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Michael Porter hypothesized that the average profitability of an industry can be explained by the various forces at play in the marketplace.
What it is: Michael Porter was a Harvard Business professor who proposed many competitive strategy hypotheses. One of his most famous (called Porter's Five Forces) was introduced in his book Competitive Strategy, published in 1980. The five forces described by Michael Porter include Buyer Power, Supplier Power, Competitor Rivalry, Substitutes, and Threat of Entry. By understanding the interplay of these forces, we can explain the current profitability of an industry and forecast future profitability by forecasting what changes will occur in the forces.
What it does: By explaining the current profitability and allowing us to forecast the future profitability of an industry we can better determine what investments we will make in the industry or what strategic actions we should plan.
How is it used: Porter's Five Forces are commonly used in strategy development and investment strategies. It provides a way to explain the current industry profitability and creates a basis from which future changes in industry profitability can be projected based on forecasted changes to the forces.
Where: There are many applications where knowing the current industry profitability and being able to project future industry profitability would be useful. Some common applications are given below:
When a company is looking to enter an industry, it is good to know what the current profitability is, how it will change over the next few years, and what impact the company's entrance will have on the current industry profit. Texaco entered the Alkanolamines Industry in the 1980s because the profitability was almost 50% EBIT. The increased competition, overcapacity, and loss of differentiation in the industry caused the profitability to drop to less than 5%. Texaco's entry had changed many of the forces in the industry, and they failed to recognize that some of the profitability of the industry was driven by the decision of the current players to act as a legal oligopoly to support profitability. When Texaco chose to act as an aggressive growth player and ignore the actions of the other competitors in the oligopoly, they turned the industry into an undifferentiated commodity with an excess capacity, which caused profitability to be wiped out in the industry.
When a company is considering its strategy for future growth and participation in an industry, the forces impacting industry profitability are critical factors.
If a company is considering investing in a new capacity, they need to understand the profitability impacting the payback for the investment during the multi-decade life of the additional capacity.
When a company is investing in research for an industry, they want to know what impact the new differentiation their product will have on the future profitability of an industry.
When a company is considering an acquisition or merger with a company in another industry, they want to know what the profitability of that industry will be in the future.
When a company is buying a competitor, what will be the impact on future industry profitability based on the new competitor rivalry that has a smaller number of rivals (and possibly less capacity)?
Governments use Porter’s Five Forces to predict the impact on competition and future product pricing if mergers or acquisitions take place in an industry
Why: Sometimes you cannot find the actual profitability of an industry because the industry is served by companies that do not break out the profitability of the products they supply to that industry, or the companies are private and do not report. When there are no public reports of profitability, the Five Forces allow a projection of the likely profitability of the industry.
Where it shouldn't be used: Any industry can be analyzed by the Five Forces, but there may be unique factors that cause the profitability to vary from that projected by the forces. The analyst must be careful to not assume that every industry will react exactly the same to a singular set of forces.
Any restrictions: Note the warning.
Warnings: There can be forces at play that are not apparent to the public view but affect the profitability of an industry. There can be players in an industry who do not follow the same desires for profitability as the forces would allow them to achieve. As an example, the Korean chemical company Formosa has a stated corporate philosophy that they only want to make a certain level of profitability. If they are able to achieve that level of profitability at a price below the industry price, then they will maintain the lower pricing to try and grow market share. So even though the Five Forces indicate a highly profitable industry, the actual industry profitability could be lower as competitors match the pricing of Formosa.
Gathering data
Low-capacity utilization increases rivalry in a high fixed-cost industry. This will cause the competitors to try and reduce average fixed costs by increasing sales, utilizing excess capacity, and spreading fixed costs over a larger volume of production.
Low switching costs will increase the rivalry in an industry because there is little deterrent to switching from one competitor to another
Highly concentrated customers (each big customer has a high percentage of the purchases in the industry) increase their buying power because they represent a significant percentage of the industry revenues.
If you do not know the capacity utilization of the industry, try and determine the lead times required for shipping. If lead times are long, capacity utilization is probably high
If you do not know if fixed costs are high or low, look at the composition of raw materials and see what percentage they make up of the final price. If the raw material costs are a low percentage of the final price, then fixed costs are probably high, or it is a very profitable industry.
