Porter’s Five Forces is a model that identifies and analyses five competitive forces that shape every industry and determine its attractiveness and potential profitability.
The model was developed by Michael E Porter, a professor at Harvard Business School, in 1979. Today, Porter’s Five Forces is still one of the most popular business tools used by owners and managers to analyse their marketplace’s competitiveness and identify opportunities and threats.
Porter’s Five Forces are:
1. The bargaining power of suppliers
How easy it is for your suppliers to negotiate price and other terms? How many potential suppliers could you work with? How unique are the products or services they provide? And how expensive would it be to change supplier?
Suppose you’re a small business that creates products using components that are only sold by a handful of suppliers. In that case, your suppliers have a lot of bargaining power because they know you may not be able to source their inputs elsewhere. Conversely, if the products you need are easy to get, your suppliers have less bargaining power – they know you can easily switch to an alternative that’s cheaper or offers more favourable terms.
2. The bargaining power of buyers
How many customers does your business have, and how much power do they have to drive prices down or dictate terms? Do you make a unique product or something they could easily find elsewhere?
If your company deals with a small number of powerful customers and your products and services aren’t particularly unique, your buyers may be able to drive prices down. On the other hand, if you have lots of independent buyers purchasing your products, you have more control to raise prices or change purchase terms.
3. The threat of new entrants
How easy would it be for a new competitor to enter your market? How much would it cost, and are there any barriers to entry (regulations, legislation, high MOQs) that might prevent them from doing so?
If it’s relatively simple and inexpensive to enter your market, you’re at risk of new entrants offering a similar product or service, weakening your competitive position and eroding your profits.
4. The threat of substitute products
Can customers buy other products or services instead of yours to meet their needs? Even if your business has no close substitutes, could buyers switch to an alternative product or service or opt for a DIY solution?
Companies that produce products or services with no close substitutes have more flexibility to dictate prices and terms. However, it’s easy to overlook substitute products that may not be immediately obvious as potential replacements for your products or services – think broadly when you’re assessing this particular one of Porter’s Five Forces.
5. Competitive rivalry
Think about the competition your small business faces. How many rivals do you have? How does the quality of their products and services compare with yours?
In ultra-competitive industries, your competitors can attract customers with aggressive marketing and low prices. Conversely, if competitive rivalry is low, you have more power to charge higher prices and set customer terms.
Together, these Five Forces provide a framework to conduct a thorough market analysis that assesses and evaluates a given market’s competitive intensity and attractiveness.
How to use Porter’s Five Forces to grow your small business
Porter’s Five Forces can simplify and streamline market analysis and help you to develop a business strategy that reflects your sector’s competitive landscape. The Five Forces should be revisited regularly and are particularly helpful at key decision points, including:
- Deciding to start a new business
- Evaluating your business’s growth and profit potential
- Assessing the effectiveness of a new business strategy
What to do with the results of your Porter’s Five Forces analysis
Once your business analysis is complete, you can create and implement a business strategy that aims to solidify and extend your competitive advantage. Porter recommends that companies pursue one of three generic strategies:
A cost leadership strategy sees your business position itself as a low-cost producer within your industry. To do this, you might look to reduce your operating costs, achieve better economies of scale or implement other cost reduction strategies. Implemented successfully, a cost leadership strategy will allow you to charge industry-average prices while improving your profits by reducing costs.
To pursue a differentiation strategy, you must make your products or services different from and more attractive than competitor offerings. To achieve this, you’ll need to choose one or more product attributes that matter to customers and provide a differentiated experience in this area.
Small businesses that use a focus strategy concentrate on specific niches where they understand customer needs and market dynamics well. A focus strategy requires an element of either cost leadership or differentiation when it comes to serving the chosen market. A business with a cost focus will seek a cost advantage in its target segment, while one pursuing a differentiation focus strategy will target product or service differentiation to a specific market niche.
Porter’s Five Forces has been a leading market analysis tool for decades due to its simplicity and effectiveness. By helping business owners better understand the competitive forces affecting their company, it’s a powerful tool to build and refine your business strategy.