I previously looked at What Is Industry Analysis and promised that I would tell you more about Michael Porter's famous Five Forces Model which is a centre point of his classic "Competitive Strategy" book.
The Sources of Profit
The principle behind Michael Porter's ideas is that profit only comes from two sources:
- Operating in an industry with an attractive structure as defined by the five forces model
- Having a sustainable competitive advantage
Michael Porter argues that the Five Forces model identifies the key factors which determine the average profitability of an industry.
Michael Porter Five Forces Model
The five forces are:
- The threat of new entrants
- The bargaining power of customers
- The bargaining power of suppliers
- The threat of substitutes
- The rivalry among existing firms.
How The Five Forces Model Works
Customers, suppliers and competitors compete for value created by the industry which is limited by substitutes or alternative solutions to the underlying customer need.
The ideal industry is one where both suppliers and customers are weak, any new companies would find it very difficult to enter the market effectively and competitors focus on enlarging the total industry profits rather than competing away profits unnecessarily through crazy pricing because there are no viable substitutes.
When Is The Five Forces Model Most Effective
I believe that the Five Forces model often gives more insight when you are considering entering a new market than for small businesses already firmly entrenched in existing markets. This is because it helps to identify the threats to making superior profits.
This problem of putting the Five Forces model to work has led to people struggling to gain much insight about what to do next in their current markets.
The options are limited:
- Can the business influence the five forces? Most small businesses can't.
- Can the business protect itself from any damaging forces or take advantage of opportunities that come from favourable changes?
- Can the business move to into an area of the market where the forces are less of an issue?
- Should the business exit this market and move its attention and resources elsewhere?
However I do believe that any business that occupies a strategic position in its market should periodically work through the five forces model and see what new insights it brings.
Industry Evolution Is Monitored By The Five Forces Model
All industries and local economies are constantly evolving and Michael Porter's Five Forces model is a proven technique for analysing industries and markets so that you identify threats and opportunities early.
Without a framework like the Five Forces Model, it is very difficult to identify all the issues that are changing and I will be looking at the threat of new entrants, buyer and supplier power, substitutes and competitive rivalry in more detail.
More Details On The Five Forces Model
Michael Porter's model deals with some very big issues and is therefore too complicated to deal with in one blog posting.
Buyer Power & Supplier Power - two sides of the same coin