An Evaluation of Porters Five Forces Model - Essay Example

An Evaluation of Porter’s Five Forces Model It is important for industry managers, economists, financial analysts and investors as well as others to be able to get a basic understanding of an industry or the market within which it operates. Such an understanding assists individuals to understand the nature of competition and to formulate strategy as well as to determine if it is worth investing in an industry. Whereas many models which attempt to explain an industry and its market environment have been presented by various authors, Michael Porter’s Five Forces Model is one of the most widely accepted models for a fundamental analysis of an industry and the competition in its market. This model has become widely known, discussed and applied to various markets or industries. Porter’s Five Forces Model attempts to explain the forces which operate in the market with a potential to reduce the profitability of a firm as a result of the interests of various actors which are a part of the market, or who interact with the industry. Although consideration of Porter’s Five Forces model is essential for any analysis related to an industry or a market, the model also presents some limitations when it is used for the analysis of dynamic, global markets in which fast innovation, technology change and a rapid change of players has come to be accepted. This essay presents an explanation of Michael Porter’s Five Forces Model and examines some of the model’s limitations. Contents Introduction 5 Porter’s Five Forces Model Explained 7 The Limitations of Porter’s Five Forces Model 11 Conclusion 12 References / Bibliography 14 List of Figures The Five Forces Described in Porter’s Five Forces Model 7 Introduction Existing industries and those players who are about to enter a market, as well as the investors who want to make an investment in an industry need to understand the competitor dynamics associated with the industry or market. Such an understanding is necessary for the assessment of the potential investment opportunities associated with a venture so as to provide a better assessment of the returns which can be expected, sound business or strategic planning and how the products or services which are being offered by an industry player may be differentiated or enhanced from what is being offered by the competitors. Various models have been offered to assist with such an analysis including the Strengths, Weakness, Opportunities and Threats or SWOT model, Igor Ansoff’s Gap Analysis model, the resource based model and Michael Porter’s Five Forces Model (Porter, 1998) and (Quick MBA, 2005). Michael Porter’s Five Forces Model is one of the most popular and respected model which attempts to provide a greater understanding of the business environment of the industry and its relative attractiveness. The five forces which are considered to be important in influencing competition in Michael E. Porter’s model include the risk of new competitors entering the industry to influence the business environment, the threat of potential substitutes which can influence the demand for a product or a service, the bargaining power of suppliers which can influence the supply of the product or service into the market, the bargaining power of the buyers who can switch their buying decisions in terms of the volume of purchases or totally switch to other suppliers and the degree of competition amongst the existing competitors in the industry or market as far as their efforts to capture the market are concerned. As a result of the insights that industry managers are able to develop in their attempts to understand these forces, it is possible for an existing industry or a new entrant in the market to develop a strategy which will provide them with an edge over their rival firms. Michael Porter’s model is based on the premise that corporate strategy should be charted after a consideration of the opportunities and threats in the external environment of the firm (Quick MBA, 2005). Michael E. Porter’s Five Forces Model was described and presented in his book “Competitive Strategy: Techniques for Analyzing Industries and Competitors”. Since it first appeared, the Five Forces Model has been widely used in the strategic planning for business and marketing. Some of the more common strategies which a firm may adopt as a result of the study of the five forces acting on the industry or the market include attempts to develop an overall cost leadership so that the firm can compete on the basis of the lower price structure that is being offered, a differentiation of products / services resulting in novel products or services that are difficult to imitate or substitute and attempts to concentrate on a niche market which is either geographically isolated or which is too small to attract serious competition. In reality, the strategic response of firms can be more complex then the simple strategies which have been previously presented. Porter’s Five Forces Model essentially concentrates on the factors which reduce the profits of the industry and this should be obvious if one thinks about how increased competition, product / service substitution, buyers switching to other products or services, suppliers attempting to increase prices or the market becoming affected by substitutes can only reduce industry profits as a whole (Porter, 1998). Despite its popularity and ready acceptance as a reasonably good model for the forces which act within a market, Porter’s Five Forces Model also has some limitations. As an example, the Five Forces Model only considers the external forces which have an impact on a firm, without considering what happens within the company. Issues arising out of the views of the stakeholders, cultural considerations, business ethics and corporate governance which influence organizational purpose are not considered (Recklies, 2001). In this essay, an attempt has been made to explain as well as evaluate Porter’s Five Forces Model for industry analysis. Porter’s Five Forces Model Explained The five competitive forces which are described in Porter’s Five Forces Model are discussed below (Porter, 1998), (Quick MBA, 2005) and (Recklies, 2001): The Five Forces Described in Porter’s Five Forces Model (Recklies, 2001) Bargaining Power of the Suppliers: All goods and services which a firm is able to produce depend on the material or service inputs which are provided by a number of suppliers. A firm then adds value to these inputs in order to produce its own products which are sold to its customers. The suppliers are also interested in their own profitability, even though they may want the industry to which they supply to