Five Competitive Forces That Shape Strategy

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In essence, the job of the strategist is to understand and cope with the competition. Often, however, managers define competition too narrowly, as if it occurred only among today’s direct competitors. Yet competition for profits goes beyond established industry rivals to include four other competitive forces as well: customers, suppliers, potential entrants, and substitute products. The extended rivalry that results from all five forces defines an industry’s structure and shapes the nature of competitive interaction within an industry.

As different from one another as industries might appear on the surface, the underlying drivers of profitability are the same. The global auto industry, for instance, appears to have nothing in common with the worldwide market for art masterpieces or the heavily regulated healthcare delivery industry in Europe. But to understand industry competition and profitability in each of those three cases, one must analyze the industry’s underlying structure in terms of the five forces.

If the forces are intense, as they are in such industries as airlines, textiles, and hotels, almost no company earns attractive returns on investment. If the forces are benign, as they are in industries such as software, soft drinks, and toiletries, many companies are profitable. Industry structure drives competition and profitability, not whether an industry produces a product or service, is emerging or mature, high tech or low tech, regulated or unregulated.

While a myriad of factors can affect industry profitability in the short run – including the weather and the business cycle – industry structure, manifested in the competitive forces, sets industry profitability in the medium and long run.


Five Forces that Shape the Industry Competition

Differences in Industry Profitability

Understanding the competitive forces, and their underlying causes, reveals the roots of an industry’s current profitability while providing a framework for anticipating and influencing competition (and profitability) over time. A healthy industry structure should be as much a competitive concern to strategists as their company’s position. Understanding industry structure is also essential to effective strategic positioning. As we will see, defending against competitive forces and shaping them in a company’s favor is crucial to the strategy.

The configuration of the five forces differs by industry. In the market for commercial aircraft, fierce rivalry between dominant producers Airbus and Boeing and the bargaining power of the airlines that place huge orders for aircraft are strong, while the threat of entry, the threat of substitutes, and the power of suppliers are more benign. In the movie theatre industry, the proliferation of substitute forms of entertainment and the power of the movie producers and distributors who supply movies, the critical input, are important.

The strongest competitive force or forces determine the profitability of an industry and become the most important to strategy formulation. The most salient force, however, is not always obvious.

Example

Even though the rivalry is often fierce in commodity industries, it may not be the factor limiting profitability. Low returns in the photographic film industry, for instance, are the result of a superior substitute product – as Kodak and Fuji, the world’s leading producers of photographic film, learned with the advent of digital photography. In such a situation, coping with the substitute product becomes the number one strategic priority.

Industry structure grows out of a set of economic and technical characteristics that determine the strength of each competitive force. We will examine these drivers in the pages that follow, taking the perspective of an incumbent, or a company already present in the industry. The analysis can be readily extended to understand the challenges facing a potential entrant.

Threat of Entry

New entrants to an industry bring new capacity and a desire to gain market share that puts pressure on prices, costs, and the rate of investment necessary to compete. Particularly when new entrants are diversifying from other markets, they can leverage existing capabilities and cash flows to shake up the competition, as Pepsi did when it entered the bottled water industry, Microsoft did when it began to offer internet browsers, and Apple did when it entered the music distribution business.

The threat of entry, therefore, puts a cap on the profit potential of an industry. When the threat is high, incumbents must hold down their prices or boost investment to deter new competitors. In specialty coffee retailing, for example, relatively low entry barriers mean that Starbucks must invest aggressively in modernizing stores and menus.

The threat of entry in an industry depends on the height of entry barriers that are present and on the reaction entrants can expect from incumbents. If entry barriers are low and newcomers expect little retaliation from the entrenched competitors, the threat of entry is high and industry profitability is moderated. It is the threat of entry, not whether entry occurs, that holds down profitability.

