“Understanding the forces that shape industry competition
is the starting point for developing strategy.”
-Michael Porter[1]
If you could only read one author on the topic of strategy, Michael Porter would win hands-down. Peter Drucker and Henry Mintzberg might be honorable mentions, but Porter literally wrote the book on strategy. In fact, he wrote nineteen books on strategy and competition.
He is a professor of Business Administration at the Harvard Business School. He “ is generally recognized as the father of the modern strategy field, and has been identified in a variety of rankings and surveys as the world’s most influential thinker on management and competitiveness.”[2]
In 1979, he published The Competitive Forces that Shape Strategy in Harvard Business Review. In 2008, he published an updated retrospective in HBR. What follows is an overview of both of these works.
In his writing, Porter moved beyond the idea of competitive advantage to consider how roles of competitors, customers, suppliers, substitute products and other factors shape entire industries.[3] While it is important to start with your core competencies, it is also important to move beyond them to shape strategy.
Winning the Game
First, stop trying to be “the best.” That sounds like odd advice, but think this through. Competition to be “the best” leads to intense rivalry that leads to negative outcomes. In Understanding Michael Porter, Joan Magretta explained:
Michael Porter has a name for this syndrome. He calls it competition to be the best. It is, he will tell you, absolutely the wrong way to think about competition. If you start out with this flawed idea of how competition works, it will lead you inevitably to a flawed strategy. And that will lead to mediocre performance.
For most managers, vying to be the best is what competition is all about. This belief is reinforced by popular metaphors drawn from warfare and sports. Management writers—and leaders trying to inspire people—are drawn to these metaphors because they are vivid and engaging. They lend emotion, drama, and consequence to business competition. But metaphors can be misleading. . . .
Competition focuses more on meeting customer needs than on demolishing rivals. Just look around. Because there are so many needs to serve, there are so many ways to win.[4]
If you are not competing to win, what should you be doing? Magretta continued, “For Porter, strategic competition means choosing a path different from that of others. Instead of competing to be the best, companies can—and should—compete to be unique.”[5]
The goal of business is not to eliminate your competitors but achieve profit. Successful businesses keep this in mind when they create their strategies. Those businesses that assume that the goal is to wipe out the competition often find out the hard way that they have been wiped out.
I do this sometimes when I play chess. I get so focused on eliminating my opponent’s pieces that I lose sight of my primary objective. While I was trying to take my opponent’s queen, he placed my king in checkmate. This can have business too if you are not careful. Remember, you do not win by driving your competition from the field.
The Five Forces
The five forces are those forces that affect every business in every industry. They include: Threats of new entrants, bargaining power of suppliers, bargaining power of customers, threats of substitutes, and rivalry as businesses jockey for position.[6] I will address each of these forces below.
Before I do, however, it’s important to note why these particular forces are important. The purpose of business is to please a customer.[7] If you do this well, you generate profit. Profit, then, is a way to measure success.
Rivalry with competitors is one way to lose profit, but it is not the only way. Suppliers can cause you to lose profit by charging more for raw materials. Customers can cause you to lose profit by pressuring you to discount. Substitutes can cause you to lose profit by diverting customers from your product to something else. The stronger each force is, the weaker your profitability will be.[8]
Let’s assume that you clear eight percent in net profits. This is higher than the national average. If the five forces become stronger in your particular industry, and they each cost you an additional two percent of net profit, you have gone from above industry average profitability to unprofitable. The essence of strategy, then, is to understand these forces and position yourself to succeed in your industry.[9]
Threat of entry
The five forces tell us that we are not just competing with rivals but with suppliers, customers, and substitutes. More competition is usually good for consumers. It forces companies to improve and it often drives down prices and forces companies to differentiate in ways that create additional value. Competition, however, is bad for profit.
