Porter’s five forces is a widely used framework for analyzing industries. It refers to the competitive influences shaping the corporate strategies that are likely to be successful. The framework has held up well over time and continues to be a staple of the coursework for business classes. There are, however, some blind spots that you should be aware of.
Overview of Porter’s 5 Forces
Michael Porter first outlined the five forces in a 1979 Harvard Business Review article, and later in his book “Competitive Strategy: Techniques for Analyzing Industries and Competitors” (1980). They are:
- The threat of new entrants to the market. Companies in markets with high barriers to entry – whether through regulation, high fixed and/or start-up costs, protected intellectual property, etc. – face less competition than companies in markets with lower barriers. Oil and gas exploration is an example of a tough market to enter because it requires a lot of capital to be able to spread the risks of an unprofitable drill across multiple leases.
- The power of the suppliers. If the number of suppliers for a sector are limited, then those suppliers have a lot of pricing power over their client companies. This can lead to the suppliers doing better than the buyers. Microsoft in the 1990s is nearly a textbook example of this dynamic. Microsoft’s operating system drove huge profits for the company while the margins for the personal computers being sold to the public with Windows grew ever thinner, and PC manufacturers saw their profits erode.
- The power of the buyers. If an industry moves product through retailers or distributors, then the buyers can exert the same type of pricing power to eat up the profit margin. When an industry has to deal with the Wal-Marts of the world, they sometimes have to give up more than a simple volume discount to get their goods listed. And if they try to push back, there will be another supplier willing to bend over backward to work with that buyer.
- Availability of substitutes. Substitutes are the products or services a customer can use to fill the same need. For example, if a cup of coffee costs too much to buy, a customer can switch to tea or simply start brewing their own at home.
- Competitive rivalry. This last force is used to sum up the level of competition within an industry. If there are a multitude of players all trying to undercut each other, then profit margins will reflect that. The airline industry is a great example of this: Carriers are always attacking each other with competing routes and trying to steal customers away. A lot of money has been lost in airlines.
Porter's Five Forces
The Blind Spots
Porter’s five forces have two main weaknesses. The first is in its composition. As a static model, it provides a snapshot of the wider industry at some point in the past. This can be useful for informing short-term strategy, but the window of applicability for the information coming out of Porter’s five forces has also been narrowed by rapidly evolving external factors. These are trends like globalization and rapid technological advances that weren’t as prominent when Porter devised his framework.
For many industries, the immediate domestic competition – sharing the same challenges of labor, shifting regulatory environments and so on – are less worrisome now than global competitors who can provide goods and services all over the world, thanks to advances in technology and logistics. Expanding the intake for the model to consider all the different competitive environments around the world makes the analysis more cumbersome for the return (a snapshot for short-term strategy).
The other weakness is that a lot of people use Porter’s five forces in ways it was never intended. Trying to apply Porter’s five forces to a specific company rather than an industry as a whole is the most common mistake. Porter’s five forces can provide information to enlighten strategic discussions, but it isn’t an individual-company analysis tool. Business owners are better off using a SWOT analysis for their specific business and Porter’s five forces as data input, if at all. Investors can use Porter’s five forces to look at the attractiveness of taking a position in an industry, but they’ll still need to dive into company-specific financials, unless they use a vehicle like an industry-specific ETF.
Another challenge in applying Porter’s five forces is defining the industry clearly. Companies can straddle multiple industries, depending on their business lines. They can’t group companies with similar business lines and call it an industry. Instead, the Porter’s five forces would be done for each business line and then amalgamated. This is one reason investors tend to frown upon a company that spreads itself too widely, because it is challenging for companies to succeed in so many different sectors. That said, the straddle strategy does seem to work well in emerging economies, before complexity in the form of regulations and access to capital for competitors push companies to focus on industries where they have the biggest edge. Which, of course, goes back to the challenges of applying Porter’s five forces in an unevenly globalized market.
In the hands of the business, the value of the information coming out of a Porter’s five forces can be further compromised by honest mistakes, like not considering all the alternatives, including those that fill one or two of the functions you provide instead of the whole package. For example, Nikon and Apple are competitors when it comes to cameras, but you could put companies like Apple and Google in a Porter’s five forces for a multitude of industries because their tech reaches into almost every industry in some sense.
Last of all, the biggest mistake is paying equal attention to all five forces. For most industries, there will be one or two forces that outweigh all the others. Looking back at some of the industries that have seen their Porter’s five forces analysis shift drastically, it is things like deregulation or dropping of trade barriers that suddenly made the threat of new entrants spike. These external factors are not as explicit as they should be in Porter’s five forces analysis.
The Bottom Line
The boundaries between industries are becoming blurred, and the uneven pace of globalization across industries makes the picture even muddier. In this environment, the shortcomings of Porter’s five forces become apparent.
The most useful thing about Porter’s five forces – and the reason it became so widely adopted in the first place – is that it encourages companies to look beyond their immediate business ventures to their industry as a whole when making long-term plans. Porter's still plays a vital role in that, but it can’t be the sole tool in the toolbox when it comes to building a business strategy.