Michael Porter

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.

Harvard professor and world famous business strategist Michael Porter has a simple view to business and how you can generate superior returns from your business – the generic strategies –  but you can get stuck in the middle, not one thing or the other.

These ideas were introduced in the book Competitive Strategy by Michael Porter.

The Keys To Successful Competitive Strategy

Either:

1. Work in a business which is an attractive industry – this is a business that is well positioned against the five competitive forces that Porter identified (threat of new entrants, threat of substitutes, buyer power, supplier power and intensity of competition).
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2. Have a competitive advantage.

Michael Porter & The Generic Strategies

And when it comes to competitive advantage, Porter was equally simple because your competitive advantage can either be:

1. From being the lowest cost operator supplier acceptable goods and services at a reasonable price (and having the ability to beat anyone else on price if necessary)
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2. From winning buyer preferences based on providing a product or service which is differentiated.

Those two cost advantages can either be applied to the broad market or to narrow focused or niched markets.

The Danger Of Being Stuck In The Middle

Unfortunately many businesses fall into the trap of being “stuck in the middle” of the generic strategies of differentiation and cost leadership.

They don’t offer the high value for money and distinctive product or service that you get from a differentiated business.

And they don’t offer the low prices that can come from buying from the cost leader.

It happens because the business managers don’t know that they have to choose or think that they can be both.

Effectively being stuck in the middle comes from trying to compromise and it creates a muddle.

A muddle for your customers who don’t really know what you stand for or what to expect from you.

And a muddle for your employee who don’t understand the priorities of their work performance.

Other Stuck In The Middle Concepts

Stuck in the middle in this strategic context does not mean:

• Being in the middle of a value chain from raw material supplier at one end to end user of final product at the other. It can be uncomfortable being squeezed by big suppliers and big buyers but that’s even more reason to follow a cost leadership or differentiation strategy.
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• Nor does it mean being stuck in mid market between the premium priced luxury products and the low-priced economy brands although that can also be uncomfortable if it’s not clear what your business stands for. This mid market position is sometimes combined with Porter’s stuck in the middle concept but it is a big simplification of what he’s trying to say. There is no reason why a business can’t have a very distinct and differentiated product offering and charge mid market prices for example in cars, think of the Mazda MX5 sports car.

How A Business Gets Stuck In The Middle

A stuck in the middle position happens when a business designed to be low cost starts adding little extra frills which don’t add a corresponding amount to the customer value of a product.

The business suffers the cost, the customer doesn’t get the benefit.

Or when a differentiated business comes under pressure on prices – perhaps there has been a market disruption from new technology or an ultra low-priced competitor from overseas – and starts cutting costs in areas which damage the differentiation advantage.

What To Do If Your Business Is Stuck In the Middle

If you think that your business is stuck in the middle – or heading in that direction – then you need to get to grips with your business strategy.

You need to decide what your business is and isn’t.

You need to decide who your business will sell to and who it won’t.

You need to decide what your business will sell and what it won’t.

Strategy is about making wise choices and then having the courage and conviction to follow through and commit to turning words and ideas into action.

The Role Of The Value Chain In Creating Competitive Advantage

In his follow-up book, Competitive Advantage, Michael Porter introduced the concept of value chain analysis to help you to analyse, understand and create competitive advantage so that a business isn’t stuck in the middle.

The value chain is an important technique which helps you to focus on advantage based on differentiation or cost leadership.

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?

The full title of this classic strategy book by Michael E. Porter is

“Competitive Strategy: Techniques for Analyzing Industries and Competitors“.

In my review posted at Amazon.co.uk, I gave this book a rating of Five Stars. This means I think it is Excellent.

Here is my book review.

A classic strategy book that goes well beyond the five forces model

This is a classic business strategy text and is essential reading for anybody who has a serious interest in business strategy.

The book is written in three sections:
1 – General Analytical Techniques
2 – Generic Industry Environments
3 – Strategic Decisions

[continue reading…]

The full title of this important book by Michael Porter is

“Competitive Advantage: Creating and Sustaining Superior Performance“.

In my review posted on Amazon.co.uk, I gave this book a rating of Five Stars. This means I think it is Excellent and is Very Highly Recommended to anyone with a deep interest in business strategy and how competitive advantage is created.

Here is my book review.

Very challenging but very rewarding if you’re interested in competitive advantage

I first read this book in 1990 when I realised strategy was the subject that combined (and reconciled) my interest in finance and marketing. I’d been very impressed with his book, “Competitive Strategy” and wanted to understand more about how you create competitive advantage through cost leadership, differentiation and focus. [continue reading…]

The full title of this book by Joan Magretta is

“Understanding Michael Porter: The Essential Guide to Competition and Strategy“.

In my review on Amazon.co.uk, I gave the book a rating of Four Stars. This means it is Good and Well Worth Reading.

Here is my book review.

An easy to understand introduction to the main strategy guru

Michael Porter shook up the world of strategy and big business with two books – Competitive Strategy in 1980 and Competitive Advantage in 1985.

Since then, he has become the established view and to often, other experts have tried to make their names by misrepresenting his work and arguing against these misrepresentations.

What’s covered in the book will be taught in every business school and it certainly was in my MBA studies although, by then, I’d read the original books. He fought back against his critics with a famous article in the Harvard Business Review called “What is Strategy” and also updated his five forces commentary in another article. [continue reading…]

Strategy? It’s obvious what is strategy, isn’t it?

Perhaps not.

What is Strategy?

My personal definition of strategy is:

“Strategy is how you achieve your own objectives by winning the hearts, minds and business of customers by out-thinking and outmanoeuvring competitors.”

Professors Johnson and Scholes, authors of the MBA text Exploring Corporate Strategy say:

“Strategy is the direction and scope of an organisation over the long-term: which achieves advantage for the organisation through its configuration of resources within a challenging environment, to meet the needs of markets and to fulfil stakeholder expectations”.

Professor Henry Mintzberg from McGill University defines strategy as

“a pattern in a stream of decisions”.

He wanted to get away from the idea that to have a strategy, you have to do strategic planning or have a strategic plan. He argues that strategy emerges from decisions and actions rather than as a result of planning activities.

The Fit Between Positioning & Capabilities

Strategy is about providing a consistent match (or what is called strategic fit) between two words – your positioning and your capabilities. [continue reading…]