Barriers to Entry

Entry barriers are advantages that incumbents have relative to new entrants. There are seven major sources:

  • Supply-side economies of scale: These economies arise when firms that produce at larger volumes enjoy lower costs per unit because they can spread fixed costs over more units, employ more efficient technology, or command better terms from suppliers. Supply-side scale economies deter entry by forcing the aspiring entrant either to come into the industry on a large scale, which requires dislodging entrenched competitors or to accept a cost disadvantage.

    Scale economies can be found in virtually every activity in the value chain; which ones are most important varies by industry. In microprocessors, incumbents such as Intel are protected by scale economies in research, chip fabrication, and consumer marketing. For lawn care companies like Scotts Miracle-Gro, the most important scale economies are found in the supply chain and media advertising. In small-package delivery, economies of scale arise in national logistical systems and information technology.

  • Demand-side benefits of scale: These benefits, also known as network effects, arise in industries where a buyer’s willingness to pay for a company’s product increases with the number of other buyers who also patronize the company. Buyers may trust larger companies more for a crucial product: Recall the adage that no one ever got fired for buying from IBM (when it was the dominant computer maker). Buyers may also value being in a “network” with a larger number of fellow customers.

    Example: Online auction participants are attracted to eBay because it offers the most potential trading partners. Demand-side benefits of scale discourage entry by limiting the willingness of customers to buy from a newcomer and by reducing the price the newcomer can command until it builds up a large base of customers.

  • Customer switching costs: Switching costs are fixed costs that buyers face when they change suppliers. Such costs may arise because a buyer who switches vendors must, for example, alter product specifications, retrain employees to use a new product,, or modify processes or information systems. The larger the switching costs, the harder it will be for an entrant to gain customers.

    Example: Enterprise Resource Planning (ERP) software is an example of a product with very high switching costs. Once a company has installed SAP’s ERP system, the costs of moving to a new vendor are astronomical because of embedded data, the fact that internal processes have been adapted to SAP, major retraining needs, and the mission-critical nature of the applications.

  • Capital requirements: The need to invest large financial resources in order to compete can deter new entrants. Capital may be necessary not only for fixed facilities but also to extend customer credit, build inventories, and fund start-up losses. The barrier is particularly great if the capital is required for unrecoverable and therefore harder-to-finance expenditures, such as up-front advertising or research and development.

    While major corporations have the financial resources to invade almost any industry, the huge capital requirements in certain fields limit the pool of likely entrants. Conversely, in such fields as tax preparation services or short-haul trucking, capital requirements are minimal and potential entrants are plentiful. It is important not to overstate the degree to which capital requirements alone deter entry. If industry returns are attractive and are expected to remain so, and if capital markets are efficient, investors will provide entrants with the funds they need.

    Example: For aspiring air carriers, financing is available to purchase expensive aircraft because of their high resale value, one reason why there have been numerous new airlines in almost every region.

  • Incumbency advantages independent of size: No matter what their size, incumbents may have cost or quality advantages not available to potential rivals. These advantages can stem from such sources as proprietary technology, preferential access to the best raw material sources, preemption of the most favorable geographic locations, established brand identities, or cumulative experience that has allowed incumbents to learn how to produce more efficiently. Entrants try to bypass such advantages.

    Example: Upstart discounters such as Target and Walmart, have located stores in freestanding sites rather than regional shopping centers where established department stores were well entrenched.

  • Unequal access to distribution channels: The new entrant must, of course, secure distribution of its product or service. A new food item, for example, must displace others from the supermarket shelf via price breaks, promotions, intense selling efforts, or some other means. The more limited the wholesale or retail channels are and the more that existing competitors have tied them up, the tougher entry into the industry will be.

    Sometimes access to distribution is so high a barrier that new entrants must bypass distribution channels altogether or create their own. Thus, upstart low-cost airlines have avoided distribution through travel agents (who tend to favor established higher-fare carriers) and have encouraged passengers to book their flights on the Internet.

  • Restrictive government policy: Government policy can hinder or aid new entry directly, as well as amplify (or nullify) the other entry barriers. Government directly limits or even forecloses entry into industries through, for instance, licensing requirements and restrictions on foreign investment. Regulated industries like liquor retailing, taxi services, and airlines are visible examples.

