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The Five Forces Competing for Profits

Understanding Michael Porter’s Best-Known Framework

E x c e r p t e d f r o m

Understanding Michael Porter:

The Essential Guide to Competition and Strategy

B y

Joan Magretta

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CHAPTER 2

The Five Forces: Competing for Profits

IN THE LAST CHAPTER we covered one of the mostwidespread misconceptions about competition: the idea that success comes from “being the best.” Here we’ll tackle

another big misconception. Most people think of competition as a

direct contest between rivals. That’s the standard definition you’ll

find if you look it up. Apple wants to sell you an iPhone. Research In

Motion promotes its device, the BlackBerry. These two rivals engage

in a contest to win your smartphone business. Similarly, Yamaha com-

petes with Steinway to sell you a piano. BMW and Audi compete to

sell you a car, and Hyatt and Westin to rent you a hotel room.

But this way of thinking about competition is too narrow. The real

point of competition is not to beat your rivals. It’s not about winning a

sale. The point is to earn profits. Competing for profits is more com-

plex. It’s a struggle involving multiple players, not just rivals, over who

will capture the value an industry creates. It’s true, of course, that

companies compete for profits with their rivals. But they are also

engaged in a struggle for profits with their customers, who would

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always be happier to pay less and get more. They compete with their

suppliers, who would always be happier to be paid more and deliver

less. They compete with producers who make products that could, in

a pinch, be substituted for their own. And they compete with poten-

tial rivals as well as existing ones, because even the threat of new

entrants places limits on how much they can charge their customers.

The real point of competition is not to beat

your rivals. It’s to earn profits.

These five forces—the intensity of rivalry among existing competi-

tors, the bargaining power of buyers (the industry’s customers), the

bargaining power of suppliers, the threat of substitutes, and the

threat of new entrants—determine the industry’s structure, an impor-

tant concept that may sound academic but is not (figure 2-1). If you

look at a building, any building—a house, a church, a warehouse—its

structure immediately gives you important information about its use,

about how the building “works,” how it creates shelter by enclosing

space. The structure is determined by elements common to all build-

ings: the foundation, the walls, the roof. Similarly, you get important

information about an industry by looking at its structure. The particu-

lar configuration of Porter’s five forces tells you immediately how the

industry “works,” how it creates and shares value. It explains the

industry’s profitability.

Porter’s research findings on the links between industry structure

and profitability challenge several popular misconceptions. Porter

has, in fact, found:

• First, as different from one another as industries might appear

on the surface, the same forces are at work under the skin.

UNDERSTANDING MICHAEL PORTER2

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From advertising to zipper manufacturing (and every industry

in between), the same five forces apply, although their relative

strength and importance may differ.

• Second, industry structure determines profitability—not, as

many people think, whether the industry is high growth or low,

high tech or low, regulated or not, manufacturing or service.

Structure trumps these other, more intuitive, categories.

Bargaining power of buyers

Rivalry among existing

competitors

Threat of new

entrants

Threat of substitute

products or services

Bargaining power of suppliers

F I G U R E 2 - 1

Industry structure: The five forces

3The Five Forces

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• Third, industry structure is surprisingly sticky. Despite the pre-

vailing sense that business changes with incredible rapidity,

Porter discovered that industry structure—once an industry

passes beyond its emerging, prestructure phase—tends to be

quite stable over time. New products come and go. New

technologies come and go. Things change all the time. But

structural change—and therefore change in the average prof-

itability of an industry—usually takes a long time.

Industry Structure: A More Powerful Tool

For any organization trying to assess or formulate strategy, the five

forces framework is the place to start. Remember that strategy explains

how an organization, faced with competition, will achieve superior per-

formance. The five forces framework zeroes in on the competition you

face and gives you the baseline for measuring superior performance. It

explains the industry’s average prices and costs, and therefore the aver-

age industry profitability you are trying to beat. Before you can make

sense of your own performance (current and potential), you need

insight into the industry’s fundamental economics.

The five forces framework explains the

industry’s average prices and costs, and

therefore the average industry profitability

you are trying to beat.

Five forces analysis answers the key question, What’s going on out

there in your industry? Of the many things that are happening, which

ones matter for competition? What deserves your attention? Before

UNDERSTANDING MICHAEL PORTER4

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Porter, the prevailing framework for sizing up the environment was

called SWOT, short for strengths, weaknesses, opportunities, and

threats. Its intent was correct—to relate the company to its environ-

ment—but the tool was weak. If you’ve sat through a SWOT exercise,

you know what I mean. Because there are no coherent economic

principles underlying SWOT, you end up with random lists of items

under each of the four headings, depending on who is in the room

and what issues are top of mind that morning.

