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How to use Porter's Five Forces to analyse industries

How to use Porter's Five Forces to analyse industries

Harry Clark

26/06/2020

When analysing a given commercial story or scenario it is critical to understand and identify what ‘industries’ are being affected.

‘Industry’ – a distinct group of productive or profit-making enterprises.
- Merriam-Webster Dictionary

Each industry will have its own particular strengths and weaknesses depending on its structure, adopted business models and ‘elasticity’ when responding to adverse market conditions.

‘Elasticity’ (economics) – the degree to which individuals, consumers or producers change their demand or the amount supplied in response to price or income changes. It is predominantly used to assess the change in consumer demand as a result of a change in a good or service's price.
Investopedia

The covid-19 pandemic has served as a good example of how each industry’s respective strengths and weaknesses are tested when the market is experiencing ‘abnormal’ behaviour from what most businesses would ideally like to see, such as a recession.

This article outlines a popular model to analyse the factors that make a certain industry strong and/or weak – Porters Five Forces.

Industry rivalry

This first factor considers how competitive the market space is between providers in a given industry. For example, there are an abundance of car manufacturers and brands for consumers to choose from, with each company trying to win over customers from each other in order to sustain and build profits. Conversely, there are other industries that exist with fewer competitors in the market, or those that are more unequally sized/influential in relation to each other, allowing one brand to dominate the market. Other factors which would indicate a lesser degree of industry rivalry include the following:

  • Brand loyalty is significant – customers are hesitant to look for alternatives from their current provider.
  • Consumer switching costs are high – customers are disincentivised to leave their current provider and are financially better off not to ‘switch’.
  • Low levels of excess production capacity – companies are producing to meet demand, rather than what is less than achievable, optimal or desirable.

Substitutes and alternatives in the market

This second factor considers how easy it is for a customer to have their need fulfilled from a different or separate industry. For example, if a person needs to commute to work each morning, they’ll have a number of different options available to them in order to do so, including walking, cycling, driving and public transport. If all of these options are priced competitively in comparison to one another or offer similar levels of quality satisfaction (in this case, the journey time of the commute) then the consumer has a lot of choice as to how their need is serviced with a large number of substitutes and alternatives in the market.

Buyer bargaining power

This factor refers to the extent that a consumer can pressurise companies and businesses to get more for less from them. For example, if there are only a handful of potential buyers/consumers in a given market, but lots of sellers/providers (businesses), those buyers will enjoy significant bargaining power in trying to negotiate a better deal for what they want. After all, if one business won’t cut them a deal they like, there are plenty of others that might be willing to in order to win their business!

Supplier bargaining power

Conversely, lots of buyers and only a handful of sellers in a market means that those businesses can exert significant control over that particular market – for example, its price, the services provided or any other conditions they see fit. Supplier bargaining power may also be greater if the cost to switch between service providers is high or if the good being provided is price inelastic.

‘Price inelasticity’ – when the price goes up, consumers’ buying habits stay about the same, and when the price goes down, consumers’ buying habits also remain unchanged.
Investopedia

Barriers to entry/threat of new entrants

Finally, how accessible a given industry or market is can affect the overall constitution of a given industry. For example, the airline industry has a significant barrier to entry in order to start a new competing business. Not only are there a number of existing service providers who rely on brand loyalty and competitive pricing to win over customers, but the costs of purchasing/leasing aircraft, hiring highly trained staff (eg, pilots, mechanics and engineers) and advertising to start the business are significant.

Conversely, if an industry had little to no apparent differentiation between competitors and start-up costs are much lower, existing businesses within that industry are much more exposed to new competitors potentially entering the market in an attempt to ‘steal’ from their customer base. A personal favourite example I use to evidence this is bottled water – the rise of artisan waters, ‘Smart’ water and flavoured varieties all compete with existing providers of ‘traditional’ natural spring waters which can be harder to differentiate, such as Buxton and Evian. Such companies may even decide to expand their range of products in order to compete with these new entrants, while leveraging their existing brand and customer loyalties.

Conducting an analysis of a company with SWOT and PESTLE, followed by an analysis of their industry with Porter’s Five Forces, can act as a good foundational structure to understand a company’s position prior to the effects of any significant commercial news stories or developments.