Five Forces

I’m ending my look at Michael Porter’s Five Forces Analysis with a look at competitive rivalry, perhaps the most powerful and destructive of the five forces as competitors carelessly compete away any profits and even create price wars that cause long term damage to industry profitability.

Competitive Rivalry Or Rivalry Amongst Existing Firms

Michael Porter introduced the Five Forces model in his book Competitive Strategy and it has since become the standard way to examine the existing industry structure and how it might change in the foreseeable future.

It’s not a coincidence that Michael Porter placed competitive rivalry in the centre of his famous Five Forces diagram.

The 5 Levels of Competition

It’s easy to falls into the trap of thinking that all competition is bad but without competitors, you’ve got no one to look good against. It’s been established that it is easier to make a decision between A and B because the brain can compare and contrast than it is to decide to buy A on its own.

I recently wrote about the 5 Levels Of Business Competition which is an important framework for assessing the intensity of competitive rivalry and what you can do to move it in the right direction.

The Symptoms of Competitive Rivalry

Competitive rivalry become intense when one or more competitors either sees an opportunity to grow and acquire the customers of competitors or feels the need to attract more customers because of low profitability.

Industries where competitive rivalry is a major issue will usually have many competitors who are struggling to make an adequate return on investment so profitability will generally be low. A few competitors – those that have established competitive advantage – will make a treasonable profit but more many, intense competitive rivalry means a fight to break even and generate enough cash to survive.

Competitive rivalry intensifies through retaliation as competitors react to aggressive strategies with their own aggressive or defensive strategies.

This rivalry often comes through in terms of lower prices, as competitors use marginal costing to justify a contribution to overheads. However, competitive rivalry can also come through in advertising, product introductions and customer service battles.

Much of the competitive rivalry is damaging to long term profitability in the industry since it raises customer expectations of value for money although advertising can expand the market or establish differentiation through branding.

Richard D’Aveni came up with the term hypercompetition to describe situations where rivals fight hard against each other. The danger is that the firms head toward the model economists call perfect competition.

The Factors That Determine Competitive Rivalry

Competitive rivalry arises from a number of factors that work together to either give competing firms an incentive to try to break ranks or a vulnerability to the other Five Forces.

Moving from the growth to the maturity stage of the product life cycle and then into decline can increase rivalry. In the growth stage, firms get used to the business growing as more customers come into the market. However new demand eventually reaches saturation point and replacement demand isn’t sufficient to continue to provide growth opportunities. Firms will therefore look to grow through taking existing customers away from competitors.

It gets worse if the industry moves into the decline stage of the product life cycle or if the wider economy goes into recession, especially if the industry is cyclical and exaggerates the effect. Competitors will see their own sales volumes go down and in the absence of industry-wide  information, assume that their rivals are cutting prices.

High fixed costs, low variable costs and low capacity utilisation provide the economic rationale for trying to increase market share because a small increment of extra volume has a disproportionate effect on profitability. Unfortunately the reverse is also true, lost volumes in this situation has a significant downward impact on competitors’ profitability making a response the natural reaction. Price wars can develop very quickly and especially if competitors are manipulated by big customers into believing short term offers are bigger and more long term than they really are.

Competitive rivalry increases with commodity products and reduces if there is effective differentiation or switching costs. Customers have an incentive to stay loyal rather than shop around for the lowest prices.

Competitive rivalry is also a function of the competitors in the market. The most orderly markets tend to be where one has established a clear leadership position and the others are tucked in behind, taking advantage of the price umbrella established by the leader. These firms can coexist if they know their place in the market and stick to it.

However, if two or more firms are competing for market leadership and market share offers economies of scale and experience curve savings (see the Competitive Advantage matrix) then rivalry intensifies. It gets worse if competitors don’t understand each other and find it difficult to interpret the intentions of each other because of different goals. Competitors from different countries and cultures can make the existing firms particularly sensitive because of fears over low-cost competition.

Competition makes it difficult for the weak firms to make a profit. It’s therefore important that the loss-making firms can exit the market easily. If there are high exit barriers, then competition increases in a desperate fight for survival.

Using The Generic Strategies To Defend Against The Damage Done By Competitive Rivalry

Michael Porter’s generic strategies offer a way out of the worst damage from competitive rivalry.

If the business is differentiated, then it effectively creates its own private market, insulated to some extent from what’s happening in the wider market. The business can’t be complacent because big changes will cause the customer value line to shift, making established positions uncompetitive without a response to improve customer value or reduce price.

If the business genuinely has a substantial cost advantage, it can afford to sell at prices that will make its competitors weep. A strong short term argument can be made for pricing based on marginal costs with its contribution to overheads but it makes no sense for any competitor to go below marginal cost unless it is desperate for cash to stave off imminent bankruptcy.

It is the businesses that are stuck in the middle that have the most strategic threat if rivalry increases.

Other Articles On The Five Forces

Michael Porter has developed the standard way to look at industry analysis with the Five Forces model.