Although SWOT is still used in some quarters, it is biased (in my

experience, heavily so) toward confirming managers’ long-standing

beliefs, whether those are based on sound economics or on an execu-

tive’s personal agenda. (Consider the big acquisition that’s put on the

“opportunity” list because that executive once worked at the target

company and now it’s payback time, or maybe the deal will earn the

executive a big bonus at year-end. Biases of these sorts are all too

common in practice.)

Industry structure is an exponentially more powerful and objec-

tive tool for understanding the dynamics of competition. It is sys-

tematic, reducing the odds that you will miss something important.

It is (or should be) built on facts and analysis, not just a listing of

bullet points. Therefore it is less likely to result in a rehash of old

agendas and more likely to teach you something new. It tackles the

economic fundamentals of competition in a way that highlights how

external forces constrain or create strategic opportunities for your

company.

Assessing the Five Forces

Each of the five forces has a clear, direct, and predictable relationship to

industry profitability. Here’s the general rule: the more powerful the

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The Fundamental Equation: Profit = Price – Cost

At its heart, business competition is about the struggle for profits, the

tug-of-war over who gets to capture the value an industry creates. As

complex and multidimensional as competition typically is, the math

of profitability is simple. Porter reminds us to stay focused on the

ultimate goal—profit—and on its two components, price and cost:

Unit Profit Margin = Price – Cost

Costs include all of the resources used in competing, including

the cost of capital. These are the resources that the industry trans-

forms to create value. Prices reflect how customers value the indus-

try’s offerings, what they are willing to pay as they weigh their

alternatives.

Note that if an industry doesn’t create much value for its cus-

tomers, prices will barely cover costs. If the industry creates a lot of

value, then structure becomes critical in understanding who gets to

capture it. Industries can, and often do, create a lot of value for

force, the more pressure it will put on prices or costs or both, and

therefore the less attractive the industry will be to its incumbents.

(A reminder: Industry structure is always analyzed from the perspective

of companies already in the industry. Because potential entrants must

overcome entry barriers, this explains why an industry can be “attractive”

to incumbents while at the same time not attracting new competitors.)

After describing each force, I’ll indicate how you can assess its

strength. The many examples I cite serve a dual purpose—they both

illustrate the force and, at the same time, give you a sense of how

specific companies have responded to the most relevant forces in

their industry. People ask all the time, “How do companies use this

UNDERSTANDING MICHAEL PORTER6

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their customers or suppliers while the companies themselves

earn very little for their efforts.

Within a given industry, the relative strength of the five forces

and their specific configuration determine the industry’s profit

potential because they directly impact the industry’s prices and

its costs. Here’s how each force works.

framework?” By definition, any successful company has positioned

itself favorably in relation to the forces that matter most in its indus-

try. But let me stress that one of the great clarifying disciplines of

Porter’s approach is to force you to think clearly about your industry’s

structure. Start there. Then you can focus on your own and rivals’ rel-

ative positions within the industry.

Buyers

If you have powerful buyers (that is, customers), they will use their

clout to force prices down. They may also demand that you put more

THE FORCE

IF threat of entry

IF supplier power

IF buyer power

IF substitutes

IF rivalry

IMPACT

because

Profitability

Profitability because

WHY

(Prices Costs )

(Costs )

(Prices Costs )

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value into the product or service. In either case, industry profitability

will be lower because customers will capture more of the value for

themselves.

Powerful buyers will force prices down or

demand more value in the product, thus

capturing more of the value for themselves.

Consider the cement industry. In the United States, big, powerful

construction companies account for a large percentage of the cement

industry’s sales. They use their clout to bargain for low prices, thus

dampening the profit potential for the industry. Now let’s cross the

border to Mexico, where 85 percent of the cement industry’s rev-

enues come from small, individual customers. Thousands of these

“ants,” as they are called, are served by a handful of large producers.

This imbalance in bargaining power between small, fragmented buy-

ers and a few large sellers is a defining element of the structure of the

Mexican cement industry. Market power allows the producers to

charge higher prices and earn higher returns.

