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Poter'S Five Forces

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Autor:  anton  09 July 2011
Tags:  Poters,  Forces
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Porter

“Strive for competitive advantage and the forces that affect it.”

Strategic Management

Dr. Cassell

By: Ashleigh Bender

Table of Contents:

I .) Executive Summary pg.

II.) Porters Five Forces Defined pg.

• Supplier Power pg.

• Buyer Power pg.

• Threats of New Entrants pg.

• Substitutes Products pg.

• Degree of Rivalry pg.

III.) Advantage and Disadvantage of Porter’s Five Forces Model pg.

IV.) Application of Porter’s Five Forces pg.

V .) Porter’s Generic Strategies pg.

• Cost Leadership pg.

• Differentiation pg.

• Focus Strategy pg.

VI .) Advantage and Disadvantage of Porter’s Generic Strategies pg.

VII .) Application of Porter’s Five Forces pg.

VIII.) Bibliography pg.

Executive Summary:

Michael Porter created two concepts used by industries to either achieve greater competitive advantage or can be used as an over all strategy in the market. Both of these concepts work in conjunction with each other to work towards the ultimate goal of generating revenue and stockholders wealth. In this paper these concepts will be discussed in-depth to explain what they are, how they are an advantage and disadvantage and how to apply them.

Introduction:

When a company is formulating a strategy, the framework for such an analysis is the environment. In order to fully assess what the company is capable of a manger needs to look at both external and internal forces that affect the company in order to effectively develop a strategy. A company can formulate a strategy based on the forces that affect the industry as a whole.

The structure of the industry has a large influence on a company and their ability to compete and the strategies that are available to them. Forces that are outside of the industry affect all firms in the industry and the key to effectively compete is the differing abilities of firms to deal with these forces.

Competition in an industry is inevitable and is created through the underlying economic structure that goes beyond the behavior of the competitors. The state of competition in an industry is based on five competitive forces. These forces combined determine the profit potential in the industry.

On a broader sense of things, a company can choose to pick one of three generic strategies. These strategies require a commitment to one strategy. Also, these are designed to outperform competitors in the industry to earn higher revenues. When combined, a company can choose what to do within the five forces to create an ultimate strategy within the given environment.

Porters Five Forces:

The Five forces is a model created by Michael E. Porter of Harvard Business in 1979. The five forces is a framework for an industry analysis and the business strategy development. This framework uses concepts developed within the industrial organization economics. The forces determine the competitive intensity and attractiveness of a market.

These forces affect the company and their ability to serve its customers and produce a profit. This means that a change in such forces will require the company to reassess their efforts to shift with the market. These forces also help a company in making a qualitative evaluation of the firm’s strategic position. A strategic manager may use this model to better understand the industry in which the firm operates, in order to create a greater competitive advantage.

In an industry with two or more competitors, competitive intensity increases. As this increases the average industry return falls. When the bargaining power of buyers and suppliers is high, the threat from new entrants and substitute products is high thus creating an intense rivalry among firms. Within this the five forces are created, as illustrated in Figure 1.

In each of these forces there are circumstances that increase the power of each of the forces. These can be used as tools by a strategist to create an “edge” over competition and can be used to boost a company’s profitability and take away from other competitors in the industry. These circumstances will be further discussed further in the paper and can be seen in figure 2.

Supplier Power:

Supplies in an industry are raw materials, labor, machinery, services and capital. These are all necessary inputs to the firm’s production process. These materials are all supplied by different interest groups within the industry.

The strength of suppliers affects the industry’s profit potential. Suppliers have the power over companies in an industry by threatening to raise prices or reduce the quality of purchases goods and services. They can also exert an influence on the producing industry, such as selling raw materials at a high price to capture some of the industries profits (Porter, 27-28). Figure 3 and 4 show when a supplier is powerful and weak as well as example of when and how they apply (Quick MBA).

Suppliers are not just other firms but also labor. There is evidence that when highly skilled employees or tightly unionized labor is scarce, labor can take away a fraction of the potential profits in an industry. Determining supplier’s power is often of the firm’s control and subject to change. Although a firm can improve their situation through effective strategy; it can enhance its threat of backward integration, eliminate switching costs and the like (Porter 28).