If you are new to it and you want to understand how the forces interact, you should read the other articles:

Five Forces Analysis

Barriers To Entry & The Threat Of New Entrants

Bargaining Power Of Buyers

Bargaining Power Of Suppliers

Threat of Substitutes

Have You Experienced The Damage Done By Intense Competitive Rivalry?

Has your business been caught in a price war or other competitive battle which seriously eroded profits. I’d like to hear the story so please leave a comment.

I’ve seen several.

The first was a company I worked for when the recession of 1990/91 was the trigger to shift us from co-existence to conflict. WE were caught in the classic profit squeeze of falling sales volumes, price cuts and lower productivity as the hourly paid workers tried to stretch their work out to fill the week. Profits fell from £100k or more a month to a £30k loss in three months and whilst the business was restored to profit, margins never returned to the old levels.

The second was a client I started working with after the damage was done. They couldn’t understand why their accounts showed losses every month but investigation into their price changes showed that competitive rivalry from the main competitor changing its value chain by outsourcing inefficient operations had forced them to slash prices beyond a level that was sensibly economically.

The threat of substitutes is an important element in the Five Forces Analysis model introduced by Michael Porter in his book Competitive Strategy.

The issue of the threat of substitutes is always a factor which limits the profit potential of a market.

In times of economic difficulties, the threat accelerates sharply but it also represents an opportunity to help lure new customers into your market as customers priorities, needs and wants change.

Other Articles On Industry Analysis and the Five Forces Model

This article on the threat of substitutes can be read in isolation but if you are not familiar with Michael Porter’s Five Forces model, it will help to read Porter’s Five Forces first and then later read about the other forces that influence industry profitability.

Threat of New Entrants

Bargaining Power Of Buyers

Bargaining Power Of Suppliers

Threat of Competitive Rivalry

What Is The Threat of Substitutes?

The threat of substitutes force recognises that every customer has a choice when they buy which is not limited to the same industry or market.

There are different ways to satisfy a particular need. See What Are You Doing On Saturday Night.

Substitutes Offer Customers the Choice Of How To Solve A Problem

If I want to travel from my home in Birmingham to Paris, I can:

• Drive (including the Channel Tunnel);
• Travel by train;
• Fly.

The airlines that fly from Birmingham are not just competing between British Airways, Air France and BMI Baby. They must recognise that I have substitute solutions to meet my desire to travel to Paris.

This threat of substitutes (driving or train) places restrictions on what the airlines have to offer to convince me that flying is the best solution. The customer value attribute map or what Blue Ocean Strategy calls the strategy canvas is a useful way to look across the dimensions of customer value to show the advantages and disadvantages of substitutes from the customer’s perspective.

The Threat of Substitutes Increases In A Recession

Takeaway restaurants have seen a migration of customers in the recession and open up opportunities for businesses like Housebites.

The threat of substitutes can impact your business both ways and, if you owned a takeaway business, you need to have marketing strategies to tempt people away from restaurants and defend against the threat of the ready meals.

For example to tempt regular restaurant trade to the substitute takeaway service, a takeaway business could emphasise the quality of the food and give tips on how you can turn your Chinese takeaway into a romantic event at home or into a party night with a small group of friends.

To protect against the threat of substitution from ready meals, the takeaway business would again emphasise quality, introduce a delivery service (it is what stops me buying fish and chips compared to Indian, Chinese, pizza etc) and have a regular buyer reward scheme e.g. buy on four occasions and get the fifth free (with some kind of value limit).

Threat of Substitutes: The Theory

Let’s take a look at how Michael Porter explained the threat of substitutes in his Five Forces Model.

The main issue is that the existence of substitute products and services place a ceiling on the price a market and companies with the market can sustain.

Going back to the takeaway food example, the closer the price the cost of the takeaway gets to the price of a restaurant meal, the less threat it is as a substitute solution.

The key issues on the threat of substitutes are:

• The willingness of customers to switch across different products (which is often a factor of how easy it is to compare and contrast the different offerings); and
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• The relative price/value offered by the different substitutes.

If we return to my example of getting to Paris for a weekend break, what I want is to travel easily, quickly and cheaply so that I have most opportunity to enjoy my time in Paris.

A cheap flight going out early Friday morning and returning late afternoon on Sunday is ideal but what if I can’t fly out until 4:00pm on the Friday?

That writes off Friday as a holiday and if combined with a forced early flight back on Sunday, it means I’m paying for the flight and two nights in Paris for the pleasure of having effectively one full day to relax and have a good time.

That could make other methods of transport attractive, especially if I lived near the south coast of England and if I have the belief that Airlines Suck (an interesting perspective on the difference between customer satisfaction and  customer value.)

Alternatively the flight times could tempt me to look at flying to Paris from a substitute airport or could get me thinking about substituting Paris for Rome, Florence, Prague or any of the other great cities in Europe. What I really want is a lovely weekend break.

The comparisons are difficult. I’m not comparing like with like and that’s why the desire to switch is so important. If I really want to go to Paris for a special reason, my potential substitutes narrow to how I can get there in ways that maximise my time in Paris and minimise the pain of the journey.

