Five forces for shaping strategy

  1. Barriers to entry
  2. Threat of substitutes
  3. Bargaining power of suppliers
  4. Bargaining power of customers
  5. Rivalry among existing competitors

Steps in Five Forces Analysis

  1. Define the industry
  2. Identify players
    • Buyers
      • End user
      • Distributor
      • Retailer
      • Others along supply chain
    • Suppliers
    • Rivals
  3. Assess the strength of each force using quantitative evidence
  4. Try project to the future

Lecture notes

Since the 1980’s the top fifteen airlines in the U.S. have all either gone bankrupt or been bought out, bar one.

Michael Porter created us a comprehensive framework with his work on the five forces that shape strategy, and this allows us to compare the profitability of industries. It is one of the most widely used, and misused, management frameworks since its release.

Barriers to entry: A high barrier to entry generally means more profitability. Think of it as moat around your profit castle.

Threat of substitute: A product or service that is different to your product that can take some of your profit. Look at fitness centres. Substitutes can range from home equipment, to public parks to even going to the bar if the user is searching more for social opportunities rather than fitness. All these are not fitness centres, but can substitute one.

Bargaining power of suppliers: Who is supplying the goods to your company? Do they have leverage to extract some of your profits?

Bargaining power of customers: Same as above, do the customers have the ability to negotiate better prices and take some of your profits?

Rivalry among existing competitors: Is there constant price-gouging done in the industry, like airline sales? Or is there more of a friendly competition where competitors might even work towards mutual benefit?

These are the five forces that define an industries profitablity.

Let’s apply these five forces to the airlines industry.

Barriers to entryLowIt is easy to lease old planes, and cheap to get slots at regional airports.
Buyer powerHighBuyers aren’t particularly loyal to airlines, they just shop for the cheapest deal.
Supplier PowerHighBoeing and Airbus provide all jumbo jets with only a handful providing regional aircraft. This means they can easily take more of the profits
Threat of substitutesHighWe have cars and trains, but also we have alternatives to travelling. Video conferencing for instance can stop the need for a business man to travel over seas
Rivalry among competitorsHighMany airline businesses have constant sales on.

Airlines have a unique characteristic of the airline business. There are very high fixed cost, but very low or no variable or marginal cost.

It cost nothing extra for an airline to put me in an empty seat on a plane, however, it cost a lot to get the plane into the sky. That means it is ideal for airlines to fill every seat in order to offset their fixed cost. Airlines work towards a higher contribution margin

Contribution Margin

Dollars that could go toward covering fixed expenses and profitability.

Seats are perishable too. Once a plane takes off, you can never sell that seat on that flight ever again.

The Five Forces are a simplification of reality.

Using the five forces:

  • Understand why some industries are profitable and others are not
  • Help with entry and exit decisions
  • Think about how you might position your company to deal with threats
  • Think about how you might shape a more favourable industry structure

The personal computing industry

Personal computing is a terrible industry from the five forces checklist. Let’s have a look

Barriers to entryLowApple started in a garage, Dell in a dorm!
Buyer powerHighWith so many options available customers can and will shop around for a better price.
Supplier PowerHighYou are almost forced to use Windows, and you’re either going use an AMD chip or a more likely an Intel one. They can set the prices as they please.
Threat of substitutesHighHuge threats these days, tablets and phones are essentially smaller, more versatile computers.
Rivalry among competitorsHighThere are many personal computer vendors. There’s even white label vendors which let you just slap on your logo. Pricing is fierce and competitive.
So we get all that and it says that personal computers are a difficult industry.

But then, how did Apple do so well? That’s simple actually. They changed the powers of the forces in favour of themselves.

Their operating system is their own custom design. It can only be used by them and their competitors. Suddenly the barrier to entry became very high, as no one else can do a Mac computer. And by making the operating system easy and pleasant to use customers want a Mac computer.

They made their own brick and mortar stores, thus reducing the buyer power down the chain. No longer do they need allow for middle men to take a slice of the profit.

In recent years they have moved away from Intel chips and have started creating their own. This means that they have reduced the demand on suppliers that make specialized hardware and instead are reliant on commodity suppliers.