thrive so that they have a stable and secure source of income. Suppliers are better able to exercise their power if the market is dominated by relatively few of them and it is difficult to find a substitute for their particular input. The industries to which the suppliers provide an input may be few and fragmented, without a cohesive stance for bargaining with the suppliers. Suppliers are also able to present a stronger bargaining position if the product or services that they provide are complex and the industries cannot switch to new suppliers easily. These suppliers will try to adopt a strategy which will enhance their profits especially if the profitability of the industry to which they supply is higher then their profitability, the buying industry has low barriers to entry or the buying industry attempts to hinder the supplying industry by not accepting new products. Volatility in the behaviour of the suppliers to an industry can cause serious problems to the industry and hence attempts are made to maintain stable, long term relations with suppliers after they have been carefully selected. Bargaining Power of Customers: The customers of an industry, especially the larger customers, are able to exercise a certain amount of say in the prices, quality as well as the supplying policies of the industry that they are dealing with. There may also be a desire to have the industry supply products to a certain specifications. The buying power of the customers can be exercised better when there are a large number of small suppliers or the buyers can produce a product or service themselves. If the supplying industry operates with a high fixed cost to supply complex and expensive products, then any switching by customers is likely to result in large losses to the suppliers. If the customers know about the production costs of a product, or if the product is not strategically important to them, then the customers are in a better position to negotiate with the supplying industry in order to get lower prices. This is also the case in a situation when the product can be easily replaced by substitutes or alternative products without incurring a high cost. Threat of New Entrants: If it is easy for new entrants to enter the market, then the competition in the market will be higher, because a lot more firms may try to gain a slice of the market in order to make a profit for themselves. Barriers which exist to prevent new entrants from joining an industry include the high cost of establishing facilities to provide the product or service, established customer agreements with existing suppliers to provide the required products or services, Difficulties associated with accessing the raw materials or expert human resources for manufacturing a product or providing a service due to existing supplier agreements, shortage of highly skilled manpower as well as a lack of distribution channels as a result of existing distribution agreements are some of the barriers to new players entering the market for a product or service. Brand loyalty by customers, patent or copyright protection as well as high switching costs for customers, government legislation or preferences for certain types of suppliers as well as the requirements to have a substantially large investment in order to effectively compete on economies of scale and mass manufacturing will also be deterrents for new market entrants. Industry policy and public interest requirements which are usually implemented by the government will usually result in there being a sufficient number of producers with a certain level of excess capacity to provide a product or service, so that shortages and sharp increases in prices do not destabilize markets. Threat of Substitutes: It is usually possible to have substitutes for all products or services. As an example, bottled soda type fizzy drinks can be substituted by manufactured water soluble powdered type drinks such as Tang. If the price of substitute products were to decline or a major marketing initiative was to be launched by the substitute product manufacturers, then it is very likely that a shift in consumer preferences will occur. Factors which can influence the switching behaviour of consumers to substitutes include switching costs for consumers, the relative price and performance of the substitute, brand loyalty for the existing product and any fads or trends which may exist in the market that will influence the consumers to try out new substitute products. Competition within the Industry: Competition within the industry refers to the nature and intensity of the rivalry or competition between the players who are together in the same industry. Intense competition will result in pressure in prices as different players attempt to capture a larger share of the market. Some of the factors which can result in an increased level of competition within the industry include slow growth within the industry which results in all competitors trying very hard indeed to increase their bottom line results, high exit costs which mean that it is likely to be very expensive to close down the existing line of business in order to try something new because of the heavy financial investment in expensive plant or equipment, high operating costs and relatively low profits, a large number of competitors with the same strengths, weaknesses as well as strategies and a lack of product differentiation with many firms selling products of identical specifications so that it is not possible to differentiate between them. Low switching costs for buyers as well as the requirement to accept orders in large quantities in order to sustain economically viable operations will also result in enhanced competition. Generally, enhanced competition will mean that prices will drop as firms try to capture markets by selling cheaply or enhance the quality of their products / services by investing in improving these. The results of enhanced competition can mean that profits may drop, but the consumers will enjoy lower prices and better products or services. There is a basic requirement for an understanding of the five forces which operate in an industry and such an understanding is considered to be essential for the analysis of the industry or for strategic planning. It is only by understanding the nature of the industry and formulating the correct strategy for a firm that managers can hope to achieve the desired levels of profitability as well as other growth objectives for a firm. Managers attempt to adopt measures that will minimize the profit reducing impact of each of the five forces on a firm. Some measures which can reduce competition in the industry may include efforts to avoid price