The Five Competitive Forces That Shape Strategy
The Five Competitive Forces That Shape Strategy Competition for industry profits goes beyond the direct competitors in the business. It included four other competitive forces as well: •Customers •Suppliers •Potential entrants •Substitute products This extended rivalry that results from all five forces defines an industry’s structure and shapes the nature of competitive interaction within the industry. Industry structure drives profitability, not products or services, or mature or emerging etc.
Understanding industry structure is essential to effective strategy. The strongest competitive force (among the five) determines profitability within the industry, though it is not always obvious what that is. Industry structure grows out of a set of economic and technical characteristics that determine the strength of each force.
•Aircraft Manufacturing – industry rivalry fierce; new entrants, substitute products, power of suppliers not so much •Movie theatres – production houses strong; substitute products abound; Threat of Entry
The threat of entry puts pressure on prices, costs and the rate of investment necessary to compete. This puts pressure on profitability. Competitors must hold down prices or boost investment to deter new entrants. Barriers to Entry 1. Supply-side economies of scale: Occurs when firms that produce larger volumes enjoy lower cost per unit, because they can spread high fixed costs over a large number of units, or have more efficient technology, or can command better terms from suppliers. 2.
Demand – side economies of Scale: Network effects.
The desire of a consumer to buy a product increases with the number of other buyers that buy the product. 3. Customer Switching Costs: There may be costs to switching suppliers, such as retooling costs, retraining costs. ERP software has high switching costs, as does autoparts industries.
4. Capital Requirements: Need to invest large financial resources can deter new entrants. (Fixed costs, working capital, initial losses). If industry is attractive and capital markets are efficient, then capital need not be a barrier. . Incumbency Advantages: Proprietary technology, preferential access to resources, locations, brand identity.
6. Unequal Access to Distribution Channels: A new food item must displace others from limited shelf space in grocery stores; requires price breaks, promotion, intense selling. 7. Restrictive Government Policy: Licensing requirements for foreign investment. Or liquor licensing, or taxi services, airlines. Patents.
Incumbents must be aware of potential ways that new entrants might find to overcome barriers.
New entrants must be aware of potential retaliation by incumbents; they may have a history of fighting back; or substantial resources and a willingness to use them; willingness to cut prices. The Power of Suppliers Powerful suppliers capture more of the value for themselves by charging higher prices, limiting quality or services, of shifting costs to industry participants. They can squeeze profitability out of an industry. •Microsoft squeezes profitability out of PC makers by raising the price of its operating software, which has to be included in each PC.
Customers are very price sensitive, and there are not high switching costs.
A supplier group is powerful if: •It is more concentrated than the industry it sells to; •The supplier group does not depend heavily on the industry it sells to; •Industry participants face switching costs in changing suppliers; •Suppliers offer products that are differentiated (pharma companies with patented drugs have power over hospitals and HMOs); •There is no substitute for what the supplier provides; The supplier group can credibly threaten to integrate forward into the industry. If industry players make too much money, the supplier will do just that. Instead, he charges dearly for the product he supplies. The Power of Buyers (Customers) Powerful customers can capture more value by forcing down prices, demanding better quality or more service and generally playing industry participants off against one another, all at the expense of industry profitability. Buyers are powerful if they have negotiating leverage relative to industry participants.
A customer group / buyer has negotiating leverage if: •There are few buyers and each one purchases volumes that are large compared to the size of a single vendor; an industry with high fixed costs will discount to such buyers in order to keep their factories full; •The industry’s products are standardized or undifferentiated; •Low switching costs for buyers; •Buyers can credibly threaten to integrate backwards and produce the industries products if vendor’s are too profitable (soft drink manufacturers can threaten packagers);
A buyer group is price sensitive (will take profits from industry) if: •Products purchased from the industry are a significant portion of its costs; They will shop around. If it’s a small portion, they will not be so price sensitive; •The buyer group earns low profits or is under pressure to trim purchasing costs; profitable customers are the opposite; •Quality of buyer’s products or services are little affected by the industry’s products; this gives the buyer purchasing alternatives and allows it to shop around; if quality is important, the industry has the upper hand (high quality ameras for the motion picture industry); •Industry’s product has little impact on the buyer’s other costs – buyer will be price sensitive; if it does have an effect on buyer’s other costs (say, it improves performance) buyer will be less price sensitive; Intermediate customers (between industry and consumers – industry output is buyer input – assemblers or part of the distribution channel) can be analyzed like most buyers, except that they can derive considerable buying power if they can influence the purchasing decisions of purchasers downstream. E. g . consumer electronics distributors can push one supplier’s products over another.
Producers attempt to overcome this by marketing directly to end users. They try to create preferences for their products with downstream customers. Threat of Substitutes A substitute performs the same or a similar function as an industry’s product by a different means. E. g. videoconferencing is a substitute for travel.
