When to use it

• To understand the average profitability level of an existing industry.
• To identify opportunities for your firm to become more profitable.

Origins

Michael Porter was a junior faculty member at Harvard Business School in the mid-1970s, with a background in the micro-economic theories of ‘industrial organisation’. That body of literature was mostly concerned about how to prevent firms from making too much money (for example, by preventing them from getting monopoly power). Porter realised that he could reframe those ideas as a way of understanding why firms in some industries were so consistently profitable anyway. He wrote a number of academic papers showing how industrial organisation and strategic thinking could be reconciled. He also popularised his ideas through a classic article in the Harvard Business Review in 1979, called ‘How competitive forces shape strategy’. His book on the same subject, Competitive Strategy, was published the following year.

The five forces was the first rigorous framework for analysing the immediate industry in which a firm was competing. Before that, most managers had used ‘SWOT’ analysis (strengths, weaknesses, opportunities, threats), which is a useful but unstructured way of listing issues facing a firm.

What it is

Five forces analysis is a framework for analysing the level of competition within and around an industry, and thus its overall ‘attractiveness’ to the firms competing in it. Collectively, these competitors make up the micro-environment of forces close to the firm, in contrast to the macro-environment (such as geopolitical trends) that typically affect an industry indirectly or more slowly. The five forces are defined as follows:

1. Threat of new entrants: Profitable markets attract new entrants, which in turn decreases the level of profitability. However, it is not always possible for firms to enter profitable markets, perhaps because of the financial or technological hurdles that have to be crossed, or perhaps even for regulatory reasons. It is therefore useful to think in terms of the barriers to entry in an industry that make it hard for new competitors to enter. Some industries (such as pharmaceuticals and semiconductors) have very high barriers to entry; other industries (including retailing and food products) have relatively low barriers to entry.
2. Threat of substitute products or services: The existence of products outside the immediate market but serving similar needs makes it easier for customers to switch to alternatives, and keeps a lid on the profitability in the market. For example, bottled water might be considered a substitute for Coke, whereas Pepsi is a competitor’s similar product. The more successful bottled water is, the tougher it is for Coke and Pepsi to make money.
3. Bargaining power of customers (buyers): The price customers pay for a product is heavily influenced by the strength of their negotiating position. For example, if Wal-Mart or Tesco decides to put your new line of spaghetti sauces in their supermarkets, you have to accept whatever price they will pay (as long as you aren’t actually losing money on the deal). There are many potential sources of customer bargaining power, such as how large they are, how important they are and how easy it is for them to switch between suppliers.
4. Bargaining power of suppliers: This is the mirror-image of the previous force. Some suppliers are providing components or services that are so important to you that they can charge extremely high prices. If you are making biscuits and there is only one person who sells flour, you have no alternative but to buy it from them. Intel is famous for its bargaining power in the PC/laptop industry – by persuading customers that its microprocessor (‘Intel Inside’) was the best in the market, they dramatically increased their bargaining power with Dell, Lenovo and HP.
5. Intensity of competitive rivalry: This refers to how competitors in the industry interact with one another. Of course, most firms believe they have very ‘intense’ competitive rivalry, but the truth is that the nature of rivalry varies dramatically from industry to industry. For example, the ‘big four’ accounting firms and many retail banks compete, for the most part, in a very gentlemanly way, by emphasising brand and service and by avoiding price competition. On the other hand, the airline industry is well known for its cut-throat pricing and for its flamboyant personalities who make personal attacks on each other.

Source: Adapted from Porter, M.E. (1979) ‘How competitive forces shape strategy’, Harvard Business Review, March/April: 21–38. Copyright © 1979 by the Harvard Business School Publishing Corporation, all rights reserved. Reprinted by permission of Harvard Business Review.

Taken together, these forces provide a comprehensive view of the attractiveness of an industry, measured in terms of the average level of profitability of the firms within it.

How to use it

The five forces framework can be used in two ways: first as a way of describing the current situation in your industry and second as a way of stimulating ideas about how to improve your firm’s competitive position.

As a descriptive tool, it is useful to go through each of the forces in turn and assess how powerful they are, in your current situation. Michael Porter’s book, Competitive Strategy, provides a detailed checklist of items to think about when doing this analysis. This can be summarised, for example, by using a single ‘+’ sign for a force moderately in your favour, or ‘–’ for a force strongly against you. This analysis should help you understand why your industry is relatively attractive or relatively unattractive. It also pinpoints which forces represent the biggest threat. For example, doing this analysis in the pharmaceutical industry in Europe one would likely conclude that the bargaining power of buyers, and specifically governments, is the biggest single threat.

The second part of using the five forces is to use the analysis to brainstorm ways of improving your competitive position – so that you can ‘push back’ on the strongest forces affecting you. For example, in pharmaceuticals if the bargaining power of government buyers is very high, one way of pushing back is to increase your own bargaining power – either by coming up with a really exciting drug that consumers start clamouring for, or by becoming bigger and more powerful yourself (witness, for example, Pfizer’s attempts in 2014 to buy AstraZeneca).

Further reading

Porter, M.E. (1979) ‘How competitive forces shape strategy’, Harvard Business Review, March–April: 21–38.

Porter, M.E. (1980) Competitive Strategy. New York: Free Press.

Porter, M.E. (1996) ‘What is strategy?’, Harvard Business Review, November–December: 61–78.