Determine the influence of market forces on your company with the industry structure analysis.
Author: Johannes Deltl
Modification date: 2023.04.12
An important model of competition research developed by Porter is the industry structure analysis (Five Forces) or also called the Five Forces Model. In order to determine competition-oriented strategies, all forces acting in or on an industry are defined and their effects on the market are assessed. Colloquially, this model is also called the competitive analysis according to Porter.
The 5 forces that have impact on the company
How to use the 5 Forces successfully in your business:
1. Competitive strength: New entrants.
This variable influencing market attractiveness deals with how easy it is for other companies to enter the market (how easy is it to enter the industry?) and what the foreseeable reaction of market participants is. Competition from new entrants reduces incumbents' profits as demand is spread across more suppliers.
Possible barriers to entry can be:
- no (physical) space
- high investment requirements
- due to experience curve, the company can produce much more cost-effectively (this must be taken into account when entering new markets)
Industries with high entry barriers are, for example, the pharmaceutical or automotive industries, i.e. areas with high monetary and technological costs.
How quickly these "protected" areas can open up, however, has been seen in the telecommunications industry, where a large number of companies have emerged in recent years and the entry barriers are now very low. Generally speaking, the lower the barriers to entry, the greater the danger posed by new competitors in the market.
2. Competitive strength: Supplier Force
In some industries, suppliers have such power that the whole market is influenced by them. A classic example of this are the two IT companies Intel and Microsoft.
The degree of bargaining power of suppliers influences the attractiveness of industries by:
- Price increases
- Quality reductions
- Service reductions (e.g. maintenance, customer service)
The bargaining power of suppliers depends on:
- Concentration on supplier market (higher or lower than on considered market?)
- Substitute products available?
- Importance of the industry as a customer of the suppliers
- Importance of the input factor under consideration per se
- Switching costs when changing suppliers (degree of product differentiation)?
- Is there a risk of forward integration by suppliers?
3. Competitive strength: Buyers Force
It assesses what market power the customer has vis-à-vis the market. One aspect of this "power position" is the factor of how easy it is for the buyer to change the product/service. For example, the scope of some is correspondingly limited by long-term contracts or due to a lack of alternatives (examples: waste collection, water, etc.). The strength of this group reduces the profitability of the supplying company by demanding: price reductions or an increase in service.
Bargaining power depends on:
- Concentration of buyers (Hardly any alternatives in customer selection).
- Substitute products
- Switching costs
- Backward integration (make or buy?)
- Required product is irrelevant
- Complete information on prices and sales volumes
In recent years, customer power in the telecommunications sector has increased considerably; the customer can easily switch and often opts for the cheapest offer. To make it difficult for the customer to make objective comparisons, telecom providers are developing different pricing models. In industries with many providers and few customers, buyer power is very pronounced, for example in the defence industry, food retailing, etc.
Market power of discount grocers like Lidl or Aldi
Due to the concentration in food retailing, only a few big players are left in Germany. This small number causes enormous price pressure for the food and beverage industry, as no company can afford not to be listed in one of the big chains. In addition, the companies are also weakened by the increasing share of private labels of the discounters. In this case, the customer also becomes a direct competitor.
Edeka versus Nestle
The retail company EDEKA could not reach an agreement with Nestle on price conditions. For this reason, all Nestle products were unceremoniously removed from the range. This increased the pressure on Nestle to accommodate Edeka.
4. Competitive Strength: Threath of Substitute Products
The influencing variable substitute products is about the susceptibility of the market/industry to new technological achievements or simply the substitution of its own products or services by others. Examples of this in recent years are very much linked to digitalization and increasing global connectivity. Travel agencies, for example, have suffered severe losses as a result of direct bookings by customers, producers of recorded music as a result of the online availability of music titles, or mobile PDAs, for example, as a result of the functional expansion of cell phones. Substitute products affect profits of an industry by setting price caps for products under consideration.
Factors to consider are:
- Are substitutes available at all?
- Price-performance ratio of these
- Price elasticity of demand
- Cross-price elasticity of demand
A threat from substitute products depends on buyers' attitudes toward substitute products and the price-performance ratio of substitute products relative to the price-performance ratio of their own products.
5. Competitive strength: Rivalry among Industry Competitors
This is about the intensity of competition within the market. A distinction is made between industries in which companies tend to operate harmoniously and without any undercutting (e.g. energy sector) and areas where there is fierce competition (IT, automotive sector - Lopez case). The decisive factor is how "satisfied" the individual market players are with their current position. Rivalry in the industry has a corresponding impact on the market. For example, fierce price competition can lower the profitability of the entire industry.
- Internal rivalry means price competition, advertising battles, introduction of new products, improved service and warranty performance
- All other forces influence rivalry within the industry
- Interaction of action and reaction of market participants
Conditions for rivalry are:
- Number and size of current competitors (concentration)
- Barriers to exit (legal or moral obligations, low liquidation value)
- Industry growth
- Differentiation/conversion costs
- Level of fixed and inventory costs
Is the market growing, or shrinking? Are there too many market players? Are there dominant players in the market? From these questions, determine the current market intensity (market power) that prevails in the industry.
The triumph of e-mail as a threat to the postal service
The importance of dealing with possible substitutes can be seen in the rapid development of worldwide e-mail traffic. After the fax machine, it was the second even greater threat to postal companies. The classic service of "letter delivery" is becoming increasingly unprofitable, and additional sources of income have to be developed. Postal companies have reacted accordingly (some sooner, some later) and are focusing on new services (including electronic ones).
Practical example of the 5 Forces analysis
As a practical example, let's take a look at the fitness center industry, which has been properly buffeted by the Corona crisis. In terms of supplier strength, the main issues here are fitness equipment and the landlords of the properties where workouts are held. Since leases are often very long-term and represent a large part of a gym's costs, the impact on the market is very large.
Customer strength is demonstrated by the alternatives available to customers. These are always looking for the best price/performance ratio.
Competition among each other will increase even more.
New competitors are currently expected to be very strong in the online sector, which also coincides with the replacement products. Existing customers may switch from the studio to online offerings, discover other sports for themselves, or organize their own sports offerings (trend toward equipment-free fitness exercises in public parks).
The bottom line is that the entire industry is under tremendous pressure, both in terms of costs and potential member churn.
The 5 market forces are analyzed to better assess what the status quo is and how the market is evolving.
The analysis tool shows whether the company's own market still has a future perspective or whether the company should focus on other markets.