It’s no surprise, then, that CEMEX, a leading producer in both

countries, earns higher returns in Mexico, and not because it creates

more value in its home market. In effect, CEMEX is competing in

two distinct industries, each with its own structure. (The box “Typical

Steps in Industry Analysis” later in this chapter highlights the strate-

gic importance of defining the boundaries of a business.)

When you assess buyer power, the channels through which prod-

ucts are delivered can be as important as the end users. This is espe-

cially true when the channel influences the purchase decisions of

the end-user customers. Investment advisors, for example, have

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enormous power, and the high margins that accompany that power.

The emergence of powerful retailers like Home Depot and Lowe’s

has put enormous pressure on the makers of home improvement

products.

Within an industry there may be segments of buyers with more or

less negotiating power, and with greater or lesser price sensitivity.

Buyers are more likely to exercise their negotiating leverage if they are

price sensitive. Both industrial customers and consumers tend to be

more price sensitive when what they’re buying is

• Undifferentiated

• Expensive relative to their other costs or income

• Inconsequential to their own performance

A counterexample that includes all three of these conditions is the

price insensitivity of makers of major motion pictures when they buy or

rent production equipment. A movie camera, for example, is a highly

differentiated piece of equipment. Its price is small relative to the other

costs of production, but the performance of the equipment has a big

impact on the success of the movie. Here quality trumps price.

Suppliers

If you have powerful suppliers, they will use their negotiating leverage to

charge higher prices or to insist on more favorable terms. In either case,

industry profitability will be lower because suppliers will capture more

of the value for themselves. Makers of personal computers (PCs) have

long struggled with the market power of both Microsoft and Intel. In

Intel’s case, the Intel Inside campaign effectively branded what might

have otherwise become a commodity component.

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Powerful suppliers will charge higher prices

or insist on more favorable terms, lowering

industry profitability.

When you analyze the power of suppliers, be sure to include all of

the purchased inputs that go into a product or service, including labor

(i.e., your employees). The bargaining power of strong labor unions

has been a perennial drag on the airline industry. Work rules such

as “receipt and dispatch,” for example, allowed only licensed

mechanics to wave planes to or from airport gates, even though

lower-paid baggage handlers or other ground crew were competent to

perform this job. Repairs were done mostly at night, but this rule

meant mechanics had to be scheduled 24/7, and the airlines had to

hire many more of them than were needed for maintenance and

repair. This rule, now gone, was effectively a job creation program for

the high-paid mechanics, and a profit drain for the airline industry.

How do you assess the power of suppliers and buyers? The same

set of questions applies to both, so I’ll give you one list instead of two.

Both suppliers and buyers tend to be powerful if:

• They are large and concentrated relative to a fragmented indus-

try (think Goliath versus many Davids). What percentage of an

industry’s purchases/sales does a supplier/buyer represent?

Look at the data and map out how it is trending. How painful

would it be to lose that supplier or that customer? Industries

with high fixed costs (e.g., telecommunications equipment and

offshore drilling) are especially vulnerable to large buyers.

• The industry needs them more than they need the industry. In

some cases, there may be no alternative suppliers, at least in

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the short term. Doctors and airline pilots, to cite two examples,

have historically exercised tremendous bargaining power

because their skills have been both essential and in short sup-

ply. China produces 95 percent of the world’s supply of

neodymium, a rare earth metal needed by Toyota and other

automakers for electric motors. Neodymium prices quadrupled

in just one year (2010), as the Chinese restricted supply. Toyota

is working hard to develop a new motor that will end its

dependence on rare earth metals.

• Switching costs work in their favor. This occurs for a supplier

when an industry is tied to it, as for example, the PC industry has

been to Microsoft, its dominant supplier of operating systems

and software. Switching costs work in the buyer’s favor when the

buyer can easily drop one vendor for another. The ease with

which customers can switch from one airline to another on pop-

ular routes makes it hard for airlines to raise prices or cut service

levels. Frequent flyer programs were intended to raise switching

costs, but they have not been effective.

• Differentiation works in their favor. When buyers see little dif-

ferentiation in the industry’s products, they have the power to

pit one vendor against another. As the PC itself has become

more of a commodity, buyer power has grown. But the PC

industry’s suppliers (Microsoft and Intel) are highly differenti-

ated. Makers of PCs are squeezed in the middle, caught

between powerful suppliers and powerful buyers.

• They can credibly threaten to vertically integrate into producing

the industry’s product itself. Producers of beer and soft drinks have

used this tactic to keep a lid on the prices of beverage containers.

