The model has similarities with other tools for environmental audit, such as political, economic, social, and technological (PEST) analysis, but should be used at the level of the strategic business unit, rather than the organisation as a whole. A strategic business unit (SBU) is a part of an organisation for which there is a distinct external market for goods or services. SBUs are diverse in their operations and markets so the impact of competitive forces may be different for each one.
Five forces analysis focuses on five key areas: the threat of new entrants, the bargaining power of buyers, the bargaining power of suppliers, the threat of substitutes, and competitive rivalry.
The threat of new entrants
This depends on the extent to which there are barriers to entry. These barriers must be overcome by new entrants if they are to compete successfully. Johnson et al (2005), suggest that the existence of such barriers should be viewed as delaying entry and not permanently stopping potential entrants. Typical barriers are detailed below:
- Economies of scale exist, for example, the benefits associated with volume manufacturing by organisations operating in the automobile and chemical industries where high fixed costs exist. Lower unit costs result from increased output, thereby placing potential entrants at a considerable cost disadvantage unless they can immediately establish operations on a scale which will enable them to derive similar economies.
- Certain industries, especially those which are capital intensive and/or require very large amounts of research and development expenditure, will deter all but the largest of new companies from entering the market.
- In many industries, manufacturers enjoy control over supply and/or distribution channels via direct ownership (vertical integration) or, quite simply, supplier or customer loyalty. Potential market entrants may be frustrated by not being able to get their products accepted by those individuals who decide which products gain shelf or floor space in retailing outlets. Retail space is always at a premium, and untried products from a new supplier constitute an additional risk for the retailer.
- Supplier and customer loyalty exists. A potential entrant will find it difficult to gain entry to an industry where there are one or more established operators with a comprehensive knowledge of the industry, and with close links with key suppliers and customers.
- Cost disadvantages independent of scale. Well-established companies may possess cost advantages which are not available to potential entrants irrespective of their size and cost structure. Critical factors include proprietary product technology, personal contacts, favourable business locations, learning curve effects, favourable access to sources of raw materials, and government subsidies.
- In some circumstances, a potential entrant may expect a high level of retaliation from an existing firm, designed to prevent entry – or make the costs of entry prohibitive.
- Government regulation may prevent companies from entering into direct competition with nationalised industries or implement complex rules that non-nationals may struggle to interpret and follow. In other scenarios, the existence of patents and copyrights afford some degree of protection against new entrants.
- Differentiated products and services have a higher perceived value than those offered by competitors. Products may be differentiated in terms of price, quality, brand image, functionality, exclusivity, and so on. However, differentiation may be eroded if competitors can imitate the product or service being offered and/or reduce customer loyalty.
The bargaining power of buyers
The power of the buyer will be high where:
- There are a few, large players in a market. For example, large supermarket chains can apply a great deal of pressure on their potential suppliers to attempt to get them to lower their prices. This is especially the case where there are a large number of undifferentiated, small suppliers, such as small farming businesses supplying fresh produce to large supermarket chains who can then ‘pick and choose’.
- The cost of switching between suppliers is low, for example from one haulage contractor to another. The service offered will have the same outcome and unless a long-term contract has been negotiated, deliveries can be arranged on a parcel-by-parcel basis.
- The buyer’s product is not significantly affected by the quality of the supplier’s product. For example, a manufacturer of paper towels and toilet paper will not be affected too greatly by the quality of the spiral-wound paper tubes on which their products are wrapped.
- Buyers earn low profits so will be very keen to negotiate lower prices from their suppliers in order to increase margins.
- Buyers have the potential for backward integration, for example where the buyer might purchase the supplier and/or set up in business and compete with the supplier. This is a strategic option which might be selected by a buyer in circumstances where favourable prices and quality levels cannot be obtained by bargaining with current suppliers alone.
- Buyers are well informed, for example, having full information regarding availability of supplies and can use that knowledge in the negotiation against the supplier.
The bargaining power of suppliers
The power of the seller will be high where (and this tends to be the reverse of the power of buyers):
- There are a large number of customers, reducing their reliance upon any single customer suggesting that they may not care if they were to lose a customer.
- The switching costs are high. For example, switching from one software supplier to another could prove extremely costly as all equipment and processes are specific to the supplier and all will need to change. This is on top of any costs of designing a new system itself.
- The brand is powerful/well known (Apple, Mercedes, McDonalds, Microsoft). Where the supplier’s brand is powerful then a retailer might not be able to operate without a particular brand in its range of products.
- There is a possibility of the supplier integrating forward, such as a brewery buying restaurants to enable control of the customer.