Differentiation And The Threat of Substitution

Effective differentiation will create buyer preference within a product category because it helps one product stand out as a bullseye match between what it offers and what the customer wants.

A product that has very strong differentiation will turn competitors’ products into possible substitutes rather than direct alternatives. The threat doesn’t go away entirely but it is reduced.

Substitutes and Customer Value

Customers want value for money and because this is a ratio, it can get better if:

• The value or benefits you receive as a customer increase.

• The price you pay reduces.

Value for money gets worse when the value reduces or the price increases.

The relative customer value between different substitutes can change because of changes in one alternative rather than the other which is why it’s important to watch what’s happening in the substitute markets.

Even with the Euro crisis, the UK has seen the value of sterling fall against the Euro, making the Christmas shopping trip to Paris a lot less attractive than in the last couple of years. The thrill of the experience of visiting Paris hasn’t changed but the price has in sterling terms.

Other times, it is the value that changes between substitutes. Some products can make fast incremental or breakthrough changes in performance which shift the relative appeal of the products and increase the threat of substitution.

Analysing The Threat Of Substitutes

Step 1  of assessing the threat from substitutes is very much seeing your business as competing within a market and also within a wider generic solution market.

Too often business managers are focused on their direct competitors and miss what’s happening in substitute markets until sales volumes are disappearing quickly.

What problems do your products or services solve? Make a list.

Then identify how else a customer can potentially solve these problems. What substitutes will the customer consider as viable alternatives?

Then start looking at each substitute so you understand the appeal.

• What benefits does the substitute provide compared to you?
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• What price point is it at?
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• What is the weakness of the substitute? What constraints or limitations does it impose on a customer?
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• Why would a customer switch between substitutes?
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• What barriers are there to stop customers switching?
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• What trends are there is the substitute markets? Where is customer value being gained or lost? What can cause sudden changes in price?

When you have the basic information, you can then start to look at building strategies to either defend against the threat of substitutes or to attract customers from another substitute market.

How can you tilt the value for money comparison in your favour by increasing the perceived value or reducing the perceived price?

How can you:

1. Identify potential switchers from a substitute market?
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2. Communicate and educate about your offerings?
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3. Tempting them into wanting to make a trial purchase?
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4. Provide reassurance against any fears of switching?
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5. Retain their customer loyalty?

A lot of this is good marketing but it is aimed at encouraging customers of substitutes to switch to a different product and when they do, to choose you.

Conclusion on the Threat of Substitutes

I have tried to show that substitution between products and services is both an opportunity and a threat and therefore can appear on both sides of your SWOT analysis.

If you don’t recognise the existence of substitutes, you won’t put in place the right defensive strategies to keep some of your current customers and you won’t follow offensive strategies to attract new customers to you.

If you want to know more about Michael Porter and his Five Forces model, his Competitive Strategy book is rightly considered a classic.

The bargaining power of buyers or customers is one of the five forces that determine industry profitability in Michael Porter‘s Five Forces Analysis model explained in his book Competitive Strategy.

The basic idea is that by using their  bargaining power as a powerful buyer, some customers can capture a high proportion of the value you create for them by forcing down your selling prices and increasing your costs to serve them.

This applies to both business to business transactions and business t o consumer although it’s usually a more powerful force in B2B because of the size of the deals.

Introduction To The Bargaining Power Of Buyers And Customers

This is the third article focused on Michael Porter’s Five Forces model for Industry Analysis:

Introduction To Five Forces Analysis

The Threat of New Entrants

The other forces are:

Bargaining Power Of Suppliers

Threat Of Substitutes

Threat Of Competitive Rivalry

This focuses on how buyers can use bargaining power to reduce the profits of a business and what the business can do to resist.

Negotiations With Buyers – Win-Win or Win-Lose?

There are two elements to any negotiation between a buyer and a seller:

1. How can you add value to my business?
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2. What price will you charge?

The first is collaborative. The customer wants the supplier to add as much value as possible and the supplier wants to establish the existence of benefits which create a competitive advantage over the competition.

When it comes to price, any reduction the buyer negotiate with a supplier transfers profit from the supplier to the buyer.

In a commodity business where there is little or no differentiation, little time is spent of the first question because buyer preference is won on price. A stronger buyer will negotiate hard on the customer value elements and then claim that the produce /  service combination is close to what’s available from competitors so a deal is possible if “the price is right.”

How well each party performs in he negotiations will depend on individual negotiation skills of the buyer and sales-person and the industry structure which usually biases the negotiating power one way or another.

Two Major Factors Determine Relative Bargaining Power Of Buyers

1. The price sensitivity of the customer to paying a high or low price.
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2. The relative bargaining power that comes from a readiness to walk away from any deal and go elsewhere.

