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3.3 Evaluating the Industry

L E A R N I N G O B J E C T I V E S

1. Explain how five forces analysis is useful to organizations.

2. Be able to offer an example of each of the five forces.

The Purpose of Five Forces Analysis

Visit the executive suite of any company and the chances are very high that the chief executive officer

and her vice presidents are relying on five forces analysis to understand their industry. Introduced

more than thirty years ago by Professor Michael Porter of the Harvard Business School, five forces

analysis has long been and remains perhaps the most popular analytical tool in the business world

(Figure 3.8 "Industry Analysis").

Porter’s Five Forces

Reproduced with permission from [citation redacted per publisher request].

The purpose of five forces analysis is to identify how much profit potential exists in an industry. To do

so, five forces analysis considers the interactions among the competitors in an industry, potential new

entrants to the industry, substitutes for the industry’s offerings, suppliers to the industry, and the

industry’s buyers.Porter, M. E. 1979, March–April. How competitive forces shape strategy. Harvard

Business Review, 137–156. If none of these five forces works to undermine profits in the industry, then

the profit potential is very strong. If all the forces work to undermine profits, then the profit potential is

very weak. Most industries lie somewhere in between these extremes. This could involve, for example,

all five forces providing firms with modest help or two forces encouraging profits while the other three

undermine profits. Once executives determine how much profit potential exists in an industry, they can

then decide what strategic moves to make to be successful. If the situation looks bleak, for example, one

possible move is to exit the industry.

The Rivalry among Competitors in an Industry

The competitors in an industry are firms that produce similar products or services. Competitors use a

variety of moves such as advertising, new offerings, and price cuts to try to outmaneuver one another to

retain existing buyers and to attract new ones. Because competitors seek to serve the same general set

of buyers, rivalry can become intense (Figure 3.9 "Rivalry"). Subway faces fierce competition within the

restaurant business, for example. This is illustrated by a quote from the man who built McDonald’s into

a worldwide icon. Former CEO Ray Kroc allegedly once claimed that “if any of my competitors were

drowning, I’d stick a hose in their mouth.” While this sentiment was (hopefully) just a figure of speech,

the announcement in March 2011 that Subway had surpassed McDonald’s in terms of numbers of

stores might lead the hostility of McDonald’s toward its rival to rise.

Understanding the intensity of rivalry among an industry’s competitors is important because the degree

of intensity helps shape the industry’s profit potential. Of particular concern is whether firms in an

industry compete based on price. When competition is bitter and cutthroat, the prices competitors

charge—and their profit margins—tend to go down. If, on the other hand, competitors avoid bitter

rivalry, then price wars can be avoided and profit potential increases.

Every industry is unique to some degree, but there are some general characteristics that help to predict

the likelihood that fierce rivalry will erupt. Rivalry tends to be fierce, for example, to the extent that the

growth rate of demand for the industry’s offerings is low (because a lack of new customers forces firms

to compete more for existing customers), fixed costs in the industry are high (because firms will fight to

have enough customers to cover these costs), competitors are not differentiated from one another

(because this forces firms to compete based on price rather than based on the uniqueness of their

offerings), and exit barriers in the industry are high (because firms do not have the option of leaving

the industry gracefully). Exit barriers can include emotional barriers, such as the bad publicity

associated with massive layoffs, or more objective reasons to stay in an industry, such as a desire to

recoup considerable costs that might have been previously spent to enter and compete.

Industry concentration is an important aspect of competition in many industries. Industry

concentration is the extent to which a small number of firms dominate an industry (Figure 3.10

"Industry Concentration"). Among circuses, for example, the four largest companies collectively own 89

percent of the market. Meanwhile, these companies tend to keep their competition rather polite. Their

advertising does not lampoon one another, and they do not put on shows in the same city at the same

time. This does not guarantee that the circus industry will be profitable; there are four other forces to

consider as well as the quality of each firm’s strategy. But low levels of rivalry certainly help build the

profit potential of the industry.

In contrast, the restaurant industry is fragmented, meaning that the largest rivals control just a small

fraction of the business and that a large number of firms are important participants. Rivalry in

fragmented industries tends to become bitter and fierce. Quiznos, a chain of sub shops that is roughly

15 percent the size of Subway, has directed some of its advertising campaigns directly at Subway,

including one depicting a fictional sub shop called “Wrong Way” that bore a strong resemblance to

Subway.

