Porter's Five Forces EXPLAINED with EXAMPLES | B2U (2023)

Porter's Five Forces Analysis is a framework that helps analyze the level of competition within a given industry. It is especially useful when starting a new business or entering a new industry. Competitiveness does not only come from competitors. Rather, the competitive state of an industry depends on five fundamental forces: threat of new entrants, bargaining power of suppliers, bargaining power of buyers, threat of substitute products or services, and existing rivalry in the industry. The collective strength of these forces determines an industry's earnings potential and thus its attractiveness. When the five forces are intense (e.g. airline industry), almost no company in the industry generates attractive returns. However, when forces are mild (e.g. soft drink industry) there is room for higher returns. Each force is further explained below using examples from the aviation industry to illustrate usage.

Figure 1: Five Forces Model

Threat of new entrants

Newcomers to an industry bring new capabilities and a desire to gain market share. The severity of the threat depends on the barriers to entry in a particular industry. The higher these barriers to entry, the lower the threat to existing players. Examples of barriers to entry are the need foreconomies of scale, high customer loyalty for existing brands, high capital requirements (e.g. large investments in marketing or R&D), the need for accumulated experience, government policies and limited access to distribution channels. See the table below for additional barriers.

example

The threat from new entrants in the aviation industry can be classified as low to medium. There are some upfront investments required to start an airline (e.g. buying planes). In addition, new entrants require licenses, insurance, distribution channels, and other qualifications that are not readily available to industry newcomers (e.g., access to airline routes). In addition, it can be expected that existing players have built up a large experience base over the years in order to reduce costs and increase the level of service. A new entrant probably doesn't have that kind of expertise and therefore creates a competitive disadvantage right from the start. However, due to the liberalization of market access and the availability of leasing options and debt financing from banks, investors and aircraft manufacturers, new doors are opening for potential market participants. Even if it doesn't sound very attractive for companies to enter the aviation industry, it is NOT impossible. Many low-cost carriers such as Southwest Airlines, RyanAir and EasyJet have successfully entered the industry over the years by introducing innovative cost-cutting business models, shaking up original players such as American Airlines, Delta Air Lines and KLM.

Porter's Five Forces video tutorial

bargaining power of suppliers

This force analyzes how much power and control a firm's supplier (aka the market of inputs) has over the potential to increase its prices or decrease the quality of goods or services purchased, which in turn would reduce an industry's potential for profitability. Supplier concentration and the availability of backup suppliers are important factors in determining supplier power. The fewer there are, the more power they have. Companies are better positioned when there are a large number of suppliers. Sources of supplier power also include the switching costs of companies in the industry, the existence of available substitutes, the strength of their distribution channels, and the uniqueness or level ofDistinctionin the product or service that the supplier delivers.

example

The bargaining power of suppliers in the aviation industry can be considered very high. Looking at the key inputs airlines require, we see that they are particularly dependent on fuel and aircraft. However, these inputs are heavily influenced by the external environment over which the airlines themselves have little control. The price of aviation fuel is subject to fluctuations in the global oil market, which can change significantly due to geopolitical and other factors. When it comes to aircraft, for example, there are only two major suppliers: Boeing and Airbus. Boeing and Airbus therefore have significant bargaining power over the prices they charge.

bargaining power of buyers

The bargaining power of buyers is also known as the market for services. This force analyzes the extent to which customers can pressure the company, which also affects customers' sensitivity to price changes. Customers have a lot of power when there aren't many of them and when customers have many alternatives to buy from. Also, it should be easy for them to move from one company to another. However, purchasing power is low when customers buy products in small quantities, act independently, and when the seller's product is very different from those of its competitors. The Internet has made it possible for customers to be better informed and thus more able to act. Customers can easily compare prices online, find out about a wide range of products and immediately access offers from other companies. Companies can take steps to reduce buyer power, for example by implementing loyalty programs or differentiating their products and services.

example

The bargaining power of buyers in the aviation industry is high. Customers can quickly check the prices of different airlines using the many online price comparison sites such as Skyscanner and Expedia. In addition, there are no switching costs in this process. Customers these days are likely to fly to and from their destination on different airlines if that would reduce costs. So brand loyalty doesn't seem to be that high. Some airlines are trying to change that with frequent flyer programs aimed at rewarding customers who return to them from time to time.