- Customers are fragmented so that they have little bargaining power individually, such as the retail customers of a petrol station situated in a remote location.
The threat of substitute products
The threat of substitutes is higher where:
- There is direct product-for-product substitution – eg for email/fax and postal services. The products are performing the same task/outcome, albeit in different ways.
- There is substitution of need. For example, better quality domestic appliances reduce the need for maintenance and repair services. The information technology revolution has made a significant impact in this particular area as it has greatly diminished the need for providers of printing and secretarial services.
- There is generic substitution competing for disposable income, such as the competition between carpet and flooring manufacturers as with email and post, these are both essentially doing the same thing, being floor coverings but perform the task in differing ways.
Competitive rivalry is likely to be high where:
- There are a number of equally balanced competitors of a similar size. Competition is likely to intensify as one competitor strives to attain dominance over another.
- The rate of market growth is slow. The concept of the life cycle suggests that in mature markets, market share has to be achieved at the expense of competitors as there are few new customers now entering the market.
- There is a lack of differentiation between competitor offerings, in such situations, there is little disincentive to switch from one to another, they are all the same.
- The industry has high fixed costs, perhaps as a result of capital intensity, which may precipitate price wars and hence low margins. Where capacity can only be increased in large increments, requiring substantial investment, then the competitor who takes up this option is likely to create short-term excess capacity and increased competition in order to fill this extra capacity.
- There are high exit barriers. This can lead to excess capacity as players will not be willing to leave and, consequently, increased competition from those firms effectively ‘locked in’ to a particular marketplace.
In summary, the application of Porter’s five forces model will increase management understanding of an industrial environment which they may want to enter, or assist them to assess a market that they are currently in.
Now that the model has been explained you need to be able to apply it in the exam. Often candidates can struggle to perform this ‘application’ effectively – either, due to not following the precise questions requirement or not using the information in the scenario effectively or even at all. So, this next section will look at a few of the ways that this may be examined in the APM exam and provide some advice on how to tackle answering those questions.
When conducting a five forces assessment an organisation will need to consider:
- how to measure the strength of the forces and how reliable those measurements are
- how to manage the forces identified to mitigate their influence on the organisation’s future performance, and
- what performance measures are required to monitor the forces.
These factors are often the basis for questions requiring the use of this model.
The examples below are based on a company making semi-conductors/micro-chips and the SBU being addressed in the question makes them for the autonomous vehicle industry (self-driving cars), a specialised use in an already specialist industry.
EXAMPLE 1 – Using the model to perform the analysis
Using Porter’s five forces model, assess the impact of the external business environment on the performance management of Scarlette Plc.
This is the first part of the requirement (the second part follows in the next example). This requirement does indeed require you to perform the analysis for the SBU. This must be done in the precise context of the scenario in the question and does not need to be preceded with explanations of the model or its parts.
An extract from a very good answer is reproduced below to show the approach that will score the maximum marks available for one force, threat of new entrants, in this scenario:
Answer – Extract showing threat of new entrants only
The threat of new entrants will be dictated by barriers to entry into the specialist semi-conductor market. These appear to be high, given the high fixed costs and the high levels of technical expertise required to develop a viable product. Also, the need to have cultivated strong relationships with the autonomous car producers and control systems manufacturers who will be the customers for the products.
Comments: The answer begins with a recognition of the issues affecting barriers, then moves on to identify the specifics for the industry. It justifies the identification of the barriers being high here, doing this both, for the microchip industry in general, then focussing in more closely on the specific use in this SBU.
EXAMPLE 2 – Providing performance measure for the forces
…and give a justified recommendation of one new performance measure for each of the five force areas at Scarlette.
Answer – Extract showing threat of new entrants only
A suitable performance measure would be percentage growth in revenue because as the industry grows Scarlette may expect their revenues to grow with it, as they gain new contracts and even new customers. Scarlette will need to compare this measure against the growth of the industry itself and competitors to ensure that they are at least keeping up with them.
[Other measures could include ratio of fixed cost to total cost (measures capital required) or customer loyalty (through long‑term contracts to supply semi-conductors to manufacturers).]
Comment: As the comment at the end of the answer shows, there are many measures which could be applied here. The key to gaining pass marks is to identify a measure which is going to be useful for the organisation in the scenario, given its industry and situation. This answer also clearly justifies the recommendation in this context.
In Performance Management models – part 2 the Boston Consulting Group matrix (BCG) will be the model focused on.
- Porter M E, Competitive Strategy, Free Press, 1980