Martin Johnson is deciding whether to switch career and become a farmer – he’s always loved the countryside, and wants to switch to a career where he’s his own boss. He creates the following Five Forces Analysis as he thinks the situation through:
This worries him:
- The threat of new entry is quite high: if anyone looks as if they’re making a sustained profit, new competitors can come into the industry easily, reducing profits;
- Competitive rivalry is extremely high: if someone raises prices, they’ll be quickly undercut. Intense competition puts strong downward pressure on prices;
- Buyer Power is strong, again implying strong downward pressure on prices; and
- There is some threat of substitution.
Unless he is able to find some way of changing this situation, this looks like a very tough industry to survive in. Maybe he’ll need to specialize in a sector of the market that’s protected from some of these forces, or find a related business that’s in a stronger position.
Porter’s Five Forces Analysis is an important tool for assessing the potential for profitability in an industry. With a little adaptation, it is also useful as a way of assessing the balance of power in more general situations.
It works by looking at the strength of five important forces that affect competition:
- Supplier Power: The power of suppliers to drive up the prices of your inputs;
- Buyer Power: The power of your customers to drive down your prices;
- Competitive Rivalry: The strength of competition in the industry;
- The Threat of Substitution: The extent to which different products and services can be used in place of your own; and
- The Threat of New Entry: The ease with which new competitors can enter the market if they see that you are making good profits (and then drive your prices down).
By thinking through how each force affects you, and by identifying the strength and direction of each force, you can quickly assess the strength of the position and your ability to make a sustained profit in the industry.
You can then look at how you can affect each of the forces to move the balance of power more in your favor.