Industry Analysis: The Five Forces

PURDUE EXTENSION
EC-722
Industry Analysis: The Five Forces
Cole Ehmke, Joan Fulton, and Jay Akridge
Department of Agricultural Economics
Kathleen Erickson, Erickson Communications
Sally Linton
Department of Food Science
Overview
Audience: Business managers seeking to assess
Assessing Your Marketplace
the nature of their marketplace
The economic structure of an industry is not an accident.
Content: Presents five forces that influence the
Its complexities are the result of long-term social trends and
profitability of an industry
economic forces. But its effects on you as a business manager
Outcome: Reader should understand the forces
are immediate because it determines the competitive rules
and be able to counter them with appropriate
and strategies you are likely to use. Learning about that
tactics
structure will provide essential insight for your business
strategy.
Using This Publication
Michael Porter has identified five forces that are widely used to
This publication describes five forces that influence an
assess the structure of any industry. Porter’s five forces are the:
industry. The publication includes a set of application
• Bargaining power of suppliers,
questions that will help you evaluate the structure of the
industry you are in or are considering entering. The more you
• Bargaining power of buyers,
understand about the strength of each force, the better able
• Threat of new entrants,
you will be to respond.
• Threat of substitutes, and
The forces affecting profitability are often beyond your
• Rivalry among competitors.
control, so you must choose tactics to respond to the forces
rather than try to change the business environment. This
Together, the strength of the five forces determines the profit
publication offers insight on specific tactics you need for
potential in an industry by influencing the prices, costs, and
success when facing competitive situations. While you may
required investments of businesses—the elements of return
assess any one force individually, you will gain the most value
on investment. Stronger forces are associated with a more
by assessing all five of the forces
challenging business environment. To identify the important
structural features of your industry via the five forces, you
With each force, a “Perspective” feature illustrates the force
conduct an industry analysis that answers the question,
for an Indiana wine entrepreneur by evaluating that market-
“What are the key factors for competitive success?”
place. To avoid repetition, we use the word “product” to mean
either a product or a service. Read more about the five forces
in Porter’s book, Competitive Strategy.

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Bargaining Power of Suppliers
• Suppliers can sell directly to your customers,
bypassing the need for your business. For example, a
How Much Power Do Your
manufacturer could open its own retail outlet and
Suppliers Have Over You?
compete against you.
Any business requires inputs—labor, parts, raw materials,
• It is difficult for you to switch to another supplier. For
and services. The cost of your inputs can have a significant
example, if you recently invested in a unique
effect on your company’s profitability. Whether the strength of
inventory and information management system to
suppliers represents a weak or a strong force hinges on the
work effectively with your supplier, it would be
amount of bargaining power they can exert and, ultimately,
expensive for you to switch suppliers.
on how they can influence the terms and conditions of
• You do not have a full understanding of your
transactions in their favor. Suppliers would prefer to sell to
supplier’s market. You are less able to negotiate if you
you at the highest price possible or provide you with no more
have little information about market demand, prices,
services than necessary. If the force is weak, then you may be
and supplier’s costs.
able to negotiate a favorable business deal for yourself.
Conversely, if the force is strong, then you are in a weak
Reducing the Bargaining Power of
position and may have to pay a higher price or accept a lower
Suppliers
level of quality or service.
Most businesses don’t have the resources to produce their own
Factors Affecting the
inputs. If you are in this position, then you might consider
Bargaining Power of Suppliers
forming a partnership with your supplier. This can result in a
more even distribution of power. For instance, Dell Computer
Suppliers have the most power when:
uses partnering with its components suppliers as a key
• The input(s) you require are available only from a
strategy to be the low-cost/high-quality leader in the market.
small number of suppliers. For instance, if you are
This can be mutually beneficial for both supplier and buyer if
making computers and need microprocessors, you will
they can:
have little or no bargaining power with Intel, the
• Reduce inventory costs by providing just-in-time
world’s dominant supplier.
deliveries,
• The inputs you require are unique, making it costly to
• Enhance the value of goods and services supplied by
switch suppliers. If you use a certain enzyme in a food
making effective use of information about customer
manufacturing process, changing to another supplier
needs and preferences, and
may require you to change your entire manufacturing
process. This may be very costly to you, thus you will
• Speed the adoption of new technologies.
have less bargaining power with your supplier.
Another option may be to increase your power by forming a
• Your input purchases don’t represent a significant
buying group of small producers to buy as one large-volume
portion of the supplier’s business. If the supplier does
customer. If you have the resources, you may choose to
not depend on your business, you will have less power
integrate back and produce your own inputs by purchasing
to negotiate. Of course the opposite is true as well.
one of your key suppliers or doing the production yourself.