    Government policy can heighten other entry barriers through such means as expansive patenting rules that protect proprietary technology from imitation or environmental or safety regulations that raise scale economies facing newcomers. Of course, government policies may also make entry easier – directly through subsidies, for instance, or indirectly by funding basic research and making it available to all firms, new and old, reducing scale economies.

    Entry barriers should be assessed relative to the capabilities of potential entrants, which may be start-ups, foreign firms, or companies in related industries. And, as some of our examples illustrate, the strategist must be mindful of the creative ways newcomers might find to circumvent apparent barriers.

Expected Retaliation

How potential entrants believe incumbents may react will also influence their decision to enter or stay out of an industry. If the reaction is vigorous and protracted enough, the profit potential of participating in the industry can fall below the cost of capital. Incumbents often use public statements and responses to one entrant to send a message to other prospective entrants about their commitment to defending market share.

Newcomers are likely to fear expected retaliation if:

  • Incumbents have previously responded vigorously to new entrants.

  • Incumbents possess substantial resources to fight back, including excess cash and unused borrowing power, available productive capacity, or clout with distribution channels and customers.

  • Incumbents seem likely to cut prices because they are committed to retaining market share at all costs or because the industry has high fixed costs, which creates a strong motivation to drop prices to fill excess capacity.

  • Industry growth is slow so newcomers can gain volume only by taking it from incumbents.

An analysis of barriers to entry and expected retaliation is obviously crucial for any company contemplating entry into a new industry. The challenge is to find ways to surmount the entry barriers without nullifying, through heavy investment, the profitability of participating in the industry.

Power of Suppliers

Powerful suppliers capture more of the value for themselves by charging higher prices, limiting quality or services, or shifting costs to industry participants. Powerful suppliers, including suppliers of labour, can squeeze profitability out of an industry that is unable to pass on cost increases in its own prices.

Example: Microsoft has contributed to the erosion of profitability among personal computer makers by raising prices on operating systems. PC makers, competing fiercely for customers who can easily switch among them, have limited freedom to raise their prices accordingly.

Companies depend on a wide range of different supplier groups for inputs. A supplier group is powerful if:

  • It is more concentrated than the industry it sells to. Microsoft’s near monopoly in operating systems, coupled with the fragmentation of PC assemblers, exemplifies this situation.

  • The supplier group does not depend heavily on the industry for its revenues. Suppliers serving many industries will not hesitate to extract maximum profits from each one. If a particular industry accounts for a large portion of a supplier group’s volume or profit, however, suppliers will want to protect the industry through reasonable pricing and assist in activities such as R&D and lobbying.

  • Industry participants face switching costs in changing suppliers. For example, shifting suppliers is difficult if companies have invested heavily in specialized ancillary equipment or in learning how to operate a supplier’s equipment (as with Bloomberg terminals used by financial professionals).

    Or firms may have located their production lines adjacent to a supplier’s manufacturing facilities (as in the case of some beverage companies and container manufacturers). When switching costs are high, industry participants find it hard to play suppliers off against one another. (Note that suppliers may have switching costs as well. This limits their power.)

  • Suppliers offer products that are differentiated.

    Example: Pharmaceutical companies that offer patented drugs with distinctive medical benefits have more power over hospitals, health maintenance organizations, and other drug buyers, for example than drug companies offering me-too or generic products.

  • There is no substitute for what the supplier group provides.

    Example: Pilots’ unions, exercise considerable supplier power over airlines partly because there is no good alternative to a well-trained pilot in the cockpit.

  • The supplier group can credibly threaten to integrate forward into the industry. In that case, if industry participants make too much money relative to suppliers, they will induce suppliers to enter the market.

Power of Buyers

Powerful customers – the flip side of powerful suppliers – can capture more value by forcing down prices, demanding better quality or more service (thereby driving up costs), and generally playing industry participants off against one another, all at the expense of industry profitability. Buyers are powerful if they have to negotiate leverage relative to industry participants, especially if they are price sensitive, using their clout primarily to pressure price reductions.