Figure 4

Suppliers are Weak if: Example

Many competitive suppliers- product is standardized Tire industry relationship to automobile manufactures

Purchase commodity products Grocery store brand label products

Credible backward integration threat by purchasers Timber producers relationship to major department stores

Customers Weak Travel agent’ relationship to airlines

Figure 3

Suppliers are Powerful if: Example

Credible forward integration threat by suppliers Baxter International, manufacture of hospital supplies, acquired American Hospital Supply, a Distributor

Suppliers concentrated Drug industry’s relationship to hospitals

Significant cost to Switch suppliers Microsoft’s relationship with PC manufactures

Customers Powerful Boycott of grocery stores selling non-union picked grapes

It is dominated by a few companies and is more concentrated than the industry it sells to. Suppliers selling to more fragmented buyers will usually be able to exert considerable influences in prices, quality and terms

It is not obliged to contend with other substitute products for sale to the industry The power of large, powerful suppliers can be checked if they compete with substitutes. For example, suppliers producing alternative sweetners compete sharply for many applications even through individual firms are large relative to individual buyers.

The industry is not an important customer of the supplier group When suppliers sell to a number of industries and a particular industry does not represent a significant fraction of sales, suppliers are much more prone to exert power.

The supplier group poses a creditable threat of forward integrations, This provides a check against the industries ability to improve the terms on which it purchases.

The suppliers’ product is an important input to the buyer’s business Such an input is important to the success of the buyer’s manufacturing process or product quality. This rises to supplier power. This is partially true where the input is not storable, thus enabling the buyer to build up stocks of inventory.

The supplier group’s products are differentiated or it has built up switching costs. Differentiation or switching costs facing buyers cut off their options to play one supplier against another. If suppliers face switching costs the effect is the reverse.

Buyer Power:

Buyers are the people and organizations who create demand in an industry. Buyer power is the ability of customers to put the firm under pressure which also has an effect on the customer’s sensitivity to price changes. Buyers in an industry can exert their power and affect a number of things. Such things are price sensitivity, barging leverage, buyer volume, switching costs and so on.

Powerful customers can exert a competitive influence over suppliers and can bargain away any potential profits from the firms in the industry. Buyers in an industry compete by forcing down prices, bargaining for high quality and services as well as play competitors against each other. Table 4 shows some of the factors that determine buyer power (QuickMBA.com).

When a buyer power is strong, the relationships to the producing industry are near to what an economist terms a monopolistic. Monopolistic is a marker in which there are many suppliers and on buyer. Under such market conditions, the buyer sets the prices. In reality, few monopolies exist.

If the number of buyers for the outputs of an industry is small, they can affect the profits in the industry. They can cause firms to undercut each other in order to get the business and use their power to extract other benefits from other competing firms.

Buyers are Weak if: Example

Producers threaten forward integration- producers can take over own distribution/retailing. Movie-producing companies have integrated forward to acquire theaters.

Significant buyer switching costs-producing not standardized and buyer cannot easily switch to another product. IBM’s 360 system strategy in the 1960’s.

Buyers are fragmented (many, different) - no buyer has any particular influence on product or price. Most consumer products.

Producers supply critical portions of buyers’ input- distribution of purchases. Intel’s relationship with PC manufactures.

Buyers are Powerful if: Example

Buyers are concentrated- there are a few buyers with significant market share DOD purchases from defense contractors

Buyers purchase a significant proportion of output-distribution of purchases or it the product is standardized Circuit City and Sears’ large retail market provides power over appliance manufactures

Buyer possess a creditable backward integration threat- can threaten to buy producing firm or rival Large auto manufactures’ purchases of tires

It Earns High Profits

It faces few switching costs

The industry’s product is unimportant to the quality of the buyer’s products or services

The products it purchases from the industry represent a significant fraction of the buyer’s costs or purchase

The products it purchases from the industry are standard or undifferentiated

Buyer has full information

Threats of New Entrants:

New Entrants to a market create new production capacity, desire to gain market share and bring more resources to the industry. Profitable markets that have high returns draw firms in, resulting in several new entrants that will take away profitability. Entry barriers are a way to limit the amount of competitors that can enter market. So threats of entry into an industry depend on the barriers to entry that are present, in conjunction with the reaction of existing competitors that entrants can expect. If the new competitor can expect a sharp retaliation from entrenched competitors, then the threat of entry is going to be low (Porter 7).