Wal-Mart has significant negotiating power over its
suppliers because it is such a large percentage of
suppliers’ business.
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Perspective on Bargaining Power of Suppliers
or juice are almost non-existent. This can have a
significant effect on a winery. And it is something the
For an Indiana winery, one of the main supply decisions lies
manager has no control over. For example, if a late spring
with the key product ingredients—winegrapes and juice.
frost hits the New York vineyards, the tender varieties will
Wineries have several options, including owning the
vineyard, purchasing grapes, or purchasing juice. An
not produce enough grapes to satisfy demand for the year.
overabundance of winegrapes and juice from the West Coast
Small wineries are particularly challenged because they
of the U.S., for instance, enhances Indiana wineries’
do not have the leverage associated with volume that the
negotiating power with grape and juice suppliers. However,
larger wineries have. As a result, the force of suppliers on
the bargaining power of Indiana wineries is generally
a small winery can be viewed as relatively strong.
weakened due to lack of winegrape growing experience.
However, a manager of an Indiana winery could decrease
If the winery needs a specific grape variety for a particular
the effect by cooperating with other small players to
wine, then the manager needs to be concerned about the
make collective purchases.
supply and demand for the product. As supply becomes
Contracts and positive relationships with suppliers and
short, the manager will find that suppliers have increasing
producers are another way a small winery can manage
bargaining power.
the uncertainty and power of suppliers. Recognizing the
Raw materials for wine production are commodity items that
power of suppliers and the influence of outside factors
are very cyclical in price, quality, and availability. There are
(e.g., knowledge and weather) is an important
times when high-quality grapes can be bought for low prices
consideration as a smal winery finds a place in the market.
(over supply) and other times when particular grape varieties
Self Assessment—Bargaining Power of Suppliers
This i
“Yes” or “No” in the space provided. “Yes” indicates a favorable competitive environment for your business. “No” indicates a
negative situation. Use the insight you gain to develop effective tactics for countering or taking advantage of the situation.
YES NO
1. Are there a large number of potential input
YES NO
4. Would it be difficult for your suppliers to
suppliers? The greater number of suppliers of
enter your business, sell directly to your
your needed inputs, the more control you will
customers, and become your direct
have.
competitor? The easier it is to start a new
business, the more likely it is that you will
YES NO
2. Are the products that you need to purchase
for your business ordinary? You have more
have competitors.
control when the products you need from a
YES NO
5. Can you easily switch to substitute products
supplier are not unique.
from other suppliers? If it is relatively easy to
switch to substitute products, you will have
YES NO
3. Do your purchases from suppliers represent a
large portion of their business? If your
more negotiating room with your suppliers.
purchases are a relatively large portion of
YES NO
6. Are you well informed about your supplier’s
your supplier’s business, you will have more
product and market? If the market is
power to lower costs or improve product
complicated or hard to understand, you have
features.
less bargaining power with your suppliers.
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Further Assessment
Using a pencil and sheet of paper, examine in greater detail how the bargaining power of suppliers will affect your business.
List the major inputs
For each input,
How can you best work with this supplier
needed for your business.
list possible suppliers.
to maximize your bargaining power?
1.
2.
3.
4.
5.
Many small customers acting as a group can create a strong
Bargaining Power of Buyers
force. For instance, because of their size, health maintenance
organizations (HMOs) can purchase health care from
How Much Negotiating Power Do
hospitals and doctors at much lower cost than can individual
Your Buyers Have?
patients.
The power of buyers describes the effect that your customers
Note that not all buyers will have the same degree of bargain-
have on the profitability of your business. The transaction
ing power with you or be as sensitive to price, quantity, or
between the seller and the buyer creates value for both parties.
service. For example, apparel makers face significant buyer
But if buyers (who may be distributors, consumers, or other
power when selling to large retailers like Wal-Mart or
manufacturers) have more economic power, your ability to
department stores, but face a much more favorable situation
capture a high proportion of the value created will decrease,
when selling to smaller specialty shops.
and you will earn lower profits.
Factors Influencing the
How Much Power Do Your Buyers
Bargaining Power of Buyers
Have Over You?