Price Sensitivity And Its Impact On the Bargaining Power Of The Buyer

Buyers will be more willing to switch from one supplier to another to get a lower price if:

1. The product is important to the buyer because it represents a high proportion of costs but there is little difference in the products from one supplier or another. The buyer knows that the product can be bought from somewhere but doesn’t particularly care where, provided the price is the lowest.
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2. The buyer will be much more sensitive to price if the buyer and its industry is under competitive pressure in its own market and has to fight for every drop of profit. Good times economically can protect suppliers from the excessive use of the bargaining power of buyers but as markets get tougher (see PEST Analysis) pressure to reduce prices will increase as buyers try to compensate for profit lost in its market. This can be a major threat which should be on your SWOT analysis.

The Ability To Walk Away And Its Impact On The Bargaining Power Of Buyers?

The second factor that determines whether buyers or sellers capture the majority of the profit from a transaction is the bargaining power that comes from the knowledge you can walk away from any deal you don’t like.

It’s a wonderful position to be in

If you are a seller and the business is performing well, it is important to keep reminding yourself that you always have a choice. You don’t have to accept any deal the supplier proposes, only the deals that are profitable.

Michael Porter’s Five Forces model says that the buyer has the advantage in bargaining power if:

1. The buyer is large and the supplier is small. This suggests that the deal is more important to the supplier.
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2. There are few buyers and many suppliers. The buyer has the choice of many suppliers to play off against each other but the supplier knows that to achieve good sales volumes, at least one of the small number of large accounts needs to be captured.
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3. The buyer knows the undifferentiated product very well and has no problem comparing goods and prices from different suppliers. Buying apples v apples and dominating the price negotiation is easy. It gets much more difficult to compare apples with oranges and feel confident that the deal is right for you.
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4. The buyer does not incur any penalties or other switching costs from moving its purchases from one supplier to another.
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5. The buyer can make a credible threat to enter the suppliers industry and provide its own supplies of the product unless the price is very low while the supplier cannot move into their customers market safely. This issue of vertical integration forward and back is a big topic which I will be covering in future business strategy articles.
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6. There are substitutes available from another a related industry and supplies are readily available.

Can you see how some of these factors apply to your relationships with your customers and hinder your negotiations?

The Bargaining Power Of Buyers May Not Just Be Price Pressure

It is easy to fall into the trap of thinking that the bargaining power of a buyer is focused on getting the best price and often it is.

Sometimes a strong buyer will insist on extra service requirements (next day delivery at no cost) or a favourable financial arrangement (extended credit terms or consignment stock) which increases the costs to service and makes that customer less profitable to the supplier.

How To Protect Your Business From The Bargaining Power Of Buyers

Chapter 6 of Michael Porter’s book Competitive Strategy is titled Strategy Towards Buyers and Suppliers and looks in detail at the bargaining power of buyers.

You can reduce the bargaining power of buyers through strategy although you may not like some implications.

1. You can differentiate your products or services. If a buyer wants what you sell but cannot get it from someone else, then the power relationship shifts in your favour. Although a professional buyer will try to knock down your prices and get the best deal, you may have a stronger position that you think. It is a common problem in negotiating to think that the other party has the stronger bargaining power because you want the business.
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2. You can also use the other generic strategy, cost leadership to protect your profits. Competitors who behave rationally can only go to a certain price before they lose money. Irrational competitors who lose money on each transactions won’t be survive for long.
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3. You can target the less price sensitive buyers and buyers where the costs to serve are less. If you don’t have a differentiation or cost advantage, then the high volume customers may not be right for you. The sales volumes may look good but margins will be small and you will be better filling your capacity with business from smaller customers.
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4. Understand your product or service costs and be ready to walk away from any deal that is wrong. If you don’t have a walk away price, the buyer will know that he or she can keep pushing to extract more price reductions. Understand the cost implications of the extras that a powerful buyer will ask for and where you or they have a cost advantage. I worked with a client who came under pressure to concede on extended terms and foreign exchange risks when it would have cost the buyer much less to put those aspects into place.
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5. Make sure you’re not trying to sell an over-engineered or r-specified solution. Different buyers want different things and if you’re selling something with features or benefits that the buyer doesn’t appreciate then you’re incurring costs to provide something that the buying won’t pay for. Have a low-priced base offering and add extras to it that the buyer does want.
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6. To fight back against the bargaining power of buyers who are highly concentrated, a firm can consolidate its part of the industry value chain.

How To Choose Buyers Who Won’t Use Their Bargaining Power

Factors to look out for when looking for buyers who are not sensitive to price and therefore less likely to use their bargaining power include:

• Buyers for whom the cost of the purchase is small relative to the rest of the business – who cares about the cost of paper clips when time is limited and there are more important things to do.
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• Where the penalty for product failure is high – sometimes quality and reliability is much more important than price.
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• The product will be an important part of the supplier’s product because it is a de facto standard – PC assemblers risk being excluded from consideration by their customers if they don’t use Windows and Intel microprocessors.
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• The buyer wants a custom designed product and there are few suppliers with the capabilities to deliver to the right standard.
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• The buyer is very profitable and is in a powerful position with its customers and can pass on cost increases easily.
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• The buyer is poorly informed about the market.