If you do not know how to measure the likely factors that drive the threat of entry, you could look at history and determine if there have been entrants recently. If there have been, the barriers to entry are probably low, lowering the potential of future profits.
Utilize the template below to identify the information you need to capture to represent each of the Five Forces.
Each force has several indicators that suggest the direction of the force.
Gather data for each indicator in each force. If certain indicators are not available, try and use a surrogate factor that explains a similar description of the factor driving the force.
If possible, gain as much information about the industry as possible by averaging the profitability of the major competitors in the industry. This should give you an educated guess as to the average industry profitability. Companies often tend toward average profitability across their product lines.
If you cannot use company profitability data to project industry profitability, attempt to create estimates of the profit-loss statements for the key competitors to see if you can estimate their profitability.
Any time you try to find the average, be sure to use a share-weighted average where companies with higher market share have a higher impact on the average of the industry than those with low market share.
Analysis of data
Fill the data into the template and try and determine the level of power associated with each force.
First, consider the Competitor Rivalry and Buyer Power; these two powers are the most immediately impactful to the current profitability. The most common practice is to average these two forces to make the first pass at average industry profitability. These two forces define how high profitability can be.
The remaining three forces put a limit on how high the industry profitability could be if the competitor rivalry and buyer powers are low. If the limiting forces are very high, they can drive the industry to negative profitability even if the competitor rivalry and buyer powers are low.
Identify the key limiting factor by seeing which of the three limiting factors are strongest. Do not average the limiting factors, but select the key limiting factor and use it to project the limit on profitability for the industry average.
Compare what the Five Forces analysis predicts to the actual measurements or estimates you made from industry data.
Try to explain the similarities and reconcile differences predicted by the different approaches to industry profitability.
Interpretation of results
If Competitive Rivalry or Buyer Power is high, it is likely that profitability will be limited to low for the industry. The average of the two forces will be the best first estimate of industry profitability.
If both Competitive Rivalry and Buyer Power are high, then the profitability will be low to negative.
If both Competitive Rivalry and Buyer Power are low, then profitability will be as high as the key limiting force will let it rise.
If the threat of a substitute is high, then the substitute products will enter the industry and put a cap on how high the profitability will grow.
If supplier power is high and they see a profitable industry among their customers, they will raise prices to capture more of the profitability for themselves.
If industry profitability rises too high, other entrants will desire to enter. If the barriers to entry are low, the new entrants will enter and increase competitor rivalry.
If all three limiting forces are low, and the competitor and buyer powers are low, then the industry profitability basically has no limits to how high it could rise.
You should compare the Porter Five Force analysis to what you calculated for current and past profitability to see how predictive the forces are.
Reconciling the forces to the calculations can point out issues and create confidence in the industry analysis.
Analyzing how the factors are forecasted to change in the future should predict the direction profitability will move in the future.
Presentation of results
The tables used in the template below are one way to show the results.
Using the common graphic for the Five Forces (competitors in the middle and the other forces surrounding) makes each force box big if the power is high and small if it is low.
Another common way to present the results is to show the graphics and list the factors next to each box. See the example below:
Once you have defined the current and potential future profitability of an industry, you can make recommendations. The profitability of an individual company in an industry is dependent on both the industry profitability and the company's competitive position. Your recommendations will depend on how these two factors interact. See the following example:
If you are trying to enter an industry, invest in new capacity, or further invest in this business, only enter or invest if at least one of the following statements is true:
The industry profitability is high and you have a competitive advantage where you will make more profitability than the average competitor.
The industry profitability is high and you have a competitive disadvantage where you will make less profit than the average competitor, but still positive overall.
The industry profitability is low or negative and you have a competitive advantage where you will make more profitability than the average competitor, and enough to be positive overall.
There is verified evidence that changes are happening in the forces or your competitive position to improve your opportunity for profitability.
This content is provided to you freely by Ensign College.
Access it online or download it at https://ensign.edtechbooks.org/projectbased_internships/industry_analysis_using_porters_five_forces.