Mike is a mechanic. There is nothing he cannot fix. If you make the sound that the car is making, he can tell you what problem is causing it. Since he was 6 years old, he has dreamed of starting his own car company. He has built or rebuilt many engines, and he believes he has the competence to build a car from scratch. His particular dream is to create a car more reliable than Toyota. How credible a threat is Michael to an established manufacturer like Toyota?[10]
The first of the five forces is the threat of new entrants. Certain barriers that make it difficult to compete can block new competitors. Porter lists a number of barriers to entry. As I list them, imagine that you are Mike. How long would it take you to design, produce, and market a new car? You might be able to build a car in a few months or maybe a few weeks. Toyota can build a new car in 17-18 hours.[11] How would these barriers affect Mike as would-be competitor?
- Economies of scale: The established firms can produce on a large scale and mass production can lower per unit cost. How long would it take a newcomer to match this cost reduction?
- Product differentiation: Established firms have earned customer loyalty over time. Toyota has customer mind-share for reliable automobiles. How hard would the newcomer have to work to overcome Toyota’s value proposition?
- Capital requirements: Sometimes, to enter a particular market, you need large financial resources. Toyota is presently spending one billion dollars to set up the new Toyota Corolla plant.[12] The price of admission to the car market is steep.
- Cost disadvantages independent of size: These are advantages accumulated over time from operating in the business. Every industry has a learning curve, and the mistakes associated with the learning curve are costly.
- Access to distribution channels: The other side of production is distribution. Established distribution channels provide the established firms an advantage over potential competition. Beyond the billion-dollar car factory, a newcomer would still need to establish his own dealerships. This poses an additional cost (and likely an additional gap in knowledge).
- Government policy: The government can create barriers through licenses, trade quotas, and other regulations. In your case, this will likely work in your favor as import quotas will work against Toyota. This will be cold comfort since the other barriers prevent you from entering the market (you do not have the billion for the factory or the knowledge to compete with Toyota head to head. For its part, Toyota has worked to overcome these import quotas by opening plants in Kentucky, Indiana, and Texas.[13]
In the revised version, Porter reconfigured this list to include customer switching costs as a seventh barrier to entry. If it is difficult for a customer to switch from your product to a newcomer’s product, this creates an additional barrier.
Just the appearance of these barriers keeps potential competitors at bay. On the other side, it is also worth noting that potential competitors do not even have to enter the market in order to cause current producers to be less profitable. Think about the $7 billion that we now spend on the TSA because of the mere threat of terrorism in the airline industry. As long as a threat is credible, the government has to respond, and they pass the cost on to the airlines and ultimately to consumers. In the same way, the mere threat of entry requires incumbent businesses to take actions that will cause them to be less profitable.[14]
The Power of Suppliers
Suppliers are an overlooked force that can have a tremendous impact on a company’s bottom line. According to Porter:
Suppliers can exert bargaining power on participants in an industry by raising prices or reducing the quality of purchased goods and services. Powerful suppliers can thereby squeeze profitability out of an industry unable to recover cost increases in its own prices.[15]
He offered the example of Microsoft in the computer industry. The Microsoft operating system has become the universal standard. Because computer manufacturers need this standard software, Microsoft diverts profits from the computer hardware manufacturers.[16] Likewise, Intel positioned itself as the industry standard for microprocessors, and they also divert profits from manufactures that cannot switch easily to an off-brand. Such pressure ultimately forced International Business Machines (IBM) out of the computer manufacturing market.[17] IBM, the computer hardware standard in the 1980s and 1990s, sold the personal computer division to Lenovo in 2005, a Chinese tech company for $1.25 billion.[18]
The dynamics are different in every industry, but as a force acting on your business, suppliers are more powerful if they are consolidated, if they sell unique products that you cannot get elsewhere, if they might credibly compete with you, or if you are not an important customer to their bottom lines.[19]
Customers
We normally think of customers as positive forces because we associate them with revenue and growth, but, “customers likewise can force down prices, demand higher quality or more service, and play competitors off against each other—all at the expense of industry profits.”[20] Customers are a powerful force if you are dependent on a few for a large share of your business, if you sell a common product that can be substituted easily, or if they are especially price-sensitive.[21] The defense against price sensitivity is product differentiation and the creation of new value.