As with suppliers, there may be distinct groups of customers who differ in bargaining power. A customer group has negotiating leverage if:

  • There are few buyers or each one purchases in volumes that are large relative to the size of a single vendor. Large-volume buyers are particularly powerful in industries with high fixed costs, such as telecommunications equipment, offshore drilling, and bulk chemicals. High fixed costs and low marginal costs amplify the pressure on rivals to keep capacity filled through discounting.

  • The industry’s products are standardized or undifferentiated. If buyers believe they can always find an equivalent product, they tend to play one vendor against another.

  • Buyers face few switching costs in changing vendors.

  • Buyers can credibly threaten to integrate backward and produce the industry’s product themselves if vendors are too profitable.

Producers of soft drinks and beer have long controlled the power of packaging manufacturers by threatening to make, and at times actually making, packaging materials themselves.

A buyer group is price sensitive if:

  • The product it purchases from the industry represents a significant fraction of its cost structure or procurement budget. Here buyers are likely to shop around and bargain hard, as consumers do for home mortgages. Where the product sold by industry is a small fraction of buyers’ costs or expenditures, buyers are usually less price sensitive.

  • The buyer group earns low profits, is strapped for cash, or is otherwise under pressure to trim its purchasing costs. Highly profitable or cash-rich customers, in contrast, are generally less price sensitive (that is, of course, if the item does not represent a large fraction of their costs).

  • The quality of buyers’ products or services is little affected by the industry’s product. Where quality is very much affected by the industry’s product, buyers are generally less price sensitive. When purchasing or renting production-quality cameras, for instance, makers of major motion pictures opt for highly reliable equipment with the latest features. They pay limited attention to the price.

  • The industry’s product has little effect on the buyer’s other costs. Here, buyers focus on price. Conversely, where an industry’s product or service can pay for itself many times over by improving performance or reducing labor, material, or other costs, buyers are usually more interested in quality than in price.

Examples: Include products and services like tax accounting or well logging (which measures below-ground conditions of oil wells) that can save or even make the buyer money. Similarly, buyers tend not to be price sensitive in services such as investment banking, where poor performance can be costly and embarrassing.

Most sources of buyer power apply equally to consumers and to business-to-business customers. Like industrial customers, consumers tend to be more price sensitive if they are purchasing products that are undifferentiated, expensive relative to their incomes, and of a sort where product performance has limited consequences. The major difference with consumers is that their needs can be more intangible and harder to quantify.

Intermediate customers, or customers who purchase the product but are not the end user (such as assemblers or distribution channels), can be analyzed the same way as other buyers, with one important addition. Intermediate customers gain significant bargaining power when they can influence the purchasing decisions of customers downstream. Consumer electronics retailers, jewelry retailers, and agricultural equipment distributors are examples of distribution channels that exert a strong influence on end customers.

Producers often attempt to diminish channel clout through exclusive arrangements with particular distributors or retailers or by marketing directly to end users. Component manufacturers seek to develop power over assemblers by creating preferences for their components with downstream customers. Such is the case with bicycle parts and with sweeteners.

Example

DuPont has created enormous clout by advertising its Stainmaster brand of carpet fibers not only to the carpet manufacturers that actually buy them but also to downstream consumers. Many consumers request Stainmaster carpets even though DuPont is not a carpet manufacturer.

Threat of Substitutes

A substitute performs the same or a similar function as an industry’s product by a different means. Videoconferencing is a substitute for travel. Plastic is a substitute for aluminum. E-mail is a substitute for express mail. Sometimes, the threat of substitution is downstream or indirect, when a substitute replaces a buyer industry’s product.

Example: Lawn-care products and services are threatened when multifamily homes in urban areas substitute for single-family homes in the suburbs. Software sold to agents is threatened when airline and travel websites substitute for travel agents.