Conclusion on The Bargaining Power Of Buyers

Powerful buyers represent a serious threat to the profitability of individual firms and all the firms in the industry.

Careful strategy can help you to reduce the damaging effects of the bargaining power of buyers.

Today we will look at how you can use barriers to entry to reduce the threat of new entrants into your market.

The threat of new entrants is one of the forces in Michael Porter’s Five Forces model of industry analysis.

This threat applies to any business of any size, big or small.

It can be particularly damaging if your market is a fixed size and suddenly you find that you have to share it with a competitor who has decided that they see an opportunity.

A simple example is if you own the only shoe shop in a small town selling shoes and boots for men, women and children. The demand and supply balance is in your favour until another entrepreneur opens up a women’s shoe shop with the latest, fashionable designs.

Why New Entrants Will Be Attracted To A Market?

Any indication that a market is growing, that it is under-served in meeting customers specific needs or particularly profitable will trigger interest from an entrepreneur who believes that there is money to be made from taking part in your market.

Evidence that existing businesses are making good profits will persuade entrepreneurs that this as an opportunity too good to miss.

So before you order a second Porsche for your wife (or husband) and move into a ten bedroom mansion, you need to think what these signs of success are saying to potential competitors.

Barriers To Entry Make It More Difficult For New Entrants And Reduce The Threat Of Entry

To discourage new firms entering your market and competing for your customers and profits, you need to have barriers to entry in place as a defensive strategy.

Without them, potential rivals are free to entry the market whenever they want.

The Common Barriers To Entry

Common barriers to entry include:

1. Entrants must make a big financial investment to buy equipment, in research and development, in stocks / inventory or to build a brand.
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2. Established firms have cost advantages unavailable to new entrants
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3. There are supply restrictions, either from incoming  materials from suppliers or outgoing to customers which make it more difficult for new entrants to become established
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4. High customer loyalty from buyers makes it much harder for new entrants to attract customers or even low cost trials
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5. Legal barriers and patents
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6. Threat of retaliation from existing competitors

A More Detailed Look At How Barriers To Entry Can Be Used To Reduce The Threat Of New Entrants

Financial Investment As A Barrier To Entry

Some industries require a large financial investment before a new business can start which creates a financial barrier and psychological barrier to entry.

Investments may be in:

• Plant & equipment
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• Lease commitments for buildings – even though the financial commitment isn’t paid upfront, landlords may want guarantees
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• Research and/or development
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• Inventory

This introduces doubt into the minds of the prospective entrepreneur and any financial backers.

Some potential competitors won’t be able to raise the funds and others won’t be prepared to risk so much on a new venture which may not succeed.

Other industries require virtually no financial investment which makes entry into those markets look very attractive for any cash-poor entrepreneur. These businesses need rely on other barriers to entry.

Cost Advantages As A Barrier To Entry

Businesses enter new markets because they expect to earn a profit – i.e. that revenues will exceed costs. If the new entrant isn’t cost competitive with existing companies, then it is clear that a profitable opportunity doesn’t exist.

Cost advantages can come from three main sources:

1. Economies of scale – the bigger the business, the lower the average unit costs. For more details see economies of scale.
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2. The experience curve – the more you perform an activity, the more opportunity you have for finding the best ways to do it for the least cost.
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3. Low cost input prices, either from a favourable location e.g. a lower wage economy or long term supply contracts at very good prices.

These factors naturally favour the existing companies in the market although increased globalisation is opening up many markets to competition from the lower wage economies for the first time.

New technology can undermine the cost position of the existing competitors.

Where brand names are important, a new competitor has a major problem becoming known and accepted unless it is prepared to invest heavily in sustained advertising and/or buy market share at a low price to stimulate trial and hopefully repeat purchases.

Supply Restrictions As A Barrier To Entry

A new entrant in the market may find it difficult to buy the supplies necessary to compete (including skilled labour) or it may be that it finds that distribution channels to the customers/consumers are reluctant to add extra lines and won’t drop existing proven products from their range.

Customer Loyalty As A Barrier To Entry

Happy customers who are delighted with the service and the products from the existing companies may be very reluctant to risk buying from a new competitor.

Depending on how important the product is, even a much lower price may not compensate for the uncertainty of dealing with a new company.

It may also be difficult for customers to suddenly switch from one supplier to another because of incompatibilities. For example, it is a big decision to switch computer suppliers because of all the inconvenience and effort required.

Legal Barriers And Patents As A Barrier To Entry

New companies may have to deal with difficult legislation issues and even legislation that doesn’t affect incumbents. When I worked for a company with an iron foundry back in the early nineties, we did not have to meet environmental legislation that a new competitor would have had to comply with.

The market may also be protected through effective patents which stop a competitor bringing out a product very similar to your own.

Threat Of Retaliation From Existing Competitors As A Barrier To Entry

Any new entrant is attracted by the prospects of high profit so if existing competitors can put together a convincing threat that they will stop this happening (by cutting prices or extensive advertising), the new company will see high profit will not materialise.

