When developing a strategy for any business ‘competition’ plays a major role. Often though, this term is viewed with too narrow a scope. In the fight for market share, your ‘competition’ is not only your rivals, but rather the underlying economic forces of your industry.
Before deciding on a strategy for your business it is important to do some research on your industry. Why is the industry structured the way it is? What competitive forces within the industry are influencing this structure? How can I profitability position myself in this industry? Porter’s 5 Forces is a simple, yet powerful model that can help you answer these questions.
Porter’s 5 Forces is a tool used to assess the level of competitive intensity within an industry. Understanding this is important to help you to determine the attractiveness of an industry, and by recognising these things that can affect your profitability within the industry, you will be able to adjust your strategy accordingly.
So what are these 5 forces?
This refers to the quantity and quality of your competitors. How many competitors do you have? How does their product quality compare to yours?
In industries where rivalry is fierce, your suppliers and buyers can always go elsewhere if they aren’t getting the best deal from you. However, in industries where competitive rivalry is limited, which can be due to being in a niche market, product differentiation, brand loyalty and more, you’ll likely hold a strong and profitable position in the market. Keep in mind though, the threat of new entrants in such markets.
Threat of New Entrants
Other business’s ability to enter into your industry can affect your position within it. Consider how easy it is for rivals to come into your industry. How much does it cost? How securely is your sector regulated?
A notably profitable industry which takes little effort and financial input to enter will attract new entrants, which in turn will increase the competitive rivalry and decrease the profitability of existing businesses. However, if there are strong barriers to entry, such as patents and government regulations, you will be able to achieve a more favourable position.
Threat of Substitution
This refers to the likelihood of your customers finding an alternative to your product. The more products there are in an industry, the more likely your customers will be drawn to an alternative choice, which can threaten your business’s profitability. Ask yourself the following questions: How many substitutable products are there for your own? Is there a clear differentiation between your product and theirs? Is there a cost to the buyer for switching?
Supplier power is determined by how easily your suppliers can increase their prices. Consider the following: how many potential suppliers does your business have? Is there a level of differentiation between suppliers? Is there a cost to switch between suppliers?
The more potential suppliers you have, the easier it will be for you to switch to a cheaper substitute. However, the fewer suppliers there are, and the more you rely on them, the stronger their position and ability to charge you more. This can impact your business’s profitability.
Buyer power refers to how easily your buyers can drive down your prices. This is determined by the following: How many buyers do you have? What are their order quantities? Is there a bigger cost for them to switch to one of your rivals?
Your buyers have higher bargaining power when supply outweighs demand in your industry. This gives buyers the ability to urge suppliers to offer higher quality products at lower prices. This buyer power is decreased however, when demand outweighs supply.
From this industry assessment you will be able to identify your business’s strengths and weaknesses and how they relate to your ability to overcome these competitive forces, to help create your business strategy. The key to a profitable business is to assert an industry position that is less susceptible to head-on attacks from industry rivals, new or existing, and to any losses from the direction of buyers, suppliers and substitutes. Establishing such a position can result from many different factors, such as product differentiation, strong product branding, and building strong customer relationships.