Rather than letting other companies make a favourable substitute, they made their own with iPad and iPhone lines.

No one else can (legally) do a Mac computer. This means they have no rivals for their ecosystem. If someone wants to enter the Apple ecosystem it has to be done via Apple.

They very nicely have made themselves an empire in an other low-profit-margin industry.

Limitations of the Framework

  • Difficult in drawing clear industry boundaries
  • Dangerous to apply on a global basis
  • Limited tools and techniques for understanding rivalry
    • Not clear on difference between price rivalry and non-price competition
  • Does not address the nature and importance of complements

What is a complement?

A complement is a product or service that adds value to the original offering when the two are used together. Examples:

  • Peanut butter and jelly
  • Computer hardware and software

Lessons Learned

  • “Sexy” industries are not necessarily high-profit industries
  • High growth doesn’t equal high profits
  • Stable, relatively low-growth industries can be very profitable
  • With the appropriate competitive positioning, firms can mitigate negative forces and make healthy earning even in a tough industry.

Reflection on Lecture

Porter’s Five Forces

This lecture was nearly exclusively centred around Michael Porter’s five forces analysis. It seems to be very well known and even an internet search of “five forces” returns references. The five forces is an analytical tool to determine what the profitability of an industry might be. Notice the emphasis on industry. You cannot apply it to your own company.

The first step is to look at the barrier to entry. If the barrier to entry is high, then you have a better chance of keeping more of the profits to yourself. If it is low, however, then you might find many competitors come and go trying to eat in to your profit share.

Next we need to look at the buyer power. Note, this is not just the end user. This includes the distributor, the brick-and-mortar stores, the online stores AND the end user. Do they have the power and leverage over you to demand a bigger slice of the pie? Look at Amazon. If you’re a small seller forced to sell on Amazon for visibility then Amazon can leverage the shit out of you for more money (and they do).

We also need to examine the supplier power. If your supplier is providing key parts of your business, then they can choose to charge more. Especially if few competitors exist. You can see this with CPU’s (Intel and AMD) or jumbo jets (Boeing and Airbus). Apple mitigated this recently by designing their own silicone. Even with that though they must pay an architectural license to Arm.

The threat of substitutes is another factor in the five forces. A substitute is a different product or service that may be able to replace your product. For instance, some people may decide to use an iPad or tablet rather than a PC. If you are in the PC market then you need to consider tablets and smartphones as a threat to your industry.

Finally we need to look at rivalry among competitors. If competitors are in constant price-cutting competitions then profits are going to be lower. If instead competitors do non-pricing competition then it can be a net benefit for all in the industry. For instance, Pepsi and Coca-Cola did not do price-cutting competition, but instead did more creative ads. The end result was that soft-drink consumption went up as whole, benefitting both Coca-Cola and Pepsi.

Fixed Cost and Contribution Margin

One thing I found interesting in this lecture was the notion of a fixed cost. Fixed cost is when providing a service cost the same whether you are providing it for one person, or a hundred. The example given in the lecture was an airplane. Putting people in the seat doesn’t cost money, getting the plane in the sky cost the money. It doesn’t (really) matter whether there is one person on that plane or it is fully loaded. To this end it is better to fill every seat in order to raise the contribution margin.

The contribution margin is money that goes to covering the fixed cost, and when that is covered then towards profitability.

I was thinking on fixed cost and I think software development could be considered a fixed cost product. I’m not talking about bespoke software made for a paying client, I’m talking about a game or a piece of software you sell to the masses. The cost involved is in the creation of the software. Once it is done you want to sell as many copies to as many people in order to increase you contribution margin.

Off-topic Reflection

It is easy to see how companies focus on profits and not the effect it has on the world. This is only the second lecture in the course but it all talks about profits, profits, profits. The tale of Pepsi and Coca-Cola growing the soft-drink market is told with admiration and up-held as a noble example. Let’s just ignore the fact that excess soft-drink consumption contributes for a number of health issues.

In the world we live in companies really do run the world. And with courses like this I can easily see why they focus so much on profit and less about the good of the world. I’m hoping doing this course doesn’t become too depressing.