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Substitutes

Substitutes—products or services that meet the same basic need as

the industry’s product in a different way—put a cap on industry prof-

itability. Tax preparation software, for example, is a substitute for a

professional tax preparer such as H&R Block. Substitutes place a

ceiling on the prices incumbents can sustain without eroding sales.

For decades, OPEC, the Organization of the Petroleum Exporting

Countries, has fended off substitutes by carefully managing the price

of oil to discourage investment in alternative forms of energy. This is

why environmentalists favor higher gas taxes.

Substitutes—products or services that meet

the same basic need as the industry’s

product in a different way—put a cap on

industry profitability.

Precisely because substitutes are not direct rivals, they often come

from unexpected places. This makes substitutes difficult to anticipate

or even to see once they appear. The threat of substitution is especially

tricky when it comes at one remove. Over the next generation, for

example, electric cars may (or may not!) become a significant substi-

tute for those powered by combustion engines. If they do, this will have

a cascading effect, causing substitution in many other parts of the car.

Batteries add weight to a vehicle, for example, so BMW is looking at

carbon fiber as a lighter substitute for the steel used in car bodies.

Companies that make or service transmissions and exhaust systems

could well become the buggy whip makers of the twenty-first century.

How do you assess the threat of a substitute? Look to the econom-

ics, specifically to whether the substitute offers an attractive

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price–performance trade-off relative to the industry’s product. Coin-

star’s Redbox—the kiosk that dispenses movie rentals for just $1—

has become a tangible threat to Hollywood’s ability to sell movie

DVDs at twenty to forty times that price. Redbox is a substitute for

buying videos, and it is a direct rival to local video rental stores that

can’t match the convenience or low cost of Redbox’s locations. (Note:

About a month after I wrote the last sentence, Blockbuster, once the

leading store operator, filed for bankruptcy protection.) While DVD

rentals have long been a substitute for buying them outright, Red-

box’s combination of rock bottom prices and convenience has clearly

hit a customer sweet spot.

The sweet spot isn’t always the lower-priced alternative. The

Madrid–Barcelona high-speed train is a higher-value, higher-price

substitute for flying. Energy drinks are a higher-price substitute for

coffee. Both drinks are caffeine delivery systems, but some con-

sumers will pay more for the substitute’s bigger jolt.

Switching costs play a significant role in substitution. Substitutes

gain ground when buyers face low switching costs, certainly the case

with movie DVDs or, to cite another example, with moving from a

branded drug to a generic one. Given that coffee drinking is such a

deeply ingrained habit, it’s no surprise that energy drinks are more

readily adopted by the young.

New Entrants

Entry barriers protect an industry from newcomers who would add

new capacity and seek to gain market share. The threat of entry damp-

ens profitability in two ways. It caps prices, because higher industry

prices would only make entry more attractive for newcomers. At the

same time, incumbents typically have to spend more to satisfy their

customers. This discourages new entrants by raising the hurdle they

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would have to clear in order to compete. In a business like specialty

coffee retailing, for example, where entry barriers are low, Starbucks

must constantly invest to refresh its stores and its menus. If it slacks

off, it effectively opens the door for a new rival to join the fray.

Entry barriers protect an industry from

newcomers who would add new capacity.

How do you size up the threat of new entry? If you are a current

player, what can you do to raise those barriers? If you are thinking of

entering a new industry, can you overcome the barriers that stand in

your way? There are a number of different kinds of entry barriers. Start

with the following questions to help you identify and assess them.

• Does producing in larger volumes translate into lower unit

costs? If there are economies of scale, at what volumes do they

kick in? The numbers matter. Where do these economies come

from: From spreading fixed costs over a larger volume? From

using more efficient technologies that are scale dependent?

From increased bargaining power over suppliers? It costs about

a billion dollars to develop a new operating system for a PC,

costs that are recovered in a matter of weeks if you have

Microsoft’s scale.

• Will customers incur any switching costs in moving from one

supplier to another? Switching from a Mac to a PC, or vice

versa, will cost you many hours of setup and relearning.

Because Apple has been the small player with low market

share, it has had much more to gain from luring customers

away from Microsoft. Therefore Apple has invested substan-

tially in reducing those switching costs for PC users.