Within fragmented industries, it is almost inevitable that over time some firms will try to steal

customers from other firms, such as by lowering prices, and that any competitive move by one firm will

be matched by others. In the wake of Subway’s success in offering foot-long subs for $5, for example,

Quiznos has matched Subway’s price. Such price jockeying is delightful to customers, of course, but it

tends to reduce prices (and profit margins) within an industry. Indeed, Quiznos later escalated its

attempt to attract budget-minded consumers by introducing a flatbread sandwich that cost only $2.

Overall, when choosing strategic moves, Subway’s presence in a fragmented industry forces the firm to

try to anticipate not only how fellow restaurant giants such as McDonald’s and Burger King will react

but also how smaller sub shop chains like Quiznos and various regional and local players will respond.

The Threat of Potential New Entrants to an Industry

Competing within a highly profitable industry is desirable, but it can also attract unwanted attention

from outside the industry. Potential new entrants to an industry are firms that do not currently

compete in the industry but may in the future (Figure 3.11 "New Entrants"). New entrants tend to

reduce the profit potential of an industry by increasing its competitiveness. If, for example, an industry

consisting of five firms is entered by two new firms, this means that seven rather than five firms are

now trying to attract the same general pool of customers. Thus executives need to analyze how likely it

is that one or more new entrants will enter their industry as part of their effort to understand the profit

potential that their industry offers.

New entrants can join the fray within an industry in several different ways. New entrants can be start-

up companies created by entrepreneurs, foreign firms that decide to enter a new geographic area,

supplier firms that choose to enter their customers’ business, or buyer firms that choose to enter their

suppliers’ business. The likelihood of these four paths being taken varies across industries. Restaurant

firms such as Subway, for example, do not need to worry about their buyers entering the industry

because they sell directly to individuals, not to firms. It is also unlikely that Subway’s suppliers, such as

farmers, will make a big splash in the restaurant industry.

On the other hand, entrepreneurs launch new restaurant concepts every year, and one or more of these

concepts may evolve into a fearsome competitor. Also, competitors based overseas sometimes enter

Subway’s core US market. In February 2011, Australia-based Oporto opened its first US store in

California.Odell, K. 2011, February 22. Portuguese-influenced Australian chicken burger chain, Oporto,

comes to SoCal. Eater LA. Retrieved from

http://la.eater.com/archives/2011/02/22/portugueseinfluenced_australian_chicken_burger_chain_oporto_comes_to_socal.php

Oporto operates more than 130 chicken burger restaurants in its home country. Time will tell whether

this new entrant has a significant effect on Subway and other restaurant firms. Because a chicken

burger closely resembles a hamburger, McDonald’s and Burger King may have more to fear from

Oporto than does Subway.

Every industry is unique to some degree, but some general characteristics help to predict the likelihood

that new entrants will join an industry. New entry is less likely, for example, to the extent that existing

competitors enjoy economies of scale (because new entrants struggle to match incumbents’ prices),

capital requirements to enter the industry are high (because new entrants struggle to gather enough

cash to get started), access to distribution channels is limited (because new entrants struggle to get

their offerings to customers), governmental policy discourages new entry, differentiation among

existing competitors is high (because each incumbent has a group of loyal customers that enjoy its

unique features), switching costs are high (because this discourages customers from buying a new

entrant’s offerings), expected retaliation from existing competitors is high, and cost advantages

independent of size exist.

The Threat of Substitutes for an Industry’s Offerings

Executives need to take stock not only of their direct competition but also of players in other industries

that can steal their customers. Substitutes are offerings that differ from the goods and services

provided by the competitors in an industry but that fill similar needs to what the industry offers (Figure

3.12 "Substitutes"). How strong of a threat substitutes are depends on how effective substitutes are in

serving an industry’s customers.

At first glance, it could appear that the satellite television business is a tranquil one because there are

only two significant competitors—DIRECTV and DISH Network. These two industry giants, however,

face a daunting challenge from substitutes. The closest substitute for satellite television is provided by

cable television firms, such as Comcast and Charter Communications. DIRECTV and DISH Network

also need to be wary of streaming video services, such as Netflix, and video rental services, such as

Redbox. The availability of viable substitutes places stringent limits on what DIRECTV and DISH

Network can charge for their services. If the satellite television firms raise their prices, customers will

be tempted to obtain video programs from alternative sources. This limits the profit potential of the

satellite television business.

In other settings, viable substitutes are not available, and this helps an industry’s competitors enjoy

profits. Like lightbulbs, candles can provide lighting within a home. Few consumers, however, would be

willing to use candles instead of lightbulbs. Candles simply do not provide as much light as lightbulbs.

Also, the risk of starting a fire when using candles is far greater than the fire risk of using lightbulbs.