Substitutes are always present, but they are easy to overlook because they may appear to be very different from the industry’s product: To someone searching for a Father’s Day gift, neckties, and power tools may be substituted. It is a substitute to do without, to purchase a used product rather than a new one, or to do it yourself (bring the service or product in-house).

When the threat of substitutes is high, industry profitability suffers. Substitute products or services limit an industry’s profit potential by placing a ceiling on prices. If an industry does not distance itself from substitutes through product performance, marketing, or other means, it will suffer in terms of profitability – and often growth potential. Substitutes not only limit profits in normal times, they also reduce the bonanza an industry can reap in good times.

Example: In emerging economies, the surge in demand for wired telephone lines has been capped as many consumers opt to make a mobile telephone their first and only phone line.

The threat of a substitute is high if:

  • It offers an attractive price-performance trade-off to the industry’s product. The better the relative value of the substitute, the tighter the lid on an industry’s profit potential.

Example: Conventional providers of long-distance telephone service have suffered from the advent of inexpensive internet-based phone services such as Vonage and Skype. Similarly, video rental outlets are struggling with the emergence of cable and satellite video-on-demand services, online video rentals services such as Netflix, and the rise of internet video sites like Google’s YouTube.

  • The buyer’s cost of switching to the substitute is low. Switching from a proprietary, branded drug to a generic drug usually involves minimal costs, for example, which is why the shift to generics (and the fall in prices) is so substantial and rapid.

Strategists should be particularly alert to changes in other industries that may make them attractive substitutes when they were not before. Improvements in plastic materials, for example, allowed them to substitute for steel in many automobile components.

In this way, technological changes or competitive discontinuities in seemingly unrelated businesses can have major impacts on industry profitability. Of course, the substitution threat can also shift in favor of an industry, which bodes well for its future profitability and growth potential.

Rivalry Among Existing Competitors

Rivalry among existing competitors takes many familiar forms, including price discounting, new product introductions, advertising campaigns, and service improvements. High rivalry limits the profitability of an industry. The degree to which rivalry drives down an industry’s profit potential depends, first, on the intensity with which companies compete and, second, on the basis on which they compete.

The intensity of rivalry is greatest if:

  • Competitors are numerous or are roughly equal in size and power. In such situations, rivals find it hard to avoid poaching business. Without an industry leader, practices desirable for the industry as a whole go unenforced.

  • Industry growth is slow. Slow growth precipitates fights for market share.

  • Exit barriers are high. Exit barriers, the flip side of entry barriers, arise because of such things as highly specialized assets or management’s devotion to a particular business. These barriers keep companies in the market even though they may be earning low or negative returns. Excess capacity remains in use, and the profitability of healthy competitors suffers as the sick ones hang on.

  • Rivals are highly committed to the business and have aspirations for leadership, especially if they have goals that go beyond economic performance in the particular industry. High commitment to a business arises for a variety of reasons.

Example: State-owned competitors may have goals that include employment or prestige. Units of larger companies may participate in the industry for image reasons or to offer a full line. Clashes of personality and ego have sometimes exaggerated rivalry to the detriment of profitability in fields such as the media and high technology.

  • Firms cannot read each other’s signals well because of a lack of familiarity with one another, diverse approaches to competing, or differing goals.

Rivalry is especially destructive to profitability if it gravitates solely to price because price competition transfers profits directly from the industry to its customers. Price cuts are usually easy for competitors to see and match, making successive rounds of retaliation likely. Sustained price competition also trains customers to pay less attention to product features and services.

Price competition is most liable to occur if:

  • Products or services of rivals are nearly identical and there are few switching costs for buyers. This encourages competitors to cut prices to win new customers. Years of airline price wars reflect these circumstances in that industry.

  • Fixed costs are high and marginal costs are low. This creates intense pressure for competitors to cut prices below their average costs, even close to their marginal costs, to steal incremental customers while still making some contribution to covering fixed costs. Many basic-materials businesses, such as paper and aluminum, suffer from this problem, especially if demand is not growing. So do delivery companies with fixed networks of routes that must be served regardless of volume.