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• Does the value to customers increase as more customers use a

company’s product? (This is called a network effect.) As with

economies of scale on the supply side, try to understand where

the value comes from and what it’s worth. Sometimes the per-

ceived stability or reputation of the company makes it a “safe”

choice; sometimes value may come from the size of the net-

work, as it does with Facebook.

• What is the price of admission for a company to enter the

business? How large are the capital investments, and who

might be willing and able to make them? Drug companies

haven’t worried much about the threat of new entrants, and

have therefore been free to raise prices, because the business

has historically required such massive investment in R&D and

marketing.

• Do incumbents have advantages independent of size that new

entrants can’t access? Examples include proprietary technology,

well-established brands, prime locations, and access to distri-

bution channels. The latter, for example, can be a formidable

entry barrier, especially if distribution channels are limited and

the industry incumbents have them locked up. This can drive

new entrants to create their own channels. For example, the

upstart discount airlines had to sell tickets via the Internet

because travel agents tended to favor the established airlines.

• Does government policy restrict or prevent new entrants? In

my state of Massachusetts, licenses to sell wine are very hard to

come by, severely limiting new entrants. Regulations, policies,

patents, and subsidies can also work indirectly, by raising or

lowering the other entry barriers.

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• What kind of retaliation should a potential entrant expect

should it choose to enter the industry? Is this industry known

for making it tough for newcomers? Does the industry have the

resources to compete aggressively? If industry growth is slow or

if the industry has high fixed costs, incumbents will typically

fight hard to retain their share of the market.

Rivalry

When rivalry among the current competitors is more intense, prof-

itability will be lower. Incumbents will compete away the value they

create by passing it on to buyers in lower prices or dissipating it in

higher costs of competing. Rivalry can take a variety of forms: price

competition, advertising, new product introductions, and increased

customer service. Drug companies, for example, have a history of

intense competition in R&D and in marketing, but they have steered

clear of price competition.

If rivalry is intense, companies compete

away the value they create, passing it on to

buyers in lower prices or dissipating it in

higher costs of competing.

How do you assess the intensity of rivalry? Porter notes that it is

likely to be greatest if

• The industry is composed of many competitors or if competi-

tors are roughly equal in size and power. Often an industry

leader has the ability to enforce practices that help the whole

industry.

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• Slow growth provokes battles over market share.

• High exit barriers prevent companies from leaving the industry.

This happens, for example, if companies have invested in spe-

cialized assets that can’t be sold. Excess capacity typically hurts

an industry’s profitability.

• Rivals are irrationally committed to the business; that is, finan-

cial performance is not the overriding goal. For example, a

state-owned enterprise might be propped up for reasons of

national pride or because it provides jobs. Or, a corporation

may feel its image requires a full product line.

Price competition, Porter warns, is the most damaging form of

rivalry. The more rivalry is based on price, the more you are engaged

in competing to be the best. This is most likely when

• It is hard to tell one rival’s offerings from another (the problem

of competitor convergence we saw in chapter 1) and buyers

have low switching costs. This typically drives rivals to lower

their prices to attract customers, a practice that has dominated

airline competition for many years.

• Rivals have high fixed costs and low marginal costs, creating

the pressure to drop prices because any new customer will

“contribute to covering overhead.” Again, the essence of airline

economics.

• Capacity must be added in large increments, disrupting the

industry’s supply–demand balance and leading to price cutting

to fill capacity.

• The product is perishable, an attribute that applies not only to

fruit and fashion but also to a wide range of products and services

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that quickly become obsolete or lose their value. A hotel room, an

airline seat, or a restaurant table that goes unfilled is “perishable.”

Why Only Five Forces?

The five forces framework applies in all industries for the simple reason

that it encompasses relationships fundamental to all commerce: those

between buyers and sellers, between sellers and suppliers, between

rival sellers, and between supply and demand. Think about it. This cov-

ers all of the bases. The five forces are universal and fundamental.

The five forces framework applies in all

industries for the simple reason that it

encompasses relationships fundamental to

all commerce.

When I lead strategy discussions among managers, I usually ask

them if they know Porter’s five forces framework. Most do. But then

something interesting happens. The conversation quickly degener-

ates into a competition to see who can name all five. Typically, people

are only able to remember three or four. Also typically, they will throw

in a candidate that isn’t one of the five forces, but they’re absolutely

certain it must be for the simple reason that in their industry, this par-

ticular phenomenon is highly relevant to their success.