Many producers dream of getting into Wal-Mart because few other distribution channels reach so many people, but if they do, they will encounter a different problem. Because of this reach and the volume Wal-Mart will purchase, it can also dictate that these producers sell their goods at extraordinarily low prices. They will sell their goods to Wal-Mart at a steep discount. As you know, Wal-Mart then passes those savings onto the customers.
Snapper had a brand reputation built on quality. Snapper costs more, but some customers will gladly pay more because they appreciate the quality. They found that their strategy was incompatible with Wal-Mart’s. Getting in at Wal-Mart all but guarantees sales, but it also guarantees small margins. For that reason, Snapper walked away from their deal with Wal-Mart, choosing instead to sell their high-quality lawnmowers through a network of small, independent dealers.[22] The defense against overwhelming customer power is to defuse that power.
Substitute Products
Unless your product is differentiated from others, you open yourself to another devastating force—substitution. A substitute “is a product or service that a consumer sees as the same or similar to another product.”[23] Unless what you sell provides something that is difficult to replace, a cheaper competitor can steal customers by providing essentially the same thing for less money. In Snapper’s case, most Wal-Mart shoppers saw one lawnmower as good as the next. Consumers who went to small dealerships were more discerning about lawnmower quality.
Substitutes may be direct. If you’re hungry and you have not yet eaten lunch, a Burger King Whopper may be an acceptable substitute for a McDonald’s Big Mac. To a customer’s mind, one may be as good as the other. The difficulty is that sometimes are indirect and we don’t recognize all the substitutes that threaten our business. Subway, Taco Bell, and Chick-fil-A are also substitutes for a quick, and expensive lunch.
The same is true in your industry. You must recognize which substitutes may threaten your business, and you must account for all the substitutes in order to defend against this threat.
Rivalry
Rivalry is the competitive force that most managers focus on because it is most obvious. The more intense the rivalry, the more potentially damaging it is to profitability. Porter explained, “rivalry is especially destructive to profitability if it gravitates solely to price because price competition transfers profits directly from an industry to customers. Price cuts are usually easy for the competitors to see and match.”[24]
Rivalry is stronger when there are many competitors of similar size, growth is slow, products lack differentiation, and when there are barriers to exit the industry.[25]
As many companies focus on increasing their market share, they invent strategies designed to undercut rivals in order to attract customers. After all, gaining a little less profit from new (e.g., someone else’s) customers is better than gaining no profits from them. They are willing to spend a little more in added services or earn a little less in revenue through discounts for new customers.
The problem is that such strategies are easy to copy. I remember well when fast food restaurants introduce the value menu consisting of items that were only a dollar. I was in graduate school at the time, so this was quite welcome. After the first restaurant created the dollar menu, it was not long before competitors joined in as McDonald’s, Burger King, Wendy’s, and others attempted to steal customers from each other. Now, the value menu is an albatross that they all want to shed, but none of them can.[26]
When competitors copy each other’s strategies, they reduce the profitability gains for all over time. And while they are preoccupied with the queen, the other four other forces conspire to place them in checkmate. As Porter concluded:
Many managers concentrate so single-mindedly on their direct antagonists in the fight for market share that they fail to realize that they are also competing with their customers and their suppliers for bargaining power. Meanwhile, they also neglect to keep a wary eye out for new entrants to the contest or fail to recognize the subtle threat of substitute products.[27]
Additional Factors
Beyond the five forces, Porter identified four additional factors that affect strategy—The industry’s growth rate, technology, the government, and complements. An industry’s growth rate is deceptive. A fast growing industry is often attractive. However, while it lessens rivalry for a time, it attracts new entrants and strengthens suppliers.