Substitution can be downstream or indirect, when a substitute replaces a buyer industry’s product. E. g . lawn products are threatened when multi family homes substitute for single family homes. Substitutes may be easy to overlook.
When the threat of substitutes is high, industry profitability suffers.
It places a ceiling on prices. The threat of a substitute is high when: •It offers an attractive price to performance trade-off to the industry’s product. •Buyer’s cost of switching to the substitute product is low. (e. g.
proprietary drug to generic) Watch out for changes in other industries that may make them attractive substitutes. Rivalry Among Existing Competitors This can take many forms, including price discounting, new product innovations, advertising campaigns and service improvements. Degree to which it drives down profits depends on intensity and basis.
Intensity is greatest if: •Competitors are numerous or roughly equal in size and power; hard not to poach business; no industry leader to impose industry discipline; •Exit barriers are high, such as specialized equipment; less healthy competitors hang on; •Rivals are highly committed to the industry; may arise for many reasons – ego; product offering completeness; •Firms cannot read competitors’ signals well due to lack of familiarity with their approached to competing or differing goals; Basis or dimensions – if rivals compete on the same basis, this will erode profits.
For instance, if they compete on price, this is destructive since it transfers wealth to buyers directly and they come to expect low prices. Price competition is likely to occur if: •Products are nearly identical and there are few switching costs; encourages competitors to cut prices; •Fixed costs are high and marginal costs low – will want to keep the factory full; may lead to competitors to cut prices below average costs and close to marginal costs; •Capacity can be expanded only in large clumps – leads to periods of excess capacity; •Product is perishable or has a short shelf life (tomatoes; PCs);
Competition on bases other than price (features, support, delivery time, brand image) is less likely to erode profitability, since it improves customer value and can support higher prices.
It can also improve value relative to substitutes. But industry participants must avoid competing on the same basis. If they all seek to meet the same needs, it will be a zero sum game. Only if they differentiate may the market actually grow, by attracting more and diverse customers. Industry structure, as measured by the five forces determines industry health. Other things may appear to, but they really can be analyzed within the five forces: Industry Growth: not a force – growth may not lead to profitability, since it may encourage new entrants and, in any events, customers may be powerful (PCs) or there may be industry rivallry;
Technology or innovation – not enough to make an industry structurally attractive – low tech with price insensitive buyers and high switching costs may be more profitable; •Government – may have a big influence but the influence has to be measured against the five forces – patents limit new entrants; antitrust policies create more; union rules favor suppliers of labor; •Complementary products or services – this may be good or bad – need to measure against the five forces; software and PCs are complementary and can increase overall demand, but software can hurt the profitability of the hardware.
Changes In Industry Structure Shifts in industry structure can change the forces. They may result from changes outside the industry or from within. Use the five forces framework to identify impact of industry developments. New Entrant: Changes in the 7 barriers can lead to existence of a new entrant. Expiration of a patent; •Changing buyer or supplier power: Their relative power may rise or decline. Consolidation of retail channels (they buy each other).
•Shifting Threat of Substitutions: Usually due to technology shifts. •New Bases of Rivalry: rivalry often intensifies over time as industry growth slows. Competitors become more alike and chase the same customers. But technological innovation can reshape rivalry. Implications for Strategy Understanding the forces that shape industry competition is the starting point for developing strategy. The five forces reveal why industry profitability is the way it is.
Where does the company stand with respect to buyers, suppliers, entrants, rivals and substitutes. Strategy will tell you if you can position the company to better cope with the current competitive forces; shape the balance of forces to create a new industry structure that is more favorable to the company. •Positioning the Company: Build defenses against competitive forces or find a position in the industry where the forces are weakest. For an entry decision, examine the five forces to see if such entry would be attractive. It may show that an acquisition is attractive. •Exploit Industry Change: Industry change can reveal competitive opportunities when examined against the five forces.
Shaping Industry Structure: A firm can be proactive to shape industry to better position itself in the context of the five forces. Two ways: redivide profitability among the incumbents; or expand industry profitability. ?Redivide Profitability: The strategists goal is to reduce the share of profits that leak to suppliers, buyers and substitutes, or are sacrificed to deter new entrants. oSuppliers: standardize specifications for parts to make it easier to switch among suppliers; oCustomers: Expand services to make switching costs more expensive; advertise to neutralize powerful channels. oRivals: invest in unique products or expand support services to customers. oSubstitutes: offer better value through new features or wider product accessibility.
Industry leaders have a special responsibility to improve industry structure. They often benefit the most. ?Expand the profit pool: Work collaboratively with suppliers to improve coordination and limit unnecessary costs in the food chain. Agree on quality standards to bring up quality and service levels and prices. How the expanded pie is divided will be determined by the five forces.
•Define the Industry: Need to be careful here. ?Scope of Products or Services: the five forces are good for resolving this. If the industry structure for two products is the same (rivals, buyers, suppliers, substitutes, new entrants, then the products are part of the same industry. ?Geographic scope.