FIVE FORCES MODEL

Michael Porter developed the five forces approach to assist the analysis of the competitive position in any business, by broadly assessing the forces of competition. The effort brought together different factors in a simple model. The intensity of competition among firms differs from industry to industry, highest being in lower-return industries. The nature of competitiveness in a specific industry is made up of these five forces.

The model focused on five forces that frame competition in an industry: Five forces are depicted in the diagram:

1. Potential entry of new competitors into the industry. 
2. The intensity of rivalry among competitor. 
3.  The bargaining power of buyers, 
4. The bargaining power of suppliers, and 
5. Potential development of substitute products

• The development of a viable strategy, therefore, should first undertake the identification and evaluation of all five forces. 
• The nature and importance of these forces vary from industry to industry and from firm to firm. 
• The purpose of the strategy, should, therefore, be to protect the firm from the resultant threats. 
• The strength of these forces restricts the ability of established companies to raise prices and earn higher profits. 
• A strong competitive force can be treated as a threat since it depresses profit. 
• A weak competitive force can be considered as opportunity, for it allows a firm to earn greater profits. 
• The task of strategic manager is to recognize opportunities and threats  and to formulate appropriate strategies. 
• The model assists in examining the competitive environment of an organization. 
• It provides an understanding of the forces at work in comprehending the changing industry environment.

1. Entry of potential competitors: 

• Potential competitors are companies that currently are outside an industry but have the intention to enter into it  if they choose. 
• Established companies in an industry attempt to discourage potential competitors from entering into, since the more companies enter an industry, the more difficult it would become for established companies to keep abreast their share of the market and to earn profits. 
• A high risk of entry by potential competitors represents a threat to the profitability of incumbent companies.  
• If the risk of fresh entry is low, established companies could take benefit of this opportunity to charge higher prices and earn greater returns. 
• The intensity of the competitive force of potential rivals is largely a function of the height of barriers to entry. 
• The barriers to entry imply that there are significant costs to joining an industry. 
• The greater the costs that potential competitors must bear, the greater are the barriers to entry.  High entry barriers keep potential competitors out of an industry even when industry returns are high.
• The scale economies are the cost advantages associated with large company size. 

The cost reductions gained through mass- production of a standard output, discounts on purchases of raw material inputs and component parts in large quantities, the spreading of fixed costs over a large volume and scale economies in advertising are the sources of scale economies. If these cost advantages are significant, then a potential entrant faces the problem of either entering on a small scale and suffering a significant cost disadvantage or take a very large risk by entering on a large scale and bearing significant capital costs. The large- scale entry of new entrants increasing the supply of products will depress prices and result in vigorous retaliation by established companies. If established companies have economies of scale, the threat of new entrants is reduced. The companies that have created brand loyalty for their products, have an absolute cost advantage with respect to potential competitors, or have significant scale economies, and then the risk of entry by potential competitors is greatly reduced.  When this risk is low, companies can charge higher prices and earn greater profits. Companies more likely pursue strategies consistent with these aims. The height of barriers to entry is the most important determinant of profit rates in an industry. Pharmaceuticals, house- hold detergents, and commercial jet aircraft are the examples of industries where entry barrier are considerably high. Pharmaceuticals and household detergents industries have achieved product differentiation through substantial expenditures for research and development and advertising and have built brand loyalty, making it difficult for new companies to enter these industries on a significant scale. The differential strategies of Procter and Gamble and Unilever have been so successful in house- hold detergents that these two companies dominate the global industry. In case of commercial jet aircraft industry, the barriers to entry are primarily due to scale economies. In some industries, scale economies are extremely important, for example, in the car or airline industry.

2. Rivalry among Competing Sellers in an Industry

 Companies will also be related with the extent of rivalry among competing sellers in an industry. The rivalry among the competing seller in an industry will be most intense where entry is likely, substitutes threaten, or buyers or suppliers exercise control. Companies have to face each others' competitive initiatives using the techniques of product introduction and innovation, pricing, quality, features, services, marketing campaigns, the use of distribution, and the like. The intensity of rivalry among competing sellers is concerned with a large number of competitors comparable in size and power, making it  difficult for a competitor to gain dominance over another and for stability to be reached, a lack of product differentiation or high switching costs, forcing all companies to fight for exactly the same market. There is little to stop customers switching between sellers. The extent of rivalry also determines the organizational performance.  The weak competitive force among companies within an industry encourages companies to charge higher price and earn greater profits. But the strong competitive force implying significant price competition may enrage price war among companies within an industry. Price competition by lowering down the profit margins reduces the profitability of the companies. The intensity of rivalry within an industry is mainly a function of three factors 
(1) demand conditions, 
(2) The height of exit barriers in the industry, and 
(3) industry competitive structure 

3. The Bargaining Power of Buyers

Buyers can pose a threat when they compel down prices or demand higher quality and better service. To do this, they may decide to play producers against each other, or refuse to buy from any single producer. Alternatively, weak buyers give a company the opportunity to raise price and earn greater returns. Whether buyers are able to make demands on a company depends on their power relative to that of the company. Buyers exercise their bargaining power if they earn low profits, as they will earn low profits, as this will create an incentive to lower purchasing costs or otherwise squeeze the industry, or to attempt to share its profit; for example, by backward integration. The firm can limit the power of buyers by targeting and selling to buyers who possess the least power to influence it adversely. In general, companies can only sell profitably in the long run to powerful buyers when it produces at a low cost and its product is adequately differentiated. If the company lacks both these characteristics, each sale to a power buyer makes the company more vulnerable. In such circumstances, targeting and selling to the weaker buyers becomes very important  

4. The Bargaining Power of Suppliers

Suppliers prove to be a threat when they can influence competitors in an industry by raising prices (thereby reducing buyers’ profitability), by reducing the quality of the product or service supplied, including delivery schedules etc. (by damaging a company’s reputation. or even by reducing output to any given company or to the industry as a whole. Alternatively, weak suppliers provide a company the opportunity to force down prices and demand higher quality.  As with buyers, the ability of suppliers to make demands on a company depends on their power relative to that of the company.  In general, suppliers are more likely to exercise their leverage when the competition in their own industry is weak. Some organizations may rely on suppliers other than tangible goods. For example, the provision of finance may be crucial to an organization and therefore, the power of the supplier of finance may be vital.

5. The Threat of Substitute Products: 

The products of industries that serve similar consumer needs as those of the industry being analyzed are thought to be substitutes. The availability of substitute products influences the actions of the firm’s customers. The fewer the substitutes, the greater the difficulty of switching to them, the more secure is the firm’s revenue.The existence of close substitutes presents a strong competitive threat, limiting the price a company can charge and thus its profitability. However, if a company’s products have few close substitutes, other thing being equal, the company has the opportunity to raise price and earn additional profits. The threat of substitutes may be actual or possible substitution of one product for another. A new product may render a product superfluous. Substitutes may also be thought of as those competing for discretionary expenditure. For example, refrigerator manufacturers or retailers should know that they compete for other household expenditure with manufacturers or retailers of television, furniture, video, cookers, gas range, scooter, car etc.  ‘Doing without’ can also be considered as a substitute, as in the case of a tobacco industry.