Because candles are a poor substitute, lightbulb makers such as General Electric and Siemens do not

need to fear candle makers stealing their customers and undermining their profits.

The dividing line between which firms are competitors and which firms offer substitutes is a

challenging issue for executives. Most observers would agree that, from Subway’s perspective, sandwich

maker Quiznos should be considered a competitor and that grocery stores such as Kroger offer a

substitute for Subway’s offerings. But what about full-service restaurants, such as Ruth’s Chris Steak

House, and “fast causal” outlets, such as Panera Bread? Whether firms such as these are considered

competitors or substitutes depends on how the industry is defined. Under a broad definition—Subway

competes in the restaurant business—Ruth’s Chris and Panera should be considered competitors.

Under a narrower definition—Subway competes in the sandwich business—Panera is a competitor and

Ruth’s Chris is a substitute. Under a very narrow definition—Subway competes in the sub sandwich

business—both Ruth’s Chris and Panera provide substitute offerings. Thus clearly defining a firm’s

industry is an important step for executives who are performing a five forces analysis.

The Power of Suppliers to an Industry

Suppliers provide inputs that the firms in an industry need to create the goods and services that they

in turn sell to their buyers. A variety of supplies are important to companies, including raw materials,

financial resources, and labor (Figure 3.13 "Suppliers"). For restaurant firms such as Subway, key

suppliers include such firms as Sysco that bring various foods to their doors, restaurant supply stores

that sell kitchen equipment, and employees that provide labor.

The relative bargaining power between an industry’s competitors and its suppliers helps shape the

profit potential of the industry. If suppliers have greater leverage over the competitors than the

competitors have over the suppliers, then suppliers can increase their prices over time. This cuts into

competitors’ profit margins and makes them less likely to be prosperous. On the other hand, if

suppliers have less leverage over the competitors than the competitors have over the suppliers, then

suppliers may be forced to lower their prices over time. This strengthens competitors’ profit margins

and makes them more likely to be prosperous. Thus when analyzing the profit potential of their

industry, executives must carefully consider whether suppliers have the ability to demand higher prices.

Every industry is unique to some degree, but some general characteristics help to predict the likelihood

that suppliers will be powerful relative to the firms to which they sell their goods and services. Suppliers

tend to be powerful, for example, to the extent that the suppliers’ industry is dominated by a few

companies, if it is more concentrated than the industry that it supplies and/or if there is no effective

substitute for what the supplier group provides. These circumstances restrict industry competitors’

ability to shop around for better prices and put suppliers in a position of strength.

Supplier power is also stronger to the extent that industry members rely heavily on suppliers to be

profitable, industry members face high costs when changing suppliers, and suppliers’ products are

differentiated. Finally, suppliers possess power to the extent that they have the ability to become a new

entrant to the industry if they wish. This is a strategy called forward vertical integration. Ford, for

example, used a forward vertical integration strategy when it purchased rental car company (and Ford

customer) Hertz. A difficult financial situation forced Ford to sell Hertz for $5.6 billion in 2005. But

before rental car companies such as Avis and Thrifty drive too hard of a bargain when buying cars from

an automaker, their executives should remember that automakers are much bigger firms than are

rental car companies. The executives running the automaker might simply decide that they want to

enjoy the rental car company’s profits themselves and acquire the firm.

Strategy at the Movies

Flash of Genius

When dealing with a large company, a small supplier can get squashed like a bug on a windshield.

That is what college professor and inventor Dr. Robert Kearns found out when he invented

intermittent windshield wipers in the 1960s and attempted to supply them to Ford Motor

Company. As depicted in the 2008 movie Flash of Genius, Kearns dreamed of manufacturing the

wipers and selling them to Detroit automakers. Rather than buy the wipers from Kearns, Ford

replicated the design. An angry Kearns then spent many years trying to hold the firm accountable

for infringing on his patent. Kearns eventually won in court, but he paid a terrible personal price

along the way, including a nervous breakdown and estrangement from his family. Kearns’s lengthy

battle with Ford illustrates the concept of bargaining power that is central to Porter’s five forces

model. Even though Kearns created an exceptional new product, he had little leverage when

dealing with a massive, well-financed automobile manufacturer.

The Power of an Industry’s Buyers

Buyers purchase the goods and services that the firms in an industry produce (Figure 3.14 "Buyers").

For Subway and other restaurants, buyers are individual people. In contrast, the buyers for some firms

are other firms rather than end users. For Procter & Gamble, for example, buyers are retailers such as

Walmart and Target who stock Procter & Gamble’s pharmaceuticals, hair care products, pet supplies,

cleaning products, and other household goods on their shelves.