competition, having products which are somehow different from those of the competitors, having an ongoing dialogue with the competitors about issues facing the industry as a whole and acting jointly to resolve these issues, attempting to buy out competitors, investing in capacity after an evaluation of the market requirements as well as focusing on different segments of the market. The impact of the bargaining power of suppliers may be reduced by entering into partnership agreements, better managing the supply chain by using information technology, developing a better understanding and deeper relationships with suppliers through supplier training or investment and attempting to make some suppliers more dependant on a firm. Similarly, the buying power of the customers may be reduced by entering into some form of partnership with other suppliers, trying to increase brand loyalty, better managing the supply or distribution chains, removing intermediaries to go directly to the consumers, offering products with better quality, service or features so that the buying decision is not made on price alone and enhancing other incentives which may be provided to customers. The threat of substitutes may be reduced by taking legal action against those who have products that infringe on the patents or copyright of a firm, attempting to differentiate a firm’s products, trying to enter the substitute product market, increasing the costs associated with switching to substitutes and generally trying to be more responsive to the needs or the requirements of the customers. Having substantial and well run operations can deter new entrants into the industry. Having an established brand image and customer loyalty will mean that there will be a lowered possibility of customers switching to new offerings. It is also important to try and establish better relationships with a firm’s suppliers or distributors so that they can be counted on if new entrants attempt to enter a market. A firm’s intellectual property and products need to be protected using patents, non – disclosure agreements or other techniques. Alliances should also be attempted to be built with suppliers of linked products or services which work together with the product or service being provided (Recklies, 2001) and (Quick MBA, 2005). Even though Porter’s Five Forces Model is an essential requirement for the formulation of a strategic plan, the model has some limitations which are discussed in the next section of the essay. The Limitations of Porter’s Five Forces Model Despite being able to provide basic insights into a market, Porter’s Five Forces model does have some limitations. Although the external environment is considered in the model, this model does not consider the strengths or weaknesses of a firm, which are known as its core competencies. In their 1990 paper “The Core Competence of the Corporation”, Prahalad and Gary Hamel argue that a firm should be built around a core of shared competencies which are difficult for others to imitate. Porter’s model assumes that firms are competing in a classically perfect market, which is deregulated. Hence, the model starts to become ineffective for a regulated market. Although Porter’s model works well with simple market structures or individual business strategies, it cannot fully explain a situation involving large corporations which may have multiple products, complex interrelations, synergies and interdependencies because attempting to narrowly focus on a particular segment of such organizations can result in some important factors related to their functioning being left out. The model presented by Michael Porter attempts to explain markets in terms of competition, but ignores the advantages which a firm can gain as a result of the application of technology, use of information technology and the development of strategic alliances. The markets today can be far more dynamic then they were at a time when the model was presented. The markets of today are characterized by rapid change involving technology breakthroughs, new entrants and global linkages. Porter’s model concentrates on existing markets, however, it is now considered necessary to create new markets in which the existing competitors may be irrelevant. Launching completely new industries or attempting to manufacture for exports only can create new markets in which there may not be any competition. Disruptive innovation brings to a fore new technology which can cause the older, established firms to fail because the new innovations offer better value for money or a greater ability to fulfil the wants of customers. It has been stated in published literature that Porter’s Five Forces Model presents significant limitations in the market environment of today which is characterized by dynamism as a result of globalization, complex government intervention and the impact of innovation. However, the Five Forces Model still presents managers with a starting point for industry analysis and this is useful in the formulation of comprehensive strategy (Recklies, 2001) and (12Manage, 2005). Conclusion The Five Forces Model presented by Professor Michael E. Porter presents a good starting point for managers, investors as well as strategists to start on their analysis of an industry within a market, by presenting the most fundamental competitive forces that operate within the market. However, the markets of today are characterized by greater dynamism, complex interventions, rapid entry and exit by new players, technology innovation as well as complex alliances. These are forces which have not been adequately addressed in the Five Forces Model. Corporate strategic planners will, therefore, most certainly consider Porter’s model in their attempts to formulate strategy, but will most probably go beyond Porter’s model to analyze markets or industry in greater depth. References / Bibliography 1. 12Manage. (2005). Five Competitive Forces (Porter). 12 Manage. Com. Retrieved: October 25, 2005. From: http://www.12manage.com/methods_porter_five_forces.html 2. Porter, Michael E. (1998). Competitive Strategy: Techniques for Analyzing Industries and Competitors. Free Press. Retrieved: October 23, 2005. From: http://www.amazon.com/exec/obidos/tg/detail/-/0684841487/ref=ase_quickmba/002-2453657-4540030?v=glance&s=books 3. Quick MBA. (2005). Porter’s Five Forces: A Model for Industry Analysis. Quick MBA. Retrieved: October 23, 2005. From: http://www.amazon.com/exec/obidos/tg/detail/-/0684841487/ref=ase_quickmba/002-2453657-4540030?v=glance&s=books 4. Recklies, Dagmar. (2001). Porter’s Five Forces. Recklies Management Project Gmbh. Retrieved: October 24, 2005. From: http://www.themanager.org/pdf/p5f.pdf Read More