Buyers have more power when:
Buyers have the most power when they are large and purchase
much of your output. If your business sells to a few large
• Your industry has many small companies supplying
buyers, they will have significant leverage to negotiate lower
the product and buyers are few and large. For
prices and other favorable terms because the threat of losing
example, you may have little negotiating power if you
an important buyer puts you in a weak position. Buyers also
and several competing companies are trying to sel
have power if they can play suppliers against each other. In
similar products to one large buyer.
the automotive supply industry, the large car manufacturers
• The products represent a relatively large expense for
have significant power. There are only a few large buyers, and
your customers. Customers may not price shop for a
they buy in large quantities. But, when there are many
quart of oil, but they will price shop if purchasing a
smaller buyers, you will have greater control because each
new vehicle.
buyer is a small portion of your sales.
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• Customers have access to and are able to evaluate
• Customers can easily, and with little cost, switch to
market information. You have less room for
another product. For example, IBM customers might
negotiation if buyers know market demand, prices,
switch to Gateway or Dell, but it may be inconvenient
and your costs.
for them to consider Macintosh.
• Your product is not unique and can be purchased
Reducing the Bargaining Power of
from other suppliers. If your brand is homogenous or
similar to all of the others, buyers will base their
Buyers
decision mainly on price.
You can reduce the bargaining power of your customers by
• Customers could possibly make your product
increasing their loyalty to your business through partnerships
themselves. Anheuser-Busch, Coors, and Heinz are
or loyalty programs, selling directly to consumers, or increas-
examples of companies that have integrated back into
ing the inherent or perceived value of a product by adding
metal can manufacturing to fill the balance of their
features or branding. In addition, if you can select the
container needs.
customers who have little knowledge of the market and have
less power, you can enhance your profitability.
Perspective on Bargaining Power of Buyers
compared to that of the wholesalers. In Indiana,
counteracting legislation allows small wineries to sell
Indiana wineries have three types of buyers—direct
directly to retail outlets without using a wholesaler.
consumers, wholesalers, and retail outlets. Direct
While the bargaining power of one of these wineries
consumers are mostly tourists out for the day, weekend, or
with retail outlets is still weak, the winery has the
even a weeklong vacation. In this situation, competition for
benefit of offering a local Indiana product that is in
those buyers is actually any travel destination in the area
demand with consumers.
competing for their leisure time. Would the buyers rather
visit a state park or a museum than a winery? A winery
Overall for Indiana wineries, buyers have more power
can reduce the bargaining power of these customers by
than the entrepreneurs. This is due to the fact that direct
offering unique products and events that offer high value.
consumers have multiple options for entertainment, and
wholesalers and retail outlets have thousands of wine
Wholesalers have a significant amount of bargaining power
brands to choose from. Therefore, a small winery owner
because they are few in number and have a considerable
must be creative in dealings with consumers, usually by
influence over the wines that are sold on the retail shelf.
offering loyalty programs and increasing perceived value.
Thus, the bargaining power of small wineries is weak
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Self Assessment—Bargaining Power of Buyers
Thi
respond with “Yes” or “No” in the space provided. “Yes” indicates a favorable competitive environment for your business. “No” indicates
a negative situation. Use the insight you gain to develop ef ective tactics for countering or taking advantage of the situation.
YES NO
1. Do you have enough customers such that
YES NO
4. Is your product unique? If your product is
losing one isn’t critical to your success? The
homogenous or the same as your competitors’,
smaller the number of customers, the more
buyers have more bargaining power.
dependent you are on each one of them.
YES NO
5. Would it be difficult for buyers to integrate
YES NO
2. Does your product represent a small expense
backward in the supply chain, purchase a
for your customers? If your product is a
competitor providing the products you provide,
relatively large expense for your customers,
and compete directly with you? The less likely
they’ll expend more effort negotiating with
a customer will enter your industry, the more
you to lower price or improve product
bargaining power you have.
features.
YES NO
6. Is it difficult for customers to switch from
YES NO
3. Are customers uninformed about your
your product to your competitors’ products?
product and market? If your market is
If it is relatively easy for your customers to
complicated or hard to understand, buyers
switch, you will have less negotiating power
have less control.
with your customers.
Further Assessment
Using a pencil and sheet of paper, examine in greater detail how the bargaining power of buyers will affect your business.
List the types of customers that
What alternatives might these
How can you build loyalty for your product
you have or expect to have.
customers have for your product?
or service to reduce customer bargaining power?
1.
2.
3.
4.
5.
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Threat of New Entrants
Overcoming barriers to entry may involve expending signifi-
cant resources over an extended period of time. Industries
How Easy Is It for Businesses to
based on patentable technology may require an especially
Enter Your Market?
long-term commitment, with years of research and testing,
before products can be introduced and compete.