But it is difficult to pull off.

Threatening retaliation against a new entrant means sacrificing the short term profitability of existing businesses so the new competitor has to be seen as a major threat which justifies the costs.

Barriers To Entry – An Effective Deterrent?

High barriers to entry are good if you are already established in a market but bad if you are investigating a market as a possible route for expansion.

The factors can change which is why it is important to keep reviewing Michael Porter’s Five Forces model and the danger is that once one entrant has succeeded, other copycats may see that entry barriers like the threat of retaliation were an illusion.

Barriers To Entry May Be Reduced From Closely Connected Industries

The other issue when assessing entry barriers is that your starting point matters.

If you already have relationships with the prospective customers, a well known brand which is portable to this new market or you have the supply capabilities, your ability to enter a new market successfully is very different from a totally new company.

Can You Increase The Barriers To Entry?

To make your industry analysis better and to protect your business from the threats of new entrants, can you find ways to move these factors in your favour?

Are you doing everything you could to capitalise on your cumulative experience so that you find better ways to provide your product or service?

Can you find ways to increase customer loyalty so that they are unlikely to be tempted away by new entrants or existing rivals?

Is your patent protection as strong as it could be?

Overcoming Barriers To Entry

The entire issue of the threat of new entrants and the issue of barriers to entry all depends on where you are coming from.

If you are already in the industry you want high barriers but if you are outside looking to get in, ideally you want low barriers for you but high barriers for every other possible entrant.

So after you have identified the potential barriers to entry for your industry, put yourself in the shoes of a new competitor eager to enter the market.

Ask yourself how you would get around the barriers.

Can you reconstruct the industry?

Traditional High Street operations like banks and insurance brokers have been disrupted by first telephone and then Internet technologies.

Amazon have done the same with books, CDs and DVDs replacing a bricks and mortar presence with a huge website with many more products and product reviews.

Can you separate out the constraining area and subcontract to take advantage of other companies’ economies of scale and learning?

Can you license trademarks, patents and products so that you collaborate with a key player and help them compete against the other competitors?

More On Industry Analysis and the Five Forces Model

My related blogs start with an introduction to industry analysis and Michael Porter Five Forces Analysis Model.

I’ll also be writing about

Supplier Power

Buyer Power

Threat Of Substitutes

Competitive Rivalry

Your Thoughts On Barriers To Entry and the Threat of New Entrants

It will be great if you can share your thoughts and experience of barriers to entry? When have they protected your business or a business you know?

How have you managed to work around traditional barriers to entry which looked formidable?

The bargaining power of suppliers and vendors is one of the Five Forces that Michael Porter identified that determine industry structure and attractiveness.

In many ways the bargaining power of suppliers is the same as the bargaining power of customers but seen from the other party’s perspective.

Powerful suppliers in the industry value chain can squeeze profits out of customers and the customers’ customers by establishing a dominant position which gives major strategic control over the entire industry. Good examples are Microsoft and Intel in the PC industry who make very high profits when other parts in the value chain struggle to make profit.

Rather than repeat what I wrote on customer buying power I thought I’d look at uses and abuses of the bargaining power of suppliers.

Uses And Abuses Of The Bargaining Power Of Suppliers

I take a very pragmatic view of what is a use of abuse of bargaining power:

• Use is when you are able to use bargaining power to increase your profitability.
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• Abuse is when bargaining power of suppliers is used against you to “steal” your profit.

I therefore see using bargaining power as an offensive strategy as you establish advantage while you need a defensive strategy to protect your business against abuses of the bargaining power.

It’s interesting to look at both sides of the situation like this because there is a tendency in negotiations to assume that the other person has a stronger position than they actually do. This feeling of weakness can make you concede too much too early because you fear the other side will walk away.

Using The Bargaining Power Of Suppliers To Increase Your Profitability

In this situation, you are intending to use the bargaining power that comes from your position as preferred supplier to increase your prices and capture more margin from customers without losing sales to lower priced competitors; or

Low competitive rivalry is a key issue to stop the competitive process forcing down prices.

Collusion and cartels are illegal and severely punished but some industries (which score well on the other Five Forces) settle into a comfortable existence with either businesses operating from their own differentiated positions in niche markets or, if differentiation hasn’t been established, the market share leader can set prices and enforce disciplined pricing by targeted responses.

Cyclical industries which exaggerate the effects of the economic cycle, like the steel industry, are constantly trying to balance demand and supply by increasing or reducing capacity. What is normally a buyer’s market can shift suddenly when suppliers have cut back capacity and demand starts increasing. I’ve seen prices increase very rapidly as suppliers ration out what’s available to desperate manufacturers eager to fill their own increased demand. As capacity gets added back, prices level off and then start reducing but high profits can be made in the early upswing of the economy.

Switching costs are an important issue which lets suppliers exert their bargaining power. These may be high business specific investments in equipment, technical issues that create compatibility problems with using goods from other suppliers or favourable terms of trade (e.g. extended credit subject to certain volumes, loans of equipment e.g. the freezer for ice cream).

