How to understand industry profitability with Porter’s five forces
Updated: Oct 15, 2021
Let’s say you are doing the #MarketingPlan for your new business and need to evaluate and select the market’s segment you want to serve, how can you do it? Or maybe you have an already operating business and want to catch an opportunity by expanding or switching your target market. How can you measure the profitability of this maneuver?
Keep reading to discover how Porter’s five forces help marketers in strategic management.
Table of contents
WHAT ARE PORTER’S FIVE FORCES
In March 1979, Harvard Business Review published How Competitive Forces Shape Strategy, an issue featured by the professor of Harvard University, Michael E. Porter, who shook up marketers with his new framework for analyzing industry attractiveness.
In 2002, The Academy of Management Executive released An Interview with Michael Porter by Nicholas Argyres and Anita M. McGahan, where the professor claimed to struggle teaching the SWOT analysis model at Harvard Business School: he believed it lacked rigor. That’s why he started seeking a new framework based on statistical tests and case studies:
The prevailing SWOT model of strengths/weaknesses/opportunities/threats was based on the idea that every case is different and that the relevant considerations are company-specific. As I was struggling to teach using the SWOT framework at HBS, I set out to add more rigor.
The five forces framework
Porter’s five forces is an amazing tool enabling organizations to evaluate the profitability of a market or industry.
It is based on five forces that affect attractiveness: competitive rivalry, supplier power, buyer power, threat of substitution and threat of new entry.
This framework lays on the structure-conduct-performance (SCP) paradigm which considers the market an ecosystem where everything is connected.
This paradigm, first published by Edward Chamberlin and Joan Robinson in 1933, was further developed by Joe S. Bain, an economist who greatly influenced Porter’s work.
Market environment has a direct and short-term impact on the market structure. There are mainly two types of structures: a market without any interference and limitation from governments (Adam Smith’s laissez-faire model) or with the presence of a controlled economy (Karl Marx’s model).
Anyway, a market structure directly affects companies’ economic behavior (conduct) which in turn determines market performance.
All of these elements are interconnected and influence each other.
How many rivals do you have? Who are they and how does the quality of their products and services compare with yours?
Knowing the level of competitiveness in the target industry is fundamental to market a product or service. Studying rivals allow marketers to figure out the right positioning and eventual competitive advantages that can make a difference for the audience.
Too many or aggressive competitors;
War of price;
Market’s competition expectation: is it flat or in decline?
How many potential suppliers do you have? How unique is the product or service that they provide and how expensive would it be to switch from one supplier to another?
Supplier’s bargaining power can become a real headache for a company. If you run short on raw material and only have a few providers, you need to play their game. For instance, if they decide to raise the price, you can’t do anything: you’ll be forced to keep buying from them and review your pricing for the final consumer.
They can decrease the quantity provided or change the delivery time (think of an e-commerce with a drop-shipping model: can you imagine how many complaints?);
They have power on price.
How many buyers are there and how big are their orders? How much would it cost them to switch from your products and services to those of a rival? Are your buyers strong enough to dictate terms to you?
When I was working as an E-commerce Manager in San Marino, I was in between the devil and the deep blue sea.
Cutting a long story short, we had two main buyers: pharmacies and Amazon. Pharmacies weren’t happy that we were selling to Amazon, because customers started preferring buy cheap online rather than in the physical stores. Amazon was able to make better offers, because it had almost total control on the sales price and lower operational costs than a pharmacy.
What happened next is that pharmacies started threatening us: they didn’t want to buy our products anymore!
So, how would you solve this dilemma?
This is an actual marketing problem for many sellers. Let me know your strategy in the comments below and let’s see if it corresponds with what I really did at that time.
Threat of substitution
A substitution that is easy and cheap to make, can weaken your position and threaten your profitability.
Substitutes are products or services that use different technologies to supply the same demand. For instance, a bicycle is the substitute of a scooter. Also meat, poultry and fish are substitutes. But Coke is not a substitute of Pepsi: they are just competitors.
Threat of new entry
How easy is it to get a foothold in your industry or market? How much would it cost, and how tightly is your sector regulated?
Organizations should establish their presence in a profitable market segment. If they enter into your industry, they can get in the way and decrease the overall profitability till it reaches zero (perfect competition: minimum requirement for an industry to stay in business; companies are not encouraged to enter or leave the industry).
Low entry barriers;