Porter’s Five Forces and Strategic Planning for Small Businesses
In a three level pyramid of strategy analysis tools, Porter’s Five Forces is in the foundation level. The “strategic analysis pyramid” from top to bottom is categorized into Industry, Firm, and Decision. Each level supports a different stage of strategy analysis and planning. Porter’s model examines the attractiveness of an industry by examining the subforces at play and understanding their impact on your strategy. For a small business, it can help answer the question of whether or not to enter the industry. It can also help decide if its time to leave an industry. While it may sound as if it is too large-scale of a tool to use for a small business, its value is in the research, thinking, and decision-making process that it forces you to do in a consistent and repeatable manner.
Although Porter’s model isn’t as prevalent as it was 10 years ago, it is still a valuable tool. In our discussion, we’ll add a sixth force to the analysis to be more comprehensive. The main values of the model are in “thinking forward and reasoning backward,” making it clear that completion occurs within an extended system, and that the intensity of competition isn’t a matter of luck. The framework helps us understand the determinants of value capture (both for the consumer and the business). This is also a great tool to use as you create and validate a business model.
The model has six components: supplier power, new entrants, buyer power, complements, substitute products, and rivalry amongst firms in the industry. Each component can be analyzed in numerous ways, but I’ll focus on explaining the model simply and quickly as a tool for strategic thinking.
Supplier power. Consider the bargaining power of suppliers within the industry. Are they in demand and specialized? Is their product an easily produced commodity where the market sets the price? Are they one of a kind and the industry is dependent upon them? For example, a decade ago corporate aircraft were selling far beyond the manufacturer’s ability to produce and finish the aircraft. Waiting lists were over a year and a half long. In the corporate aircraft industry, the aircraft manufacturers only made the basic airplane. Separate companies did the “completion” work. Picture buying a car and having it delivered without paint and with no interior and basic gauges. Under this model, the true bottleneck to delivery was the completion centers. Multiple manufacturers used the same companies and shared a common waiting list to have their aircraft completed. Given that missing delivery deadlines created fiscal penalties for most aircraft manufacturers, the suppliers (completion centers) had a tremendous amount of power. One manufacturer, Gulfstream, solved their problem by purchasing a completion center so that their aircraft were completed quickly and their competitor’s aircraft waited even longer for completion. The supplier in this case was able to charge very high prices and its owners capitalized on demand by selling their company at much higher than market value. While the corporate aircraft market looked very attractive, understanding supplier power suggests that any new entrants consider how they would overcome this issue.
New entrants. How likely is it that other firms are going to enter this market? If margins are high, costs are low, and demand is present the market is likely going to attract many new entrants. These new entrants will change the complexion of the market and drive profits down as more options exist for consumers and prices are reduced to capture and maintain market share. When the cost of entry is high, such as investing in a factory, real estate, equipment, etc. then new entrants are less likely to enter. If the incumbent firms can easily retaliate against new entrants then the market isn’t as attractive. For instance, an existing auto repair shop might lower its prices for a period of time to drive away a new competitor. Regulatory aspects might provide advantages to incumbents too, such as having rights of refusal on a large number of landing slots at an airport.
Buyer power. How strong an influence do buyers have in a market? If there are many possible customers and they don’t act as a group, they have less power. Conversely, if only a few buyers dominate the market, their power is significant. The market for fighter jets in the US is dominated by buyer power. The US government drives the market and regulates what can be sold. Buyer power is also influenced by options. If buyers have few options, they have minimal power. Consider gas prices. While alternative fuel is beginning to arrive, for the most part if people want to drive they have to buy gas. As there aren’t alternatives, buyers have little choice except to purchase gas.
Substitutes. What could the customer purchase that would fit their need instead of your product? A Rolex might be nice to have, but if the economy falters and spending decreases, how many Rolex customers might defect to Citizen? Rolex would need to know how many of their potential customers will stay solvent and spend regardless of the economic situation. Without knowing the answer to the market composition and size, Rolex would be at risk. Another example is SUVs and their sales numbers when gas prices skyrocketed. Many people opted to purchase more fuel-efficient cars and the lack of quick response imperiled the auto industry as thy had to alter their manufacturing at time when their profits had already shrunk and inventory was high.
Complements. Complements are the exact opposite of substitutes. While not a part of the original framework, complements are important to consider. What add-ons or consumable goods does a product need? Ink jet printers vary widely in price. Some printers are expensive, but ink is inexpensive and readily available. Other printers are almost free, but ink is proprietary and expensive. It is necessary to understand complements not only for your products, but also for your competitors and other potential entrants. If you rely on expensive ink and another manufacturer starts selling compatible cartridges for your printers, your business model might be damaged severely.
Rivalry among competing firms in the industry. It is critical to understand rivalry in an industry before entering or expanding into the market. Rivalry will be less intense in markets where the market is growing substantially, it is easy to differentiate your products, it is inexpensive to leave the market, and there is little excess capacity in the market. Rivalry is intense in the personal computer market because most firms allowed customers to completely customize their systems. Customization and lack of differentiation led to the view that computers are a commodity to be purchased based upon price. Apple suffered in this environment for many years as it produced few varieties of systems and had a closed software environment with fewer titles. Apple became very successful when it grasped the opportunity to differentiate and expand upon the systems and products available. Their growth significantly accelerated when their systems started allowing Windows programs to run and people started to switch. In this case, Apple’s challenging years may have provided the differentiation within the marketplace as their competitors started to compete on price alone.
Use the Five (Six) Forces Model when considering entering a new market, expanding geographically, launching a product, creating a business plan, etc. It provides an organizational structure to consider the attractiveness of a market and is also useful in the process of creating and validating a business model. These types of analysis exist to help you think through as much as possible before committing resources to a venture. The framework isn’t an answer in itself, but it is a part of the analysis that will help you reach an answer.
The Cogent Coach
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