Toolkit: Porter’s five forces model
January 14, 2009
I evaluate Porter’s five forces model of competition in an industry.
Toolkit: Porter’s five forces model
This post is the second post in a series in which I discuss various frameworks and models that I might be able to use to answer questions on my CGU IST screening exam of Jan 23.
Porter’s five forces model is used to analyze the external forces that act on a firm within a market and using it, management may be able to illuminate strategic options for improving the firm’s position relative to its competitors. Also, the firm can use this model to think about the lay of the land in new markets they might want to enter. The five forces are:
- Bargaining power of suppliers: If a supplier has power over the firm, this means they can control the deals they make with the firm, and this affects the quality and price of the end product or service that the firm offers to its customers. They do this by dictating price and availability of raw materials. Things that affect this factor are: how many suppliers are there, how differentiated is the supplier we’re using, are there substitutes for the thing we’re getting from our supplier? How likely is it that we might buy them?
- Bargaining power of customers: If customers have power over the firm, this means that they can easily threaten to switch to a competitor, or if they’re powerful, they may threaten to buy the company. I imagine that if customers bring legal action against the firm, or stage boycotts, this is similar?
- Threat of new entrants: This is about barriers to entry. How easy is it for a new rival to start up and be a full fledged competitor to the firm? Things like specialized hardware and skills, important intellectual property rights, brand equity raise barriers to entry.
- Threat of substitute products: How likely is it that a competitor, or a firm from a different industry, even, may make products that allow customers to achieve similar goals in different ways. Things like the likelihood that customers will switch and customer focus of the firm, strength of relationships with customers and brand equity affect this force
- Competitive rivalry in the industry: what is our relationship to other firms in our industry? Highly competitive? Not very competitive? This is about how strongly the industry will react to the actions of one firm. High rivalry is indicated when the players are all about the same size; there are high exit costs; the market is saturated and the only way one firm can do well is at the expense of another in the industry.
The model is drawn as five boxes in a cross form, with “competitive rivalry” being fed by the other four boxes.
Porter says that there are three strategies to achieve strategic advantage, which I’ll call the strategic intent of the firm:
- cost leadership: reduce the cost to create our product/service to the point where it is difficult for our rivals to copy us. To do this, we’re probably going to need to decrease the bargaining power of suppliers, as well as our operating costs. In doing so, we increase switching costs (because our rivals’ products/services are more expensive) and raise the barrier to entry for new entrants. Typically, this is about operating efficiencies and economies of scale.
- differentiation: increase the uniqueness of our product or service compared to that of our rivals. This decreases the bargaining power of customers (they have to lose things to switch away). How we actually implement this will affect what happens in the other forces. Typically this is about R&D.
- focus: Our goal is to choose a narrow segment of the market and achieve either cost leadership or differentiation there. We hope that this will increase customer loyalty and raise switching costs. Think: Apple. They don’t have many products, but they do them very well and can thus charge a premium.
Evaluation for use by CIO in searching for options
There are two ways the CIO can use this model: to search for options, and to evaluate potential options. In either case, you’re not going to use it directly, because your business colleagues are going to be the ones to carry out the analysis: they’re the business strategists. The CIO will use the results of that in combination with consulting with the business executives.
In terms of searching for options, this model is somewhat hard to use in a general sense; you really need specifics about the firm and industry. But if you sit at the table with the business execs as they perform and discuss their five forces analysis, you may be able to offer insights as to how upcoming technologies can be used to alter the balance of those forces in our favor, or how the firm’s current infrastructure could be leveraged to do so.
In terms of strategic intent, however, we can think of some generic strategies. Is cost leadership our strategic intent? Then the CIO may want to work with business leaders to create an enterprise architecture that emphasizes process standardization as a way of decreasing costs, and data integration to reduce duplicated effort. You’re going to focus on the operations and overhead of the firm, and reduce costs and increase efficiencies there. Is differentiation our strategic intent? Then the CIO might want to seek ways to increase the power of the research and development arm of the firm, by increasing collaborative and knowledge sharing ability and supplying processing power, CAD/CAM systems, etc.. Is it focus? The CIO may want to build analytical capacity to analyze our and related market segments so that we can choose a focus and keep it.
When the input or output of our firm is information, then the CIO has special powers over changing the impact of those forces. Can we supply information to our customers that will add value to our product, increasing switching costs? Can we do it in a way that is hard to duplicate (think Amazon recommender systems, data mining, data warehousing)? Can we generate necessary input information ourselves?
Evaluation for use by CIO in evaluating potential options
Porter’s five forces model is quite useful, however, in evaluating an IT technology or project for its strategic impact.
- It may change the nature of the competition by informing customers and staff better, or by transforming business processes in such a way as to give competitive advantage, or help the firm more easily achieve economies of scale.
- It may change the bargaining power of buyers and suppliers. Forcing suppliers to conform to a certain EDI format, as Walmart does, is an example of this.
- It may raise or lower barriers to entry. It may offer capabilities that are expensive or illegal (intellectual property wise) for rivals to implement, or open new channels to market, or decrease time to market.
- It can increase switching costs. Examples, Google Apps and Intuit Quicken. Once they’ve got a customer’s data, that customer becomes increasingly unlikely to want to switch to another company.
- It can add value to existing products, or allow the creation of new products and services.
