This analysis identifies five forces that control the market(s) that you operate within. Central to this analysis is the rivalry of market competitors that exist to serve and react to the other four forces. Five Forces Analysis complements the identification of the product life cycle by providing the ability to see how the market may change during each phase:
"We are not fit to lead an army on the march unless we are familiar with the face of the country—its mountains and forests, its pitfalls and precipices, its marshes and swamps." | ||
| --Sun Tzu, The Art of War | ||
Figure 3.4: The five forces that exist in all markets affecting the balance of negotiating power.
The central element that allows for the existence of the other four forces is the presence in the market of other entities competing for the same business. More competition provides buyers (customer segments) with more bargaining power and can eventually lead to the market becoming saturated to a point where buyers have the power to force prices to a minimum and quality to a maximum in order to receive the best value propositions. This eventual situation is referred to in another analysis tool, Blue Ocean Strategy, as a red ocean, where it is necessary for businesses to operate high risk razor thin margins just to survive.
Key considerations:
- How fierce is the competition?
- Is it a red ocean?
- Who are the market leaders?
- Do they have too much influence in the market for you to compete against?
- What market share does the typical business in the market capture?
- Would an equivalent market share be considered a success for your business?
The next step up from existing competitors is the availability of alternative options that your customer segments can choose to buy instead of your product or service. These are not direct competitors in the sense that they provide an equivalent product or service, but instead offer alternative solutions that match the value propositions that the market seeks to buy. Regardless of whether you sell a product or service, substitutes can come in any form—for example a service that provides the same value propositions as your product.
Key considerations:
- What alternative solutions are there to provide your value proposition?
- Are there specific situations in which these alternatives are viable options?
- What situations are substitutes for a valid option?
- It is entirely possible to put a website together with Microsoft Word, but would it be accepted by someone wanting highly optimized HTML for search engines?
With most startups failing within their first three years, most new market entrants are not likely to pose the same level of threat as existing competitors in the market. They still pose a threat to damage your sales and ability to negotiate with buyers; especially when it comes to entrants who price themselves to make a loss—the types who later cease operating when they run their business into debt.
The more serious threat from new market entrants comes from those with significant financial clout, as well as those with the ability to disrupt the market through innovation. There is a relationship between these two factors—innovation is often made possible through financial investment. The types of market entrant who pose the most risk are those who are, or are backed by, large companies already established in other markets.
The cancelled Nintendo PlayStation project became a serious mistake for Nintendo, which led to Sony becoming a market entrant to the videogames industry—and ultimately using their financial clout to become a dominant player in the market. At the time of writing, Sony's PlayStation Network (PSN—the online gaming network for PlayStation games consoles) generates more money than Nintendo's entire business. Additionally, the anticipation of certain businesses becoming a new entrant can also be enough to lose significant sales—as happened to Sega in 2000 with their Dreamcast games console when many console buyers held off upgrading in anticipation for the launch of Sony's PlayStation 2.
A consideration that can be used to protect your business against the threat of new entrants, especially those who are inexperienced enough to introduce loss making pricing, is the requirement of skills and certification to become eligible as a player in the market. A requirement for higher skills will mean the need for more commitment from new market entrants to learn those skills, hence them likely to place a higher value on their time. Where certification is required, otherwise known as red tape, the difficulty, effort and skill required to complete the necessary paperwork can be enough to deter many of the potential market entrants.
Key considerations:
- How easy is it to provide an equivalent to your product or service?
- For software development services, are there software service equivalents such as Wix.com, or open source projects like WordPress, that lower the skill requirements for new entrants?
- Is red tape a barrier to market entry?
- Effort required to meet all of the requirements may deter the majority of potential market entrants, if not making it impossible.
- Does your brand recognition within the market protect you?
- New market entrants may find it impossible to win business from customers who are already highly satisfied with your services and products.
- Are your customers willing to pay a premium price for your product or service?
- If so, this will protect you against unproven new market entrants using aggressive pricing strategies to undercut you.
In addition to other sources of work that your suppliers target, the number of competitors and alternative suppliers in your market are likely to influence your ability to negotiate better value propositions from suppliers. Negotiation goes against you when your suppliers are in a position where there is more demand for their supplies than they can fulfill, whether it be from the market you operate in or otherwise; hence every competitor in your market who needs their services plays a role in eroding your ability to negotiate. With the exception of a market crash or where your supplier's market becomes flooded with alternatives, you will always be at your strongest negotiation position when establishing a new market category—that is, Blue Ocean Strategy.
Key considerations:
- How eager are suppliers for your business?
- Can they afford to turn your business away?
- Do suppliers have more demand than they can fulfill?
- Can they pick and choose who they work for?
- Are the growing number of competitors in your market affecting your ability to negotiate?
- Are your competitors increasing demand for supplies to a point where suppliers are able to turn away your business to fulfill orders from your competitors offering suppliers a more lucrative deal?
- Are you able to gain buying power with big orders to suppliers?
- Are you able to become classed as such an important customer that suppliers will go out of their way to retain customer loyalty?
- Are there alternative suppliers you can negotiate better deals with?
- Are there better deals on the market that you can use to negotiate your existing supplier to give you a better deal?
The buyer has the most negotiating power when a market has more suppliers than there is a demand for. Where you have a high number of competitors who offer the same solution and substitutes who also provide comparable options to your value propositions, there becomes the need to be highly efficient in your operations in order to be able to offer the highest value propositions with the most competitive prices so that you can win the sales you need. Alternatively, differentiating your services products in a way that targets less competitive or new market spaces is a viable solution to this problem.
Key considerations:
- What are buyers demanding?
- Do they want lower price, high quality, or both?
- How achievable is it to be profitable in meeting the buyer's demands?
- Are the demands of buyers worth your time and effort?
- What innovations can you develop to increase profit margins and meet demands?
- Is there a way that you can become better positioned to win business and make a profit?