There are six barriers to entry as outlined in fig 5. They are: economies of scale, product differentiation, capital requirements, switching costs, access to distribution channels, and cost disadvantages independent of scale and government policy (Porter, Quick MBA).

FIG 5

Barrier to Entry: Example:

Economies of Scale Economies of Scale force a new entrant to come in at a large scale and accept cost disadvantage.

Product Differentiation Product Differentiation is when established firms have brand identification, customer loyalties which both come from past advertising, customer service or simply by being in the industry first or for a while.

Capital Requirements A firm needs to invest a large amount for resources in order to compete create a barrier of entry. Such industries are computers and mineral extraction because they require a large amount of capital to start.

Switching Costs One-time costs facing the buyer of switching from one supplier to another. Such costs are employee retraining costs and new equipment.

Access to Distribution Channels A new entrant will need to set up new distribution channel to get the product out and can be difficult to persuade existing distribution channels to carry their product. Ben and Jerry’s faced this problem when trying to find refrigeration trucks for their ice cream.

Cost Disadvantages Independent of Scale Established firms may have cost advantages that other firms can not mimic. These could be product technology and know-how, access to raw materials, location, government and so on.

Barriers of entry and exit work similar to the other. Exit barriers are the ability of a company to leave the market and entry barriers of those barriers that make it easy or hard to enter. Figure 6 shows examples of how it would be easy or hard to enter or leave a market.

Figure 6

Easy to Enter:

• Common Technology

• Little Brand franchise

• Access to Distribution Channels

• Low scale threshold Difficult to Enter if there is:

• Patented or proprietary know-how

• Difficulty in brand switching

• Restricted distribution channels

• High scale threshold

Easy to Exit if there are:

• Saleable assets

• Low Exit costs

• Independent businesses Difficult to Exit if there are:

• Specialized assets

• High exit costs

• Interrelated businesses

Threats of Substitutes:

Substitute products are the buyer’s propensity to substitute a firm’s products over another. In other words, they are products from other industries. The strength of competition from substitutes is affected by the speed in which the buyer can change to the other substitutes. This means that if a substitute becomes more attractive in terms of price or performance, some buyers will then become more inclined to switch to the other firm (Members.com).

There are many ways that increase the threat of substitutes. For instance flexible manufacturing systems, they have made it quicker, easier and more affordable to incorporate enhanced features n products. An example would be a shoe company that can produce the same product as another but add more features at a better price. More customers will want the product that offers more, but has the same or less price (Quick MBA).

Threats of substitute’s products affect the price in industries in different ways. Competition grows in an industry when threats of substitute’s products come from outside the industry. An example would be cloth vs. disposable diapers. Cloth diapers of the substitute for disposable therefore affecting the price (Quick MBA).

Rivalry among Competitors:

In the economic model of competition, competition among rival firms drives profits towards zero. Unfortunately competition is not perfect and firms are not passive price takers. Firms strive for competitive advantage over their rivals. The intensity of rivalry varies from industry to industry and strategic annalists are interested in there differences.

Economists measure rivalry by indicators for industry concentration. One such way is a concentration ration. The Bureaus of Census p[periodically reports the census reports for major standard industrial classification. The Census reports indicates the person of marker share held buy the four largest firms. A high concentration ratio indicates that a high concentration of marker share is help by the largest firms. When there are few firms that hold market share, the competitive landscape is less competitive. Low concentration indicates that the industry is characterized by many rivals.

A firm tires to gain competitive advantage to gain profits from other firms in the industry. When firms compete more and more for market share and profits, rivalry become more intense. There are a few ways this happens, such as advertising battles, product introductions, increased customer service and so on. There are also a number of structural factors. These are diverse competition, slow industry growth, high fixed costs and more. As outlined in fig 7 are how rivalry is influenced and how.

FIG 7

Intensity of Rivalry is influenced by: Example:

Structure of Competition Rivalry is more intense where there are many small or equally sized competitors. Rivalry is less when a industry has a clear market leader

Slow Industry Growth Where there are many competitors in a market that is in maturity then competition will increase vigorously.

High Fixed High Fixed costs create pressure on firms to fill capacity which can lead to price cutting to sell off the product quickly.

Lack of Differentiation When a product or service is perceived to be a commodity, the buyer has a choice between product based on service and price. This will lead to a advertising and marketing battle between firms.