Threat of substitute products

The presence of products outside of the common product boundaries increases the propensity of customers to switch to alternatives. To discover these alternatives, one should look beyond similar products that are branded differently by competitors. Instead, each product that serves a similar customer need should be considered. Energy drinks like Redbull, for example, aren't typically seen as competitors to coffee brands like Nespresso or Starbucks. However, since both coffee and energy drinks fulfill a similar need (i.e., stay awake/gain energy), customers might be willing to switch from one to the other if they feel coffee or energy drink prices are rising too much. This ultimately affects the profitability of an industry and should therefore also be taken into account when evaluating the attractiveness of the industry.

example

Regarding the aviation industry, it can be said that the general need of its customers is to travel. It may be clear that there are many alternatives to travel besides the plane. Depending on the urgency and distance, customers could travel by train or car. Especially in Asia, more and more people are using high-speed trains such as Bullet Trains and Maglev Trains. In addition, the aviation industry could face serious competition in the future from Elon Musk's Hyperloop concept, in which passengers travel in capsules through a vacuum tube while hitting speed limits of 1200 km/h. Overall, the risk from substitutes in the airline industry can be rated as at least medium to high.

Rivalry between the existing competitors

This last force of Porter's Five Forces examines how intense the current competition is in the market, which is determined by the number of competitors in existence and the capability of each competitor. Rivalry is strong when there are many competitors of roughly the same size and capability, when the industry is growing slowly, and when consumers can easily switch to a competitor's low-cost offering. A good indicator of competitive rivalry is theconcentration ratioan industry. The lower this ratio is, the more intense the rivalry is likely to be. When rivalry is high, competitors are likely to actively engage in advertising and price wars, which can hurt a company's bottom line. In addition, rivalry intensifies when exit barriers are high, forcing companies to stay in the industry despite falling profit margins. These exit barriers can be, for example, long-term loan agreements and high fixed costs.

example

If we look at the airline industry in the United States, we see that the industry is extremely competitive for a number of reasons including the entry of low-cost airlines, the tight regulation of the industry which puts safety first, resulting in high fixed costs leads, and high exit barriers and the fact that the growth of the industry is very stagnant at the moment. Switching costs for customers are also very low and many players in the industry are similar in size (see chart below), resulting in particularly fierce competition between these companies. Overall, the rivalry among existing competitors in the airline industry is high.

(Source: United States Department of Transportation, 2016)

By looking at each competitive force individually, you can roughly map the focus industry and its attractiveness. Note that the attractiveness of the industries may differ depending on the country you are looking at. For example, government policies are likely to be different in each country, and the number of suppliers and buyers may also vary from country to country. Porter's Five Forces are a good starting point for evaluating an industry, but should not be used in isolation. You could combine it with a for exampleAnalysis of the value chainor through theVRIO-Frameworkto get a better sense of where your company's competitive advantage comes from and to better position your company among competitors. In addition, Porter's Five Forces is often combined with thePESTEL-Analyseto give a good overview of the environment of the organization. Finally, it should be said that the framework has also been criticized by several authors. For example, some authors have argued that the model requires a sixth force called "complementors" to explain the rationale for strategic alliances and joint ventures. This advanced model is also calledvalue net model. Despite the criticism, however, Porter's Five Forces is still one of the most widely used frameworks for strategy development and will likely remain so for the foreseeable future.

Figure 2: Factors of Porter's Five Forces

Full list of factors of Porter's Five Forces:

Threat of new entrants

• economies of scale
• product differentiation
• Brand Identity/Loyalty
• Access to Distribution Channels
• capital requirement
• Access to the latest technology
• Access to necessary inputs
• Absolute cost advantages
• experience and learning effects
• government policy
• conversion costs
• Expected retaliation from existing players

bargaining power of suppliers

• number of suppliers
• size of suppliers
• supplier concentration
• Availability of substitute products for the supplier's products
• Uniqueness of the supplier's products or services (differentiation)
• Switching costs for the supplier's products
• Threat of forward integration by the supplier
• Industry threat from backward integration
• Contribution of the supplier to the quality or service of the industrial products
• Importance of volume for the supplier
• Total industry costs contributed by suppliers
• Importance of the industry for the supplier's profit

bargaining power of buyers

• Buyer volume (number of customers)
• Size of each buyer's order
• buyer concentration
• ability of the buyer to substitute
• exchange costs of the buyer
• Availability of Buyer Information
• Threat of the buyer with backward integration
• Threat to the industry from forward integration
• price sensitivity

Threat of substitute products or services

• Number of replacement products available
• Buyer's propensity to substitute
• Relative price development of substitutes
• Perceived level of product differentiation
• conversion costs
• Profitability and aggressiveness of the replacement producer

Rivalry between the existing competitors

• number of competitors
• diversity of competitors
• Industry concentration and balance
• industry growth
• Industry Life Cycle
• differences in quality
• product differentiation
• Brand Identity/Loyalty
• conversion costs
• Temporary overcapacity
• information complexity
• exit barriers

Further reading:

• Porter, ME (1979). How competitive forces shape strategy. Harvard Business Review
• Porter, ME (2008). The five competitive forces that shape strategy. Harvard Business Review

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