So let me underline the big idea here. Memorizing the five forces

won’t make you a better business thinker; it will only help you to

sound like one. It matters that you grasp the deeper point: there are a

limited number of structural forces at work in every industry that sys-

tematically impact profitability in a predictable direction.

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Other factors may be important, but they are not structural. Con-

sider four that get the most attention:

• Government regulation will be relevant to competition if it

changes the industry’s structure through its impact on one or

more of the five forces.

• The same goes for technology. If the Internet, for example,

makes it easier for customers in an industry to shop around for

the best price, then industry profitability will drop because, in

this instance, the Internet has changed the industry’s structure

by increasing the power of buyers.

• Managers often mistakenly assume that a high-growth indus-

try will be an attractive one. But growth is no guarantee that

the industry will be profitable. For example, growth might put

Supply and Demand

Everyone has learned at some point in their training about the

importance of supply and demand in determining prices. In perfect

markets, the adjustment is very sensitive: when supply rises, prices

immediately drop to the new equilibrium. In perfect competition

there are no profits because price is always driven down to the mar-

ginal cost of production. But in practice, very few markets are “per-

fect.” Porter’s five forces framework offers a way to think

systematically about imperfect markets. If there are barriers to

entry, for example, new supply can’t simply rush into the market to

meet demand. The power of suppliers and buyers, for example, will

have direct consequences for prices. And so on.

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suppliers in the driver’s seat, or, combined with low entry bar-

riers, growth might attract new rivals. Growth alone says

nothing about the power of customers or the availability of

substitutes. The untested assumption that a fast-growing

industry is a “good” industry, Porter warns, often leads to bad

strategy decisions.

• Finally, complements are sometimes proposed as a “sixth force.”

Complements are products and services used together with an

industry’s products—for example, computer hardware and soft-

ware. Complements can affect the demand for an industry’s

product (would you buy an electric car if you had no place to

plug it in?), but like the other factors under discussion—

growth, government, technology—they affect industry prof-

itability through their impact on the five forces.

Rivalry

Substi- tutes

Threat of entry

Buyer power

Supplier power

Price – Cost = Profit

F I G U R E 2 - 2

How the five forces impact profitability

UNDERSTANDING MICHAEL PORTER20

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Depending on your industry, then, understanding and managing

these factors can be important to your success. But the impact on

industry profitability of “more” of any of these factors, unlike “more

buyer power,” will be neither systematic nor predictable. Some tech-

nologies might raise costs and lower prices, therefore lowering prof-

itability. Others might have the opposite effect. Still others will have

no impact at all. The same goes for growth, for government, and for

complements. If a force is structural, you can always predict that

“more” will affect prices or costs in a known direction. More buyer

power always drives prices down, not up. More supplier power always

pushes costs higher, not lower. Figure 2-2 summarizes the dominant

impact on profitability of each of the five forces.

Implications for Strategy

The collective strength of the five forces matters because it affects

prices, costs, and the investment required to compete. Industry

structure determines how the economic value created by an industry

is divided—how much is captured by companies in the industry

versus customers, suppliers, distributors, substitutes, and potential

new entrants. Industry structure can be linked directly to the income

statements and balance sheets of every company in the industry. The

insights gained from this kind of analysis should lead directly to deci-

sions about where and how to compete.

How can you use industry analysis? Consider two representative

examples. First, does the industry offer the possibility of attractive

returns? In 2005, IBM sold its PC business to Lenovo. A five forces

analysis makes clear immediately why the business had become so

unattractive that even one of its marquee players decided to throw in

the towel. Its two superpower suppliers, Microsoft and Intel, cap-

The Five Forces 21

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Typical Steps in Industry Analysis

1. Define the relevant industry by both its product scope and geo-

graphic scope. What’s in, what’s out? This step is trickier than

most people realize, so give it some real thought. The five forces

help you draw the boundaries, avoiding the common pitfall of

defining the industry too narrowly or too broadly. Are you facing

the same buyers, the same suppliers, the same entry barriers,

and so forth? Porter offers this rule of thumb: where there are

differences in more than one force, or where differences in any

one force are large, you are likely dealing with distinct indus-

tries. Each will need its own strategy. Consider these examples:

• Product scope. Is motor oil used in cars part of the same

industry as motor oil used in trucks and stationary engines?