Often an industry’s growth rate is driven by new technology. Technological improvements are important, but they do not have the same impact as the five forces. Likewise, governments can affect an industry through rules and regulations. It too must be watched carefully.
Finally, compliments sometimes need to be factored into strategic decisions. Compliments are two products that work together. Each enhances the value of the other. In fact, the one might not be worth much without the other. Computer hardware and software are the most common examples. Hardware without a common operating system is not very useful; Software without hardware is useless. Automakers have the technology to produce hydrogen cars, but until hydrogen filling stations are abundant as gas stations, they will not be well received in the market.[28] Cell phones require cell towers and smart phones additionally require the internet. If your product has a compliment, you cannot ignore this factor.
Mike’s Garage
Once you recognize the five forces, the next step is identifying them in your industry. Let’s return to Mike the mechanic. His dreams of becoming the next Toyota were dashed when he realized that the barriers to entry were too high. But after a few years in the business, he quit his job and he opened his own repair shop.
The five forces affected him and his repair shop too. New entrants constantly threatened his business because the barriers to entry our so low. In fact, a couple years into his business, a competitor set up shop diagonally across the street, but by that time, Mike had built his own barriers.
For example, he developed a reputation for honest service. He did this by making the process transparent. He posted his labor rate and estimated times for service on the wall and website. He added additional computer monitors facing the customer so they could see the prices he saw as he searched for their parts. Few begrudged his mechanics making a decent wage so long as they were confident that the mechanics were honest.
His mechanics regularly inspected each vehicle that came in for signs of potential trouble, and this was perceived as added value because he never pressured customers about early warnings. This was a free, added service that provided an additional stream of revenue. He was not the low-cost producer, but female customers who were particularly concerned about mechanics who might take advantage of them flocked to Mike’s garage because of his reputation for honesty.
Mike could not do much about the costs from his suppliers. He had no leverage over them. He had the same access to the same parts that other mechanics had, so he could not do much about this force, but he could affect his customers.
Because of his method of operation, he began to attract female customers. After a while, he became hyper efficient in the basic services that females purchased more frequently such as oil changes. This was a regular service for some and an add-on for others. These customers saw his garage as an honest Jiffy-lube. They gave him great ratings online, and because no single customer sent him a lot of business, he did not have to offer discounts to attract business. After a while, he no longer had to advertise, and this also increased his profits. In fact, he was constantly busy trying to serve all of his customers.
Often, mechanics try to be all things to all people, but not Mike. He specialized in mundane services that were common to his particular customers, rather than seek out the high-end, lucrative jobs. Once he realized that females were a disproportionate percentage of his customers, he made sure that his waiting room was clean. It felt more like Target than an auto repair shop. He gated off a play area for small children with a television that continuously played cartoons, another distinctive feature that young mothers appreciated.
Substitutes abounded in his industry. While it was unlikely that customers would buy a new car rather than get it fixed unless they had to, auto mechanics are everywhere. There are over 252,000 such businesses in the United States, or roughly one business for every thousand automobiles.[29] Mike had five competitors in a three-mile radius. Nevertheless, Mike’s differentiation had minimized the threat of substitutes.
Rivalry was intense, but Mike addressed rivalry in two ways. His effort to specialize in the mundane was one part of his defense and his willingness to share with others was another. He was intentional about identifying other honest mechanics and making that information available to his customers. If he could not perform a service, he directed his customers to a trustworthy competitor. He would even call the competitor in front of the customer to see if he could take her immediately. This ingratiated Mike with the competitor and the customer. Both sent Mike additional referrals. He never built the better Toyota, but he created a service environment that was second to none.
Strategy
According to Porter, “Strategy can be viewed as building defenses against the competitive forces or as finding positions in the industry where the forces are weakest.”[30] By identifying each of Porter’s five forces, and strategically positioning his shop, mike grew a successful business.