The relative bargaining power between an industry’s competitors and its buyers helps shape the profit

potential of the industry. If buyers have greater leverage over the competitors than the competitors

have over the buyers, then the competitors may be forced to lower their prices over time. This weakens

competitors’ profit margins and makes them less likely to be prosperous. Walmart furnishes a good

example. The mammoth retailer is notorious among manufacturers of goods for demanding lower and

lower prices over time.Bianco, B., & Zellner, W. 2003, October 6. Is Wal-Mart too powerful? Bloomberg

Businessweek. Retrieved from

http://www.businessweek.com/magazine/content/03_40/b3852001_mz001.htm In 2008, for

example, the firm threatened to stop selling compact discs if record companies did not lower their

prices. Walmart has the power to insist on price concessions because its sales volume is huge. Compact

discs make up a small portion of Walmart’s overall sales, so exiting the market would not hurt Walmart.

From the perspective of record companies, however, Walmart is their biggest buyer. If the record

companies were to refuse to do business with Walmart, they would miss out on access to a large portion

of consumers.

On the other hand, if buyers have less leverage over the competitors than the competitors have over the

buyers, then competitors can raise their prices and enjoy greater profits. This description fits the

textbook industry quite well. College students are often dismayed to learn that an assigned textbook

costs $150 or more. Historically, textbook publishers have been able to charge high prices because

buyers had no leverage. A student enrolled in a class must purchase the specific book that the professor

has selected. Used copies are sometimes a lower-cost option, but textbook publishers have cleverly

worked to undermine the used textbook market by releasing new editions after very short periods of

time.

Of course, the presence of a very high profit industry is attractive to potential new entrants. Firms such

as Unnamed Publisher, the publisher of this book, have entered the textbook market with lower-priced

offerings. Time will tell whether such offerings bring down textbook prices. Like any new entrant,

upstarts in the textbook business must prove that they can execute their strategies before they can gain

widespread acceptance. Overall, when analyzing the profit potential of their industry, executives must

carefully consider whether buyers have the ability to demand lower prices. In the textbook market,

buyers do not.

Every industry is unique to some degree, but some general characteristics help to predict the likelihood

that buyers will be powerful relative to the firms from which they purchases goods and services. Buyers

tend to be powerful, for example, to the extent that there are relatively few buyers compared with the

number of firms that supply the industry, the industry’s goods or services are standardized or

undifferentiated, buyers face little or no switching costs in changing vendors, the good or service

purchased by the buyers represents a high percentage of the buyer’s costs, and the good or service is of

limited importance to the quality or price of the buyer’s offerings.

Finally, buyers possess power to the extent that they have the ability to become a new entrant to the

industry if they wish. This strategy is called backward vertical integration. DIRECTV used to be an

important customer of TiVo, the pioneer of digital video recorders. This situation changed, however,

when executives at DIRECTV grew weary of their relationship with TiVo. DIRECTV then used a

backward vertical integration strategy and started offering DIRECTV-branded digital video recorders.

Profits that used to be enjoyed by TiVo were transferred at that point to DIRECTV.

The Limitations of Five Forces Analysis

Five forces analysis is useful, but it has some limitations too. The description of five forces analysis

provided by its creator, Michael Porter, seems to assume that competition is a zero-sum game, meaning

that the amount of profit potential in an industry is fixed. One implication is that, if a firm is to make

more profit, it must take that profit from a rival, a supplier, or a buyer. In some settings, however,

collaboration can create a larger pool of profit that benefits everyone involved in the collaboration. In

general, collaboration is a possibility that five forces analysis tends to downplay. The relationships

among the rivals in an industry, for example, are depicted as adversarial. In reality, these relationships

are sometimes adversarial and sometimes collaborative. General Motors and Toyota compete fiercely

all around the world, for example, but they also have worked together in joint ventures. Similarly, five

forces analysis tends to portray a firm’s relationships with its suppliers and buyers as adversarial, but

many firms find ways to collaborate with these parties for mutual benefit. Indeed, concepts such as

just-in-time inventory systems depend heavily on a firm working as a partner with its suppliers and

buyers.

K E Y TA K E AWAY

“How much profit potential exists in our industry?” is a key question for executives. Five

forces analysis provides an answer to this question. It does this by considering the

interactions among the competitors in an industry, potential new entrants to the industry,

substitutes for the industry’s offerings, suppliers to the industry, and the industry’s buyers.

E X E R C I S E S

1. What are the five forces?

2. Is there an aspect of industry activity that the five forces seems to leave out?

3. Imagine you are the president of your college or university. Which of the five forces would

be most important to you? Why?