You may have the market cornered with your product, but
your success may inspire others to enter the business and
Factors Affecting the Threat of
challenge your position. The threat of new entrants is the
New Entrants
possibility that new firms will enter the industry. New entrants
bring a desire to gain market share and often have significant
The threat of new entrants is greatest when:
resources. Their presence may force prices down and put
• Processes are not protected by regulations or patents.
pressure on profits.
In contrast, when licenses and permits are required to
Analyzing the threat of new entrants involves examining the
do business, such as with the liquor industry, existing
barriers to entry and the expected reactions of existing firms
firms enjoy some protection from new entrants.
to a new competitor. Barriers to entry are the costs and/or
• Customers have little brand loyalty. Without strong
legal requirements needed to enter a market. These barriers
brand loyalty, a potential competitor has to spend
protect the companies already in business by being a hurdle
little to overcome the advertising and service
to those trying to enter the market. In addition to up-front
programs of existing firms and is more likely to enter
barriers, a new competitor may inspire established companies
the industry.
to react with tactics to deter entry, such as lowering prices or
forming partnerships. The chance of reaction is high in
• Start-up costs are low for new businesses entering the
markets where firms have a history of retaliation, excess cash,
industry. The less commitment needed in advertising,
are commit ed to the industry (see Rivalry Among Competitors),
research and development, and capital assets, the
or the industry has slow growth.
greater the chance of new entrants to the industry.
Unique Barriers
• The products provided are not unique. When the
products are commodities and the assets used to
Entry barriers are unique for each industry and situation,
produce them are common, firms are more willing to
and can change over time. Most barriers stem from irrevers-
enter an industry because they know they can easily
ible resource commitments you must make in order to enter
liquidate their inventory and assets if the venture fails.
a market. For example, if the existing businesses have well-
• Switching costs are low. In situations where customers
established brand names and fully differentiated products,
do not face significant one-time costs from switching
as a potential market entrant you will need to undertake an
suppliers, it is more attractive for new firms to enter
expensive marketing campaign to introduce your products.
the industry and lure the customers away from their
Barriers to entry are usually higher for companies involved
previous suppliers.
in manufacturing than for companies that provide a service
because there is often a significant expense in setting up a
• The production process is easily learned. Just as
production facility.
competitors may be scared away when the learning
curve is steep, competitors will be attracted to an
Another type of entry barrier is regulatory. To produce organic
industry where the production process is easily
food there is a three-year wait before land may be certified.
learned.
During the waiting period, producers must raise the crop as
organic, but may not market it as organic until the three-year
• Access to inputs is easy. Entry by new firms is easier
“cleansing process” of the land is completed.
when established firms do not have favorable access to
raw materials, locations, or government subsidies.
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• Access to customers is easy. For instance, it may be
Reducing the Threat of
easy to rent space to sell produce at a farmer’s market,
New Entrants
but nearly impossible to get shelf space in a grocery store.
You are more likely to find new entrants in the food
Enhancing your marketing/brand image, utilizing patents,
business using the farmer’s market distribution system
and creating alliances with associated products can minimize
over grocery stores.
the threat of new entrants. Important tactics you can follow
include demonstrating your ability and desire to retaliate to
• Economies of scale are minimal. If there is little
potential entrants and setting a product price that deters entry.
improvement in efficiency as scale (or size) increases,
Because competitors may enter the industry if there are excess
a firm entering a market won’t be at a disadvantage if
profits, setting a price that earns positive but not excessive
it doesn’t produce the large volume that an existing
profits could lessen the threat of new entry in your industry.
firm produces.
Perspective on Threat of New Entrants
for all wineries involved. People may not travel an hour
from home to visit only one winery, but they would view
The threat of new entrants has a unique twist in the
the trip as worthwhile if they had the opportunity to visit
winery business. A winery is not an easy business to start
four wineries. This clustering effect enhances the
because it is capital intensive and market entry can take
attractiveness and profitability of all wineries involved.
multiple years due to licensing requirements and initial
production time for vineyards and wine. A strong
Barriers to entry in the local wine market are high due to
knowledge base is also required in order to make high-
capital investments, licensing, and knowledge
quality wine and understand the complexities of the
requirements. However, having competition close to a
industry. Thus, there are significant barriers to entry.
business does not necessarily have a negative effect on
the bottom line. Therefore, some industries may actually
However, in at least one respect, competitors are
encourage and support new entrants up to a point.