Mike found that rivalry is not necessarily a zero-sum game where if you win, I must lose. As Porter explained:
Rivalry can be positive sum, or actually increase the average profitability of an industry, when each competitor aims to serve the needs of different customer segments, with different mixes of price, products, services, features, or brand identities. Such competition can not only support higher average profitability but also expand the industry, as the needs of more customer groups are better met. The opportunity for positive-sum competition will be greater in industries serving diverse customer groups.[31]
Mike had tapped into this positive sum competition and hit helped him—and his direct competitors to both do better.
Industry and Performance
Mike did everything right, but you can still do everything right and still do poorly. Much of your success depends on the industry in which you compete. The five forces affect all businesses in all industries, though not all in the same way.[32]
If the forces are intense, as they are in such industries as airlines, textiles, and hotels, almost no company earns attractive returns on investment. If the forces are benign, as they are in industries such as software, soft drinks, and toiletries, many companies are profitable. Industry structure drives competition and profitability, not whether an industry produces a product or service, is emerging or mature, high tech or low tech, regulated or unregulated.[33]
In a previous lesson I explained that net profit was, on average, a rather low 6.40%.[34] The highs were roughly 24-25% for tobacco and banking while insurance generated 6-9%, and grocery stores averaged roughly 2%. The five forces explain the difference between these industries.
For the U.S tobacco industry, barriers to entry are high due to economies of scale. While you can grow your own tobacco, it would be very difficult for a homegrown competitor to enter the industry at the scale needed to compete. Suppliers have limited power and many customers are addicted. Substitutes are moderate, but increasing with an ever-growing number of smoking substitutes. Rivalry is high between a few major brands.[35]
For banks, the threat of new entrants is weak. It takes a lot of capital to start a bank. Though there are many substitutes and competitive rivalry is high between the big banks, the power of suppliers is weak and the power of customers is diffused. While large, corporate clients have some pull, the average consumer holding a mortgage or car payment faces high switching costs.[36]
In contrast, retail grocery stores face very different competitive forces. The power of new entrants, suppliers, substitutes, and rivalry tend to be higher in retail grocery. By comparing the forces between industries, you come to see that the industry has more of an effect on profitability than what the company actually does.[37]
How do the five forces affect your industry?
Actionable items:
How do the five forces affect your industry?
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Should you be doing something differently as a consequence of your analysis? If so, what should you be doing?
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End Notes
[1] Porter, M. E. (2008). The five competitive forces that shape strategy. Harvard Business Review, 86(1), p. 88.
[2] Michael E. Porter. (n. d.). Shared Value Initiative. Retrieved from http://sharedvalue.org/partners/thought-leaders/michael-e-porter
[3] Porter, M. E. (1979). How competitive forces shape strategy. Harvard Business Review, 57(2), 137-145.
[4] Magretta, J. (2012). Understanding Michael Porter: The essential guide to competition and strategy. Boston, Mass: Harvard Business Review Press. pp. 21-22.
[5] Magretta, J. (2012). Understanding Michael Porter: The essential guide to competition and strategy. Boston, Mass: Harvard Business Review Press. p. 29.
[6] Porter, M. E. (1979). How competitive forces shape strategy. Harvard Business Review, 57(2), 137-145.
[7] Drucker, P. F. The practice of management. Oxford, UK: Elsvier. (p. 31).
[8] Magretta, J. (2012). Understanding Michael Porter: The essential guide to competition and strategy. Boston, Mass: Harvard Business Review Press. (p. 41).
[9] Porter, M. E. (2008). The five competitive forces that shape strategy. Harvard Business Review, 86(1), 78-93.
[10] Author’s note: Mike is a fictional amalgam based on actual persons, but designed to illustrate each of the five forces.
