Porter's Five Forces

2) Threat of Substitutes

All firms must recognize that they compete against firms producing substitute products, those products that are capable of satisfying similar customer needs but come from outside the industry and thus have different characteristics. The prices of the substitute products, the need to match quality the performance differences and the cost associated with creating perceived differentiation may significantly influence potential profits.

f) Access to Distribution Channels

As existing firms in an industry generally have developed effective channels for distributing products, these same channels may not be available to new firms entering an industry. Thus, access (or lack thereof) may serve as an effective barrier to entry. The cost of developing the channels reduces the potential profits for new entrants.

a) Barriers to Entry

Barriers to entering an industry are present when entry is difficult or when it is too costly and places potential entrants at a competitive disadvantage (relative to firms already competing in the industry). There are seven factors that represent potentially significant entry barriers that can protect profitability by deterring new competitors from entry.

c) Product Differentiation

Customers may perceive that products offered by existing firms in the industry are unique as a result of service offered, effective advertising campaigns, or being first to offer a product of service to the market. If customers perceive a product or service as unique, they generally are loyal to that brand. Thus, new entrants may be required to spend a great deal of money over a long period of time to overcome customer loyalty to existing products.

b) Economies of Scale

Economies of scale refers to the relationship between quantity produced and unit cost: As the quantity of a product produced during a given time period increases, the cost of manufacturing each unit declines.

g) Cost Disadvantages Independent of Scale

Existing firms in an industry often are able to achieve cost advantages that cannot be efficiently duplicated by new entrants .

h) Government Policy

Governments (at all levels) are able to control entry into an industry through licensing and permit requirements.

a) Numerous or Equally Balanced Competitors

Industries with a high number of firms can be characterized by intense rivalry. Patterns of frequent actions and reactions often result in intense rivalry. Rivalry also will be intense in an industry that has only a few firms of equivalent resources and power.

1) Threat of New Entrants

New entrants to an industry are important because, with new competitors, the intensity of competitive rivalry in an industry generally increases. One result may be a decline in sales and lower returns for many firms in the industry. The seriousness of the threat is affected by two factors: barriers to entry and expected reactions from incumbent firms in the industry.

d) Lack of Differentiation or Low Switching Costs

Products that are not characterized by brand loyalty or perceived uniqueness are generally viewed by buyers as commodities. Products for which customers incur no or few switching costs are subject to intense price- and service-based competition, thus reducing the profit margins.

4) Bargaining Power of Suppliers

Suppliers to the industry wish to capture as much of the profit in the value chain as possible. If an intermediary is earning excessive profits, suppliers will raise prices in order to capture a greater share of the profit. 1) How are inputs differentiated? Commodity products among competing suppliers eliminates supplier bargaining power as the price is set by market forces. 2) Are substitute products available that the firm could switch to if the supplier raises prices? 3) Are there switching costs? 4) Does the firm compete with its supplier? (Is there a threat of forward integration?)

d) Capital Requirements

Switching costs are the one-time costs customers will incur when buying from a different supplier. These can include such explicit costs as retraining of employees or retooling of equipment as well as the psychological cost of changing relationships. Incumbent firms in the industry generally try to establish switching costs to offset new entrants that try to win customers with substantially lower prices or an improved product.

e) Switching Costs

Switching costs are the one-time costs customers will incur when buying from a different supplier. These can include such explicit costs as retraining of employees or retooling of equipment as well as the psychological cost of changing relationships. Incumbent firms in the industry generally try to establish switching costs to offset new entrants that try to win customers with substantially lower prices or an improved product.

f) High Exit Barriers

The higher the barriers to exit, the greater the probability that competitive actions and reactions will include price cuts and extensive promotions.

e) High Strategic Stakes

The intensity of competitive rivalry increases when success in an industry is important to a large number of firms. For example, the success of a diversified firm may be important to its effectiveness in other industries, especially when the firm is in interdependent or related industries. The high strategic stakes impact the long term profit potential for an organization.

5) Competitive Rivalry

The intensity of rivalry in an industry depends upon the extent to which firms in an industry compete with one another to achieve strategic competitiveness and earn above-average returns. Competition can be based on price, quality, or innovation, each of which changes the costs and revenue within the industry. Because of the interrelated nature of firms' actions, action taken by one firm generally will result in retaliation by competitors.

b) Slow Industry Growth

When a market is growing at a level where there seem to be "enough customers for everyone," competition generally centers around effective use of resources so that a firm can effectively serve a larger, growing customer base. The intensity of competition in a slow growth industry often results in a reduction in industry profitability. Slow market growth also reduces the chance of gaining the cost advantages of economies of scale.

c) High Fixed Costs or High Storage Costs

When an industry is characterized by high fixed costs relative to total costs, firms produce in quantities that are sufficient to use a large percentage of their production capacity so that fixed costs can be spread over the maximum volume of output. While this may lower per unit costs, it also can result in excess supply if market growth is not sufficient to absorb the excess inventory. The intensity of competitive rivalry increases as firms use price reductions, rebates, and other discounts or special terms to reduce inventory, each of which reduces the profit potential.

3) Bargaining Power of Customers

While firms seek to maximize their return on invested capital, buyers are interested in purchasing products at the lowest possible price (the price at which sellers will earn the lowest acceptable return). To reduce cost or maximize value, customers bargain for higher quality or greater levels of service at the lowest possible price by encouraging competition among firms in the industry. The bargaining power may increase the potential profits of the buyers and reduce the potential profits for the suppliers.