Porter’s 5 Forces Essay, Research Paper

Porter’s 5 Forces

With the wealth of information available today, businesses can find a wide variety of schemes visualizing the strategic planning process are available. In essence they usually consists of a series of steps or building blocks.

The analysis starts with defining the business and formulating a vision and then goes on to assess the internal and external environment. The strategic planning process ends with the financial budget and goes into a feedback loop

The essence of formulating a strategy is relating a company to its environment. Therefore the analysis phase is crucial to the outcome of the total planning process. A major part of the analysis phase is a diagnosis of the external environment. Several tools and techniques have been developed to assist the planners in evaluating the external environment. Of particular interest is the assessment of the profit potential in the industry.

Many years ago, most business analyzed themselves in a comparative sense. The comparative advantages of a business were determined through an economic theory, first developed by David Ricardo of England, that attributed the cause and benefits of international trade to the differences among countries in the relative opportunity costs (costs in terms of other goods given up) of producing the same commodities. In Ricardo’s theory, which was based on the labor theory of value (in effect, making labor the only factor of production), the fact that one country could produce everything more efficiently than another was not an argument against international trade.

The theory of comparative advantage is a strong argument in favor of free international trade and specialization among countries. The issue becomes more complex, however, as the simplifying assumptions (e.g., a single factor of production, a given stock of resources, full employment, and a balanced exchange of goods) are relaxed.

More recently, Michael C. Porter put forth the idea that competitive advantages were more important. In The competitive Advantage of Nations, published in 1990, Porter said that instead of trying to enter a market where there is little or no competition, a company should instead participate in national markets with the strongest rivals and most demanding customers. This is mainly due to the fact that in a closed, domestic industry, a company accustomed to weak competitors and undemanding customers has little to fear. In today’s global marketplace, such newly strong competitors are in no short supply. That is why it is important to understand one’s competition. (Yip, 1995)

Michael Porter’s Competitive Forces Model (commonly referred to as Porter’s Five Forces Model) is by far the most widely used framework for an assessment of the profit potential in an industry. The collective strength of the so-called five forces differs from industry to industry.

Each of those five forces is based on structural features (dimensions) which collectively impact the profit potential. All five forces jointly determine the intensity of the industry competition and profitability. The strongest forces become crucial from the point of view of strategy formulation.

Porter’s Five Forces are a framework for diagnosing industry structure, built around the competitive forces that erode long-term industry average profitability. The industry structure framework can be applied at the level of the industry, the strategic group (or group of firms with similar strategies) or even the individual firm. Its ultimate function is to explain the sustainability of profits against bargaining and against direct and indirect competition. The five forces are covered in more detail below.

Barriers to entry

These are the important structural components with an industry to limit or prohibit the entrance of new competitors. The major components are scale economies (advantage of experience, learning and volume), differentiation (brand image and loyalty), capital requirements (new entrants will face a risk premium), switching cost involved by the customer, access to distribution channels and cost disadvantages (patents, location, subsidies).

Some of the elements involved with the barriers to entry force are shown in the list below.

? Economies of scale

? Proprietary product differences

? Brand identity

? Switching costs

? capital requirements

? Access to distribution

? Absolute cost advantages

? Proprietary learning curve

? Access to necessary inputs

? Proprietary low-cost product design

? Government policy

? Expected retaliation

Rivalry among existing competitors

In most industries, especially when there are only a few major competitors, competition will very closely match the offering of others. Aggressiveness will depend mainly on factors like number of competitors, industry growth, high fixed costs, lack of differentiation, capacity augmented in large increments, diversity in type of competitors and strategic importance of the business unit.

Some of the elements involved with the rivalry among existing competitors force are shown in the list below.

? Industry growth

? Fixed (or storage) costs/value added

? Intermittent over capacity

? Product differences

? Brand identity

? Switching costs

? Concentration and balance

? Informational over complexity

? Diversity of competitors

? Corporate stakes

? Exit barriers

Substitutes

These are products or solutions that basically perform the same function but are often based on a different technology. Depending on the level of abstraction nearly everything can be a substitution. In general the only factor that really matters is a shift in technology.

Some of the elements involved with the substitutes force are shown in the list below.

? Relative price performance of substitutes

? Switching costs

? Buyer propensity to substitute

Power of buyers

Through their bargaining power buyers can force the competitors to lower their prices or force higher quality or better service. The major factors which determine the bargaining power are volume (relative to seller sales), does the product represent a major fraction of the buyer’s costs or purchases, differentiation or standard product, switching costs, buyer profitability (hence their price sensitivity), threat of backward integration, importance to the quality of the final product, and level of knowledge and information of the buyer of industry demand, actual market prices and supplier cost.

Some of the elements involved with the power of buyers force are shown in the list below.

? Bargaining Leverage

? Buyer concentration versus firm concentration

? Buyer volume

? Buyer switching costs relative to firm switching costs

? Buyer information

? Ability to backward integrate

? Substitute products

? Pull-through

Price Sensitivity

? Price / total purchases

? Product differences

? Brand identity

? Impact on quality / performance

? Buyers profits

? Decision makers’ incentives

Power of suppliers

Suppliers can exert their bargaining power over participants by threatening to raise prices or reduce the quality. A supplier group is powerful if they are more concentrated than the industry they sell to, or if the customer group is not important for the suppliers, if the product is an important input to the buyer’s business, or they have built up switching costs, or the supplier group poses a threat of forward integration.

Some of the elements involved with the power of suppliers force are shown in the list below.

? Differentiation of inputs

? Switching costs of suppliers and firms in the industry

? Presence of substitute inputs

? Supplier concentration

? Importance of volume to supplier

? Cost relative to total purchases in the industry

? Impact of inputs on cost or differentiation

? Threat of forward integration relative to threat of backward integration by firms in the industry

Strategy and industry analysis are vital for anyone wishing to compete, and utilizing Michael Porter’s ideas to their fullest extent can be the difference between success and failure. The following excerpt from Fortune says it best.

For Porter, much of what has passed for management thinking in the past decade may have been important, but it wasn’t strategy–and isn’t nearly as crucial as good strategy. “Strategy is not accidental. It is a purposeful process,” he says. “Luck is alive and well. Intuition is alive and well. But human beings have some control over their own destiny. And you can improve your odds of making better judgments.” (Surowiecki, 1999)

Porter’s skepticism about the idea that strategy is less important today than it once was is mirrored by his skepticism about the idea that the Internet will turn the business world upside down. “The arrival of the Internet will affect every industry in some way, but for 50% or more of the economy it’s not a transformational event,” he says. “It will have a powerful impact on the supply of information to customers and the relationship between companies and their suppliers, but it’s not like the automobile. You don’t have to change the theory of strategy to deal with the Internet.” (Surowiecki, 1999)

Porter points to the dominant players in the New Economy as classic exemplars of successful strategic thinking. “The average technology company is not all that gifted in terms of strategy,” Porter says. “But the most successful companies–the Dells, the Intels, the Ciscos–don’t think about strategy as incremental or impossible. They have a clear sense of what they’re trying to do and of how to do it.” (Surowiecki, 1999)

Bibliography

References

Surowiecki, James. The Return of Michael Porter. Fortune; February 1, 1999

Yip, George S.. Total Global Strategy: Managing for Worldwide Competitive Advantage. Prentice Hall, Englewood Cliffs, NJ. 1995

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