• 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 does it do: 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.

• 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 that affects 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 that is 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.

Demonstrations:

• Michael Porter's 5 Forces model explained

• The Five Competitive Forces That Shape Strategy (interview with Michael Porter)
• w2m1 Porter's 5 Force Model

Step-by-step process:

• 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, utilize the excess capacity, and spread 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 % of the purchases in the industry) increases their buying power because they represent a significant % 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 % they make up for the final price of the product. If the raw material costs are a low % 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 threat of entry, you could look at history and determine if there have been entrants recently. If there have been, then 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. As examples:
• Gather data for each indicator in each force. If certain indicators are not available to 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 can not 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 what their profitability is
• 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 the forces of these two forces to make the first pass at average industry profitability. These two forces define how high profitability can be.
• The remaining 3 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 3 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 that 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 is High or if Buyer Power is high, it is likely that profitability will be between 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 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 raises 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 of what has occurred in the industry
• Reconciling the forces to the calculations can point out issues and create confidence in the industry analysis
• Then analyzing how the factors are forecasted to change in the future should predict at least the direction that 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 5 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:
• 

Output representation and recommendations:

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, for example:

• If you are trying to enter an industry, invest in new capacity, or further invest in this business, you should only enter or invest if:
• The industry profitability is high and you have a competitive advantage where you will make more profitability than the average competitor - or
• 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 - or
• 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 - or
  
• There is verified evidence that changes are happening in the forces or your competitive position to improve your opportunity for profitability

Examples:

Porter's Five Forces: Analyzing the Competition 

Additional resources:

•  Porter's Five Forces (Quick MBA)
• Understanding Competitive Forces to Maximize Profitability
• How to use Porter’s Five Forces
• Industry Handbook: Porter's 5 Forces Analysis