The oil itself is similar. But automotive oil is marketed

through consumer advertising, sold to fragmented cus-

tomers through powerful channels, and produced locally to

offset the high logistics costs of small packaging. Truck

and power generation lubricants face a different industry

structure—different customers and selling channels, dif-

ferent supply chains, and so on. From a strategy perspec-

tive, these are distinct industries.

• Geographic scope. Is the cement business global or

national? Recall the CEMEX example discussed earlier.

tured almost all of the value the industry created. And as the industry

matured, the PC itself had become a commodity, giving customers

more power. Since one beige box was as good as another, customers

could easily switch brands in order to get a good price. Rivalry among

UNDERSTANDING MICHAEL PORTER22

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Although some elements are the same, buyers are radically

different in the United States and Mexico. The geographic

scope is national, not global, and CEMEX will need a sepa-

rate strategy for each market.

2. Identify the players constituting each of the five forces and, where

appropriate, segment them into groups. On what basis do these

segments emerge?

3. Assess the underlying drivers of each force. Which are strong?

Which are weak? Why? The more rigorous your analysis, the

more valuable your results.

4. Step back and assess the overall industry structure. Which forces

control profitability? Not all are equally important. Dig deeper

into the most important forces in your industry. Are your results

consistent with the industry’s level of profitability today and

over the long term? Are the more profitable companies better

positioned in relation to the five forces?

5. Analyze recent and likely future changes for each force. How are

they trending? Looking ahead, how might competitors or new

entrants influence industry structure?

6. How can you position yourself in relation to the five forces? Can

you find a position where the forces are weakest? Can

you exploit industry change? Can you reshape structure in

your favor?

PC makers was intensifying, with more price pressure coming from

emerging Asian producers. To top it off, a new generation of potential

substitutes was taking off—a range of mobile devices that had some

of the same functionality as PCs.

The Five Forces 23

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Five forces analysis is used most often to determine the “attractive-

ness” of an industry, and this is certainly indispensible for companies

and investors deciding whether to exit, enter, or invest in an industry.

But using five forces analysis simply to declare that an industry is

attractive or unattractive misses its full power. This use stops short of

vital insights into the following questions:

• Why is current industry profitability what it is? What’s propping

it up?

• What’s changing? How is profitability likely to shift?

• What limiting factors must be overcome to capture more of the

value you create?

In other words, a good five forces analysis allows you to see

through the complexity of competition, and it opens the way to a host

of possible actions you can take to improve performance. As unattrac-

tive as the PC business is for most of its players, Apple appears to

have found a way to make money. By designing its own operating sys-

tem, Apple has never been subject to Microsoft’s supplier power. By

creating distinctive products, it has limited buyer power. Apple loyal-

ists would rather pay more than switch.

A second representative question is, Can you position your com-

pany where the forces are weakest? Consider the strategy developed

by heavy-truck maker Paccar. This is another industry with an

uninviting structure:

• There are many big, powerful buyers who operate large fleets of

trucks; they are price sensitive because trucks represent a large

piece of their costs.

• Rivalry is based on price because (a) the industry is capital

intensive, with cyclical downturns, and (b) most trucks are

built to regulated standards and therefore look the same.

UNDERSTANDING MICHAEL PORTER24

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• On the supplier side, unions exercise considerable power, as do

the large independent suppliers of engines and drive train com-

ponents.

• Truck buyers face substitutes for their services (rail, for exam-

ple), which puts an overall cap on truck prices.

Between 1993 and 2007, the industry average return on invested

capital (ROIC) was 10.5 percent. Yet over the same period Paccar, a

company with about 20 percent of the North American heavy-truck

market, earned 31.6 percent. Paccar has developed a positioning

within this difficult industry where the forces are the weakest. Its tar-

get customer is the individual owner-operator, the guy whose truck is

his home away from home. This customer will pay more for the status

conferred by Paccar’s Kenworth and Peterbilt brands and for the abil-

ity to add a slew of custom features such as a luxurious sleeper cabin

or plush leather seats. Paccar’s made-to-order products come with a

number of accompanying services geared to make the owner-operator

more successful. For example, Paccar’s roadside assistance program

limits downtime, a key to the owner’s economics. In an industry

marked by price competition, Paccar is able to charge a 10 percent

price premium.

Paccar doesn’t try to compete by being the “best” truck maker in

the industry. If it did, it would go after the same customers with the

same products. It would get caught up in the industry’s price compe-

tition, intensifying rivalry, which, in turn, would cause further deteri-

oration in industry structure. The lesson here is relevant to many

companies in many industries: by your own choices in how you com-

pete, you can easily make a bad situation worse.