Some switching costs create a hurdle at the beginning of the relationship as well as a barrier at the end.

Other switching costs that enhance the bargaining power of the supplier come from being excellent at what they do. The quality or service provided might become an integral part of the buyer’s own value proposition to its customers. The thought of switching to another supplier can create high levels of business risk and personal stress to the decision maker. IBM did very nicely out of the idea that “no one gets fired for buying IBM.”

Some firms will look along the industry value chain and believe there are opportunities for profit by vertically integrating forward into their buyers’ markets. There may be distinct advantages through better coordination which would give the business a competitive advantage over its customers in their markets. Suppliers can use the threat of vertical integration to exercise their bargaining power (if we don’t meet our profit targets doing what we do, we’ll have to look at competing with you.)

Defending Against the Bargaining Power Of Suppliers To Protect Your Profitability

In this situation, you are defending against the abuse of bargaining power by a powerful supplier.

An interesting example of excessive bargaining power is Premiership football in England where the clubs manage to get very high payments for TV rights but then, instead of keeping a share of this as profit for the shareholders, the money is paid out to the pampered footballers.

While businesses can’t form cartels to fix prices, employees can join trade unions and use the power of collective bargaining backed up with the threats of works-to-rule and even strikes. Businesses can form buying groups to increase their bargaining power. I’ve worked in several industries where these groups were able to establish 10% to 15% discounts compared with independents.

Buyers can look across supplier markets for alternative supplies. For example, I used to work for an electrical fittings company with an iron foundry and steel press-work. While we operated in a niche market selling to electrical wholesalers, the larger wholesalers could have gone out to the general foundries and steel fabricators and bought the tooling required to make the high volume items.

Buyers also have the option of vertically integrating backwards if they look at the make or buy decision and decide that the potential savings justify the trouble of manufacturing their own supplies.

Labour & Unionisation To Increase Bargaining Power

Don’t get trapped into thinking that suppliers / vendors only supply materials and components.

It includes all costs and one of the biggest is labour which may be unionised. This can be a significant source of competitive advantage or disadvantage depending on the position of one business compared to its peers.

Unionisation may have a double negative impact on the ability of the business to compete (and to continue to provide employment):

• Wages and salary rates may be higher through collective bargaining and pressure to maintain pay differentials whilst moving up the pay of the lowest paid.
• Restrictive practices may cause low productivity and unnecessary delays in the operational processes.

Do You Have Other Examples Of The Bargaining Power Of Suppliers?

If you have experienced other examples of using the bargaining power as a supplier, or defending against the abuse of bargaining power, then please leave a comment.

More On Michael Porter’s Five Forces

If you found this article on the bargaining power of suppliers helpful, then take a look at my other articles on Michael Porter’s Five Forces:

Five Forces Analysis

Threat Of New Entrants

Bargaining Power of Customers

Threat Of Substitutes

Competitive Rivalry

Michael Porter’s book Competitive Strategy is difficult to beat if you want to look at the Five Forces in detail and their impact on strategy. Although it is over 30 years since it was published, it is still essential reading for any strategy specialist.

In my guide to strategic planning models I described Michael Porter’s Five Forces Analysis as probably the most famous of the strategy models but until now, I haven’t written about it in detail on my blog.

Background To The Five Forces Analysis Model

The Five Forces Analysis model was first introduced in the Harvard Business Review in 1979 in an article by Michael Porter called “How Competitive Forces Shape Strategy.”

It was then a major element in Michael Porter’s book, Competitive Strategy.

In 2008 Michael Porter returned to the Five Forces Model with an updated article in the Harvard Business Review called “The Five Competitive Forces That Shape Strategy.

For more than thirty years, the Five Forces Analysis has become the standard way to analyse an industry, look at changes that are taking place and to think about how a business can best position itself to defend against damaging forces and maximise opportunities where the forces are weak.

The Sources of Profit

The principle behind Michael Porter’s ideas is that profit only comes from two sources:

1. Operating in an industry with an attractive structure as defined by the five forces analysis model

2. Having a sustainable competitive advantage

In simple terms, an attractive industry is about the balance of supply and demand. If demand is greater than supply, then businesses should find it easy to make a profit. If supply is greater than demand, then the business needs a competitive advantage to survive the competition process.

Of course things aren’t that simple in the real world. Michael Porter argues that the Five Forces analysis model identifies the key factors which determine the average profitability of an industry.

Michael Porter Five Forces Analysis Model

The roots of the Five Forces analysis model lie in industrial economics and represent many of the key assumptions in the model of perfect competition. These assumptions keep the supply and demand within a market in equilibrium and stop firms who compete n it from earning big profits or making big losses.

The five forces that Michael Porter identified are:

1. The threat of new entrants
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2. The bargaining power of customers
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3. The bargaining power of suppliers
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4. The threat of substitutes
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5. The rivalry among existing firms.