High Storage Costs Firms that have products in storage for to long tend to sell their product for a lower price to try to break even or just make room for more products. If there are other firms in the industry doing the same, the rivalry intensifies.

Strategic Stakes High When a firm needs to change strategies wither they are losing market share of gaining, the rivalry increases.

Low Switching Costs When a customer can switch easily from one product to another can cause increases rivalry.

High Exit Barriers Cause a firm to stay in a industry even if it is not profitable.

Industry Stakeout When an industry has high profits and more and more new entrants the industry will become crowded. If the growth rate slows there will be an excess of demand leading towards stakeout issues. Bruce Henderson summarized this idea as the Rule of Three and Four.

Generic Strategies:

There are two ways of determining a firm’s profitability, first if the attractiveness of the industry in which the firm operates and the other is the firms’ position within that industry. Even if an industry has below average profitability, a firm can have a great position that yields high returns. Michael Porter identified three generic strategies that can be implemented at the business unit level (one of the three levels strategy can be formulated on), to create a competitive advantage. The proper generic strategy will position the firm to leverage its strengths and defend against the adverse effects of the five forces. They are called generic strategies because they are not form or industry dependent. Porter generic strategies are cost leadership, differentiation and market segmentations. You can see these strategies in figure 7. Market segmentation is narrow in scope while the other two, differentiation and cost leadership, are broad (Porter).

With these strategies a company can gain competitive advantage in the industry. When choosing a strategy it is important to focus on one strategy at a time because there is only one time that is it is beneficial to use multiple strategies. This is when a company will combine market segmentation with product differentiation to match a firm’s product strategy to the characteristics of your target market segments. Combining the others can be hard to implement due to potential conflict over cost minimization and addition cost of adding value in differentiation for instance (Porter).

Figure 7

Target Scope

LOW COST

PRODUCT UNIQUENESS

Broad

( Industry Wide)

Cost Leadership Strategy

Differentiation Strategy

Narrow

(Market Segment)

Focus Strategy

(low cost)

Focus Strategy

(Differentiation)

Cost Leadership:

To achieve cost leadership a company must create efficient-scale facilities, cost reduction in all areas of operation and production, tight cost control and more. Cost leadership also requires tight manger control of the facilities and spending. To achieve a low cost strategy a firm must have high market share and access to raw materials, large amount of capital, components, labor and other important inputs. The cost idea must run throughout the whole company in order for this strategy to be most effective. In the end a company will yield high returns despite strong competitors in the industry.

Cost Leadership has its own defenses against the five forces. This strategy is a firm’s defense against rivalry since the company is able to earn returns even if competitors invest more in advertising and other tactics. Powerful buyers are less abrasive due to the already low prices offered by a low cost strategy. Strong suppliers also are weakened because to the flexibility of cope with input cost increases. The low cost position protects the company from new entrants because of the established to the economy of scale. It is hard for a new or existing company to compete with the price that economies of scale create. Also, cost leadership place a firm in a good position compared to substitute products because of the price.

Differentiation:

Differentiation is creating a product that is unique to the industry. This can be created through brand image, technology, customer service and the like. These unique benefits should provide superior value for the customer in order for this strategy to be successful. If the customers see the product as unrivaled the elasticity of demand is reduced and customer loyalty is established. Ways of achieve differentiation is through research, strong product engineering skills, creativity, strong marketing, highly skilled employees, and so on.

Differentiation, like cost leadership, also created defenses again the five forces. By creating brand loyalty and lower sensitivity to price, differentiation offers a defense against competition and substitution. Customer Loyalty and the degree to which it is easy to duplicate a product can create a barrier to entry. High margins help yield supplier power and buyer power due to the less comparable products and services offered on the market. All of which is shown in figure 8.

Focus:

Focus strategy requires a firm to focus on a buyer group, segment of the product line or geographical region. This strategy is based on serving one market very well and a firms ability to serve this market as efficient and effectively as the other competitors. When this is done, a firm is either going to differentiate itself through meeting the needs and wants of the target group or by offering a low cost product. Focus strategy incorporates the differentiated strategy and cost leadership as shown in figure 9. In figure 8 shows how to use focus strategy to defend itself against the five forces by combining both cost leadership and differentiation tactics.



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