Competing to be unique, meeting different needs or serving differ-

ent customers, lets Paccar run a different race. The forces affecting

its prices and costs are more benign. “Strategy,” Porter writes, “can be

viewed as building defenses against the competitive forces or finding

The Five Forces 25

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a position in the industry where the forces are weakest.” As Paccar

illustrates, good strategies are like shelters in a storm. Five forces

analysis will give you a weather forecast.

Structure Is Dynamic

As some or all of the forces shift over time, industry profitability will

follow. Industry structure is dynamic, not static, a point that Porter

has to repeat often because there has been a remarkably persistent

misconception that industry structure and positioning are static, and

therefore irrelevant in a fast-changing world. Since, as I said in my

introduction, many people get their Porter second hand, this is a

point worth highlighting. To repeat, then, industry structure is

dynamic, not static. When you do industry analysis, you are taking a

snapshot of the industry at a point in time, but you are also assessing

trends in the five forces.

Over time, buyers or suppliers can become more or less powerful.

Technological or managerial innovations can make new entry or sub-

stitution more or less likely. Choices managers make or changes in

regulation can change the intensity of rivalry. In 1970, for example,

Walmart was barely a blip on anyone’s radar. Today, as the world’s

most powerful buyer, it is the dominant force in industry after indus-

try. In what must be one of the most honest job titles I’ve ever seen,

the company’s chief buyer is called “vice president for international

purchase leverage.” For anyone tracking the five forces, this was not a

sudden disruption that happened overnight. It was—for many indus-

tries that supply Walmart—a train wreck seen in painfully slow

motion. There was plenty of time to prepare, to choose, to act.

In any industry, there is always change. The better your grasp of

industry structure, the more likely it is you will spot and exploit new

strategic opportunities or moves that could reshape industry struc-

UNDERSTANDING MICHAEL PORTER26

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ture in your favor. The challenge is to discern the changes that mat-

ter. Change that is truly strategic affects the five forces.

Why are some companies more profitable than others? We’ve just

finished part one of the answer: industry structure explains some of

the difference. Now we can move on to part two. A company’s relative

position within its industry—the subject of the next chapter—can

account for even more of the difference.

The Five Forces: Competing for Profits

• The real point of competition is earning profits, not taking busi-

ness away from your rivals. Business competition is about the

struggle for profits, the tug-of-war over who gets to capture the

value an industry creates.

• Companies compete for profits with their direct rivals, but also

with their customers, their suppliers, potential new entrants, and

substitutes.

• The collective strength of the five forces determines the average

profitability of the industry through their impact on prices, costs,

and the investment required to compete. A good strategy pro-

duces a P&L better than this industry average baseline.

• Using five forces analysis simply to declare that an industry is

attractive or unattractive misses its full power as a tool. Because

industry structure can “explain” the income statements and bal-

ance sheets of every company in the industry, insights gained

from it should lead directly to decisions about where and how to

compete.

• Industry structure is dynamic, not static. Five forces analysis can

help anticipate and exploit structural change.

The Five Forces 27

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Chapter Notes and Sources

Chapter 2. The Five Forces: Competing for Profits

This chapter draws from and quotes Michael E. Porter’s “The Five Competi- tive Forces That Shape Strategy,” reprinted in On Competition, Updated and Expanded Edition (Boston: Harvard Business School Publishing, 2008).

The story of market power in the cement industry comes from Peter Fritsch, “Hard Profits: A Cement Titan in Mexico Thrives by Selling to Poor,” Wall Street Journal, April 22, 2002. See also Pankaj Ghemawat, “The Globalization of CEMEX,” Case 9-701-017 (Boston: Harvard Business School, 2004).

The “receipt and dispatch” work rule is described by Micheline Maynard, “More Than Money Is at Stake in Votes by Airline Unions,” New York Times, April 29, 2003.

For the exclusive use of Q. GAO, 2018.

For an example of an extremely thorough and rigorous five forces analysis, see the posting on the ISC Web that covers the airline industry, at http:// www.isc.hbs.edu/pdf/IATA_Vision_2050_Chapter_1.pdf. For help with doing your own industry analysis, see Jan Rivkin and Ann Cullen, “Finding Information for Industry Analysis,” Note 9-708-481 (Boston: Harvard Business School, 2010).

29Chapter Notes and Sources

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