  • Capacity must be expanded in large increments to be efficient. The need for large capacity expansions, as in the polyvinyl chloride business, disrupts the industry’s supply-demand balance and often leads to long and recurring periods of overcapacity and price cutting.

  • The product is perishable. Perishability creates a strong temptation to cut prices and sell a product while it still has value. More products and services are perishable than is commonly thought. Just as tomatoes are perishable because they rot, models of computers are perishable because they soon become obsolete, and information may be perishable if it diffuses rapidly or becomes outdated, thereby losing its value. Services such as hotel accommodations are perishable in the sense that unused capacity can never be recovered.

Competition on dimensions other than price – on product features, support services, delivery time, or brand image, for instance – is less likely to erode profitability because it improves customer value and can support higher prices. Also, rivalry focused on such dimensions can improve value relative to substitutes or raise the barriers facing new entrants. While non-price rivalry sometimes escalates to levels that undermine industry profitability, this is less likely to occur than it is with price rivalry.

As important as the dimensions of rivalry is whether rivals compete on the same dimensions. When all or many competitors aim to meet the same needs or compete on the same attributes, the result is zero-sum competition. Here, one firm’s gain is often another’s loss, driving down profitability. While price competition runs a stronger risk than non-price competition of becoming zero-sum, this may not happen if companies take care to segment their markets, targeting their low-price offerings to different customers.

Rivalry can be a positive sum, or actually increase the average profitability of an industry, when each competitor aims to serve the needs of different customer segments, with different mixes of prices, products, services, features, or brand identities. Such competition can not only support higher average profitability but also expand the industry, as the needs of more customer groups are better met.

The opportunity for positive-sum competition will be greater in industries serving diverse customer groups. With a clear understanding of the structural underpinnings of rivalry, strategists can sometimes take steps to shift the nature of competition in a more positive direction.

How to Analyse Industry – (Michael Porter, HBR-Jan, 2008)

  • Analyse average industry profitability over a period

  • A 3-5 year period can distinguish temporary/cyclical changes from structural changes

  • Understanding the underpinnings of competition and the root causes of profitability in an industry analysis is not important to declare an industry attractive or unattractive

  • Analyse industry structure quantitatively, then qualitatively with lists of factors

  • Quantify the 5 forces – % age of buyer’s total cost accounted for by industry’s product (to understand buyer price sensitivity); %age of industry sales required to fill a plant or operate a logistical network of efficient scale (to assess barriers to entry); buyer’s switching cost (to determine inducement an entrant or rival must offer customers)

  • Define relevant industry – Products, exclusive/indirect industry, scope, competition

  • Identify and segment participants – buyers, suppliers, competitors, substitutes, and potential entrants

  • Assess drivers of each competitive force – determine which are strong and weak – Why

  • Determine overall industry structure and consistency – profitability levels and reasons, controlling factors; are more profitable players better positioned wrt the 5 forces

  • Analyse future changes (+/–) in each force

  • Aspects of industry structure, influenced by company, competitors, or new entrants

  • Common Pitfalls

  • Defining industry – too broadly or too narrowly

  • Paying equal attention to all forces than focusing on the most important ones

  • Confusing effect (price sensitivity) with cause (buyer economics)

  • Using the static analysis that ignores industry trends

  • Confusing cyclical or transient changes with true structural changes

  • Use a framework for strategic choices then declare the industry – attractive/unattractive
Article Source
  • E Mosakowski, “A Resource Based Perspective on the Dynamic Strategy-Performance Relationship”, Journal of Management, Vol. 19, 1993.

  • G Saloner et al., Strategic Management, John Wiley & Sons, New York, 2001.

  • M H Hitt, R D Ireland, and R E Hoskisson, Strategic Management, South Western Publishing Company, Cincinnati, Ohio, 2001.

  • N W C Harper & S P Viguerie, Are you too Focused?, Business World, 7-10-2002.

  • P Kotler, Marketing Management, Pearson, Delhi, 2003.


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