terms and conditions of delivery and payments have significant impact on the profit trends of an industry. However, suppliers’ ability to do all these depends on the bargaining power over buyers.
 

Suppliers’ bargaining power would normally depend on:


a) Importance of the Buyer to the Supplier Group: The size of the supplies taken by a particular buyer is likely to put the buyers in a relatively advantageous position. The same may be found true if the supplier tends to get an image advantage by supplying to a particular firm. Consequently in dealing with such buyers, suppliers’ bargaining power is naturally reduced. Just opposite happens when buyer is not so important to the supplier and the latter then is less likely to offer favourable terms to win or retain the customer.

b) Importance of the Supplier’s Product to Buyers: Here the position may just be opposite of the above situation where suppliers have a better bargaining power coming from their sheer size or image.

c) Greater Concentration Among Suppliers than among Buyers: An industry, which is largely dominated by a few large firms is a highly concentrated industry. Such few firms hold greater power with them as the proportion of the industry’s total output is in hands of such large firms. This gives such firms greater power over those who do business with them. The converse is true when industry has low concentration in suppliers. A higher concentrated supplier position may be possible on account of the sources of raw materials available, R & D or patent rights available with fewer firms.

d) High Switching Costs for Buyers: In this case buyers suffer because of the suppliers’ advantageous position or by the nature of supplies itself, the buyers have to face a higher switching cost.

e) Credible Threat of Forward Integration by Suppliers: Suppliers in a given situation may see an opportunity in moving up the value chain and may seriously think of getting into the business of what its buyers have been doing till now. Any indication of that nature from supplier side puts the buyers at the receiving end as they feel threatened because of a new player in that market and of losing an assured source of supplies. A recent example may be of Reliance which has decided to move from exploration and refining of oil to sealing of oil through its own retail petrol pumps.
 

3) Bargaining Power of Customers
 

Customers with a stronger bargaining power relative to their suppliers may force supply prices down or demand better quality for the same price and may demand more favourable terms of business. For instance, there will always be a difference in the bargaining power between an individual’s buying different construction material like cement, steel or bricks and a real estate builder buying them for the number of properties he may have been building over so many years.
 

Few of the following facts attach greater power to buyers:
 

a) Undifferentiated or Standard Supplies: A supplier, given the nature of products it supplies, may have a very limited choice in providing any differentiated products and this enables a customer to get the deal at the most favourable terms. In a perfectly competitive market situations with large number of suppliers, prices automatically are at their lowest.

b) Customer’s Price Sensitivity: Customer’s buying behaviour vary with respect to their sensitivity to prices. Depending on how important the item is for the customer’s usage and proportion he may be spending on the item concerned, buyers’ sensitivity to price varies. Any customer with high price sensitivity gains advantage in its bargaining power.

c) Accurate Information about the Cost Structure of Suppliers: A more informed customer is capable of negotiating with suppliers. Whenever such customers notice a decline in the supplier’s costs they would always bargain for a proportional decrease in price. This aspect is more relevant in today’s context of global markets where cost benefits can come from anywhere in the world at any point in time for various reasons. There may be a general decline in prices of a product in world market because of a glut situation or somewhere some new discoveries may have pulled the prices down.

d) Greater Concentration in Buyer’s Industry than in Supplier’s Industry and Relatively large Volume Purchase: This means that buyers are large and more powerful than suppliers. Government departments like police department when negotiating for large orders of security weapons or intelligence equipments will necessarily command a greater hold than its supplier as there will be only few number of such institutions buying them at a given point of time.

e) Credible threat of Backward Integration by Buyers: Different from forward integration which suppliers tend to attempt at, buyers in order to hold their position stronger in the market may integrate in backward manner. This will mean that the buyer extends itself to the previous stage of manufacturing or distribution for which it had been dependent on suppliers till now. An example could be of an entertainment channel which airs programmes outsourced from organizations producing them outside, get into the business of producing its programmes in house.
 

4) Threat of Substitutes

Often firms in an industry face competition from outside industry products, which may be close substitutes of each other. For example, with the new technologies in place now the electronic publishing are the direct substitutes of the texts published in print. Similarly, newspaper find their closest substitutes in their online version, though it may be a smart strategic move to position them as complementary products.

However, the competitive pressure, which any industry may face, depends primarily on three factors:

1) Whether the substitutes available are attractively priced;

2) Whether buyers view substitutes available as satisfactory in terms of their quality and performance;

3) How easily buyers can switch to substitutes.



Generally it is observed that the availability and acceptability of substitutes determine an upper price limit to a product. When relative prices of the product in question rise above that of the substitute products, customers tend to switch away from them.

5) Competitive Rivalry

The level of rivalry is minimum in a perfectly competitive market where there are large number of buyers and sellers and the product is uniform with everyone. Same is true for a monopoly market where there is only one player and the type of product is also one. However in case of oligopoly or monopolistic competition, where you will find few players and the market conditions allow them to differentiate their products and services, competition if found to be fierce. Few of the following factors explain the level of rivalry:

a) The Stability of Environment: An unstable environment is likely to call for a hyper-competitive situation and of the several factors that affect stability could be technological innovation, changes in government regulations, customers’ profile and their needs. In an industry which witnesses high movements in terms of entry or exit, the rules of the game may change too frequently. One of such

instances of fierce competition could be noticed on account of the onslaught of new technologies like CDMA affecting the general environment of telecom industry in India. The entry of Reliance India Mobile with CDMA technology intensified the rivalry between telecom players to such an extent that the government had to intervene through its institution, Telecom Regulatory Authority of India (TRAI).


b) The Life Expectancy of Competitive Advantage: There are industries for example consumer electronics or white goods in which the fruits of innovations do not last longer and hence the companies do not even bother to patent them.


This has an adverse implication for the stability of the competitive environment leading to intense rivalry. Length of innovation cycle, patent protection or switching costs between rivals are few factors, which may impact the life expectancy of competitive advantage.

c) Characteristics of the strategies pursued by competitors: This also has or may have an impact on the general approach to rivalry. For example, in a market segmented approach on part of the competitor leads to lesser rivalry situation. Also the kind of goals, which competitors pursue has an impact on the rivalry. Competitors pursuing the goal of increased market share will lead to increased rivalry again.

Lastly, few implications can be picked up from the five forces framework itself. Lower threats to entry or a higher possibility for substitutes have the potential of increasing rivalry. A lower engagement between supplier will result into a lesser rivalry. So will be the effect when buyers face higher switching costs.


In an overall assessment, two critical observations regarding rivalry can be made here. First a powerful competitive strategy employed by one rival can greatly intensify the competitive pressure on other rivals. Second, the frequency and rigor with which rivals use any or all competitive weapons at their disposal can be a major determinant of whether the competitive pressures associated with rivalry are cut throat, fierce, strong, moderate or weak. 

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