[11] Children’s question room (n. d.). Toyota. Retrieved from http://www.toyota.co.jp/en/kids/faq/b/01/06/
[12] Toyota’s new $1B Mexico plant to build 2020 Corolla. USA Today. Retrieved from http://www.usatoday.com/story/money/cars/2015/04/15/toyota-mexico-corolla-factory/25811997/
[13] FAQs: Frequently asked questions for all things Toyota. (n. d.). Toyota. Retrieved from http://toyota.custhelp.com/app/answers/detail/a_id/7660/~/where-are-toyota-vehicles-assembled-for-the-u.s.-market%3F
[14] Porter, M. E. (2008). The five competitive forces that shape strategy. Harvard Business Review, 86(1), p. 81.
[15] Porter, M. E. (1979). How competitive forces shape strategy. Harvard Business Review, 57(2), p. 140.
[16] Porter, M. E. (2008). The five competitive forces that shape strategy. Harvard Business Review, 86(1), p. 82.
[17] Magretta, J. (2012). Understanding Michael Porter: The essential guide to competition and strategy. Boston, Mass: Harvard Business Review Press.
[18] Young, D. (2015, May 4). 10 years after IBM, Lenovo looks for new relevance. Forbes. Retrieved from http://www.forbes.com/sites/dougyoung/2015/05/04/10-years-after-ibm-buy-lenovo-looks-for-new-relevance/#586d49be769a
[19] Porter, M. E. (1979). How competitive forces shape strategy. Harvard Business Review, 57(2), p. 140.
[20] Porter, M. E. (1979). How competitive forces shape strategy. Harvard Business Review, 57(2), p. 140.
[21] Porter, M. E. (1979). How competitive forces shape strategy. Harvard Business Review, 57(2), pp. 140-141.
[22] Fishman, C. (2006). The Wal-Mart effect: How the world’s most powerful company really works– and how it’s transforming the American economy. New York: Penguin Press.
[23] Substitute. (n. d.). Investopedia. Retrieved from http://www.investopedia.com/terms/s/substitute.asp
[24] Porter, M. E. (2008). The five competitive forces that shape strategy. Harvard Business Review, 86(1), p. 85.
[25] Porter, M. E. (1979). How competitive forces shape strategy. Harvard Business Review, 57(2), 137-145.
[26] Tuttle, B. (2014, Jan 14). Fast food chains are desperate to kill the dollar menu. Time. Retrieved from http://business.time.com/2014/01/14/fast-food-chains-are-desperate-to-kill-the-dollar-menu/
[27] Porter, M. E. (1979). How competitive forces shape strategy. Harvard Business Review, 57(2), p. 145.
[28] Porter, M. E. (2008). The five competitive forces that shape strategy. Harvard Business Review, 86(1), p. 86.
[29] Auto mechanics in the US: Market research report. (2016). IBIS World. Retrieved from http://www.ibisworld.com/industry/default.aspx?indid=1689
[30] Porter, M. E. (1979). How competitive forces shape strategy. Harvard Business Review, 57(2), p. 143.
[31] Porter, M. E. (2008). The five competitive forces that shape strategy. Harvard Business Review, 86(1), p. 86.
[32] Porter, M. E. (1979). How competitive forces shape strategy. Harvard Business Review, 57(2), p. 138.
[33] Porter, M. E. (2008). The five competitive forces that shape strategy. Harvard Business Review, 86(1), p. 80.
[34] Damodaran, A. (2016). Margins by sector (US). Stern School of Business. New York University. Retrieved from http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/margin.html
[35] Trefis Team. (2015, Aug. 17). Altria in the U.S tobacco industry—A Porter’s five forces analysis. Forbes. Retrieved from http://www.forbes.com/sites/greatspeculations/2015/08/17/altria-in-the-u-s-tobacco-industry-a-porters-five-forces-analysis/#35ab70db6ffb
[36] Investopedia staff. (n. d.). The industry handbook:The banking industry. Investopedia. Retrieved from http://www.investopedia.com/features/industryhandbook/banking.asp
[37] Porter, M. E. (2008). The five competitive forces that shape strategy. Harvard Business Review, 86(1), p. 86.