These are summarised in a classic diagram.

How The Five Forces Analysis Model Works

Customers, suppliers and competitors compete for the profit from the value created by the industry which is limited by substitutes or alternative solutions to the underlying customer needs.

The ideal industry structure is one where the five forces are weak:

• Both suppliers and customers willingly accept terms offered by the business,
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• There is no viable substitute to the product or service sold which meets the customers’ needs and wants,
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• Any potential new companies would find it very difficult to enter the market effectively, and
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• Competitors focus on enlarging the total industry profits rather than competing away profits unnecessarily through crazy pricing because there are no viable substitutes.
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• Competitors who are struggling to make money, can leave the industry easily and use their skills and resources elsewhere.

When Is The Five Forces Analysis Model Most Effective?

I believe that the Five Forces analysis model gives more insight when you are considering entering a new market than for small businesses who are already firmly entrenched in established markets.

This is because the model helps to identify the threats to making superior profits before you’ve made the commitment.

Yes the Five Forces model can be used to identify market segments which are protected from the worst of the forces but a business can’t keep switching positions with different products and customers.

Michael Porter Explains The Five Forces Model

Here is a 13 minute video of Michael Porter explaining the five forces model and why it is still relevant after it was first introduced in 1979. Highly recommended.

Porter looks at how the Five Forces apply to the airline industry, which traditionally has been a very low profitability industry but which paradoxically is seen as “sexy” and attracts new entrants. The opposite example, with weak competitive forces is the soft drinks industry which he describes as a “licence to print money.”

Problems With The Five Forces Analysis Model

This problem of putting the Five Forces model to work has led to people struggling to gain much insight about what to do next in their current markets.

This is partly because the model isn’t used well and the dynamics of the slow evolution aren’t captured until they speed up and hit the tipping point. It helps to use the model with PEST Analysis, both looking back over how the industry has evolved over recent years and forward as you think about how it could change, perhaps even using scenario planning. SKEPTIC is a model which combines the Five Forces and PEST.

Common mistakes to using the Five Forces analysis include:

• Inappropriate definitions of the market / industry which may be too narrow or too broad. If in doubt and you’re juggling with two market definitions, try both. You may be able to eliminate one quickly because it doesn’t feel right or both might give you valuable but different insights.
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• Making a list of issues rather than thinking through the implications and finding strategic insight about what’s happening.
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• Making black and white judgements about the industry, either that it is attractive or unattractive without identifying the strategic implications.

The options to take action using what you’ve learnt from your Five Forces analysis are limited:

• Can the business influence the five forces? Most small businesses can’t.

• Can the business protect itself from any damaging forces or take advantage of opportunities that come from favourable changes?

• Can the business move to into an area of the market where the forces are less of an issue?
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• Should the business exit this market and move its attention and resources elsewhere?

However, I do believe that any business that occupies a strategic position in its market should periodically work through the five forces model and see what new insights it brings.

Industry Evolution Is Monitored By The Five Forces Model

All industries and local economies are constantly evolving and Michael Porter’s Five Forces analysis model is a proven technique for analysing industries and markets so that you identify threats and opportunities early. These would be included in your SWOT analysis.

Without a framework like the Five Forces Model, it is very difficult to identify all the issues that are changing and I will be looking at the threat of new entrants, buyer and supplier power, substitutes and competitive rivalry in more detail.

The Sixth Force Missing From The Five Forces Model

Various strategies experts have suggested that Michael Porter’s Five Forces Model isn’t complete and that there is a sixth competitive force.

Unfortunately there is no agreement on what is the sixth force.

Some have suggested that complementors or complementary products are a sixth force. These are products and services which add value to the original product when it is used. This came from work done in game theory for strategy purposes. If the complementary products grow in value e.g. apps for the iPhone and iPad then demand for the original product is strong. If complementary products are weak, then demand for the original product is weak.

Others have suggested that government or the full PEST factors act as a sixth force in Porter’s model. Personally I prefer to look at their impact through the original five forces model.

Tony Grundy believes that the central force in the industry analysis model is not competitive rivalry but industrial mindset which is the sixth force which binds everything else together. This is interesting, especially from a differentiation perspective which requires you to challenge the traditional rules and patterns of success to find breakthrough value for customers.

Combining PEST Analysis With the Five Forces

Stephen Haines developed the SKEPTIC model which combines the five forces with PEST Analysis. It’s a useful concept and a memorable acronym since many people lose site of the benefits of the Five Forces analysis and PEST analysis because they are done so badly.

More Details On The Five Forces Model

Michael Porter’s five forces model deals with some very big strategy issues and is therefore too complicated to deal with in one blog article.

Threat of new entrants

Buyer Power & Supplier  Power – two sides of the same coin

Threat of substitutes

Competitive rivalry

What Do You Think Of Porter’s Five Forces Analysis Model?

Do you find the Five Forces model helpful?

Do you think there are more forces that should be included in a model for industry analysis? If so, what?

Have you done a five forces evaluation on your model and found yourself thinking so what?