complementary for Indiana wineries. When several
wineries exist in close proximity, it becomes beneficial
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Self Assessment—Threat of New Entrants
Th
respond with “Yes” or “No” in the space provided. “Yes” indicates a favorable competitive environment for your business. “No” indicates

YES NO
1. Do you have a unique process that has been
YES NO
5. Is there a process or procedure critical to your
protected? For example, if you are a
business? The more dif icult it is to learn the
technology-based company with patent
business, the greater the entry barrier.
protection for your research investments, you
YES NO
6. Will a new competitor have difficulty
enjoy some barriers to entry.
acquiring/obtaining needed inputs? Current
YES NO
2. Are customers loyal to your brand? If your
distribution channels may make it difficult
customers are loyal to your brand, a new
for a new business to acquire/obtain inputs
product, even if identical, would face a
as readily as existing businesses.
formidable bat le to win over loyal customers.
YES NO
7. Will a new competitor have any difficulty
YES NO
3. Are there high start-up costs for your
acquiring/obtaining customers? If current
business? The greater the capital
distribution channels make it difficult for a
requirements, the lower the threat of
new business to acquire/obtain new customers,
new competition.
you wil enjoy a barrier to entry.
YES NO
4. Are the assets needed to run your business
YES NO
8. Would it be difficult for a new entrant to have
unique? Others will be more reluctant to
enough resources to compete efficiently? For
enter the market if the technology or
every product, there is a cost-efficient level of
equipment cannot be converted into other
production. If challengers can’t achieve that
uses if the venture fails.
level of production, they won’t be competitive
and therefore won’t enter the industry.
Further Assessment
Using a pencil and sheet of paper, examine in greater detail how the threat of new entrants might affect your business.
1. How would a new entrant
affect your business?
2. What will your competitors
do if there is a new entrant
into your marketplace?
3. How will you respond to a
new competitor?
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Threat of Substitutes
If wheat prices are low, corn prices will also be low, because,
as corn prices rise, livestock feeders will quickly shift to wheat
What Products Could Your
to keep ration costs low. This reduces the demand and
Customers Buy Instead of Yours?
ultimately the price of corn.
Products from one business can be replaced by products from
It’s more difficult for a firm to try to raise prices and make
another. If you produce a commodity product that is undiffer-
greater profits if there are close substitutes and switching costs
entiated, customers can easily switch away from your product
are low. But, in some cases, customers may be reluctant to
to a competitor’s product with few consequences. In contrast,
switch to another product even if it offers an advantage.
there may be a distinct penalty for switching if your product is
Customers may consider it inconvenient or even risky to change
unique or essential for your customer’s business. Substitute
if they are accustomed to using a certain product in a certain
products are those that can fulfill a similar need to the one
way, or they are used to the way certain services are delivered.
your product fills.
Factors Affecting the Threat of
As an example, a family restaurant may prefer to buy the
Substitution
packaged poultry produced at your plant, but if given a better
deal, they may go to another poultry supplier. If you grow
Substitutes are a greater threat when:
free-range organically grown chickens, though, and you are
• Your product doesn’t offer any real benefit
selling to upscale restaurants, they may have few substitutes
compared to other products. What will hold your
for the product that you are providing.
customers if they can get an identical product from
Substitutes Can Come in
your competitor?
Many Forms
• It is easy for customers to switch. A grocer can easily
switch from paper to plastic bags for its customers,
Be aware that substitute products can come in many shapes
but a bottler may have to reconfigure its equipment
and sizes, and do not always come from traditional competi-
and retrain its workers if it switches from aluminum
tors. Pork and chicken can substitute in consumer diets for
cans to plastic bottles.
beef or lamb. Aluminum beverage cans battle in the market
against glass bottles and plastic containers. Cotton competes
• Customers have little loyalty. When price is the
with polyester from the petroleum industry. Barnes and Noble
customer’s primary motivator, the threat of substitutes
retail bookstores compete with Internet retailer Amazon.
is greater.
Postal services compete with e-mail and fax machines.
Reducing the Threat of Substitutes
When developing a business plan, it is critical to assess the
You can reduce the threat of substitutes by using tactics such
other options your customers have to satisfy their needs. To do
as staying closely in tune with customer preferences and
this, look for products that serve the same function as yours. A
differentiating your product by branding. In some cases, the
threat exists if there are alternative products with lower prices
advertising required to differentiate is more than one firm can
or better performance or both.
bear. In that case, collective advertising for an industry may
How Substitutes Affect the
be more effective.
Marketplace
Substitutes essentially place a price ceiling on products.
Market analysts often talk about “wheat capping corn.” This
occurs because wheat and corn are substitutes in animal feed.
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