Small Business Advantage: Master Porter's 5 Forces
Porter’s Five Forces framework provides a deep understanding of the competitive dynamics that impact profitability helping inform small business strategies that establish competitive advantage.
Imagine navigating a battlefield without understanding the terrain or your opponents. This is the strategy that small business owners employ by operating without a deep understanding of their chosen markets and the industry at large. It’s a strategy bound to lead your business in the wrong direction, resulting in margins and profitability levels well below the company’s true capabilities.
First introduced by Michael Porter in an article for the Harvard Business Review, Porter's Five Forces framework has emerged as a powerful tool for strategic analysis, helping you assess the forces shaping your industry and ultimately, your success. In this article, we'll walk you through completing the Five Forces framework, discussing its benefits and limitations, and providing an example to illustrate its potential.
Download our free Porter’s Five Forces template to help you conduct your analysis and begin implementing strategies that will lead to competitive advantage.
What are Porter's Five Forces?
Michael Porter introduced the Five Forces framework to expand how people thought about the factors that drive competition. He asserted the five forces included in the framework were primarily responsible for the competitive intensity of an industry and in turn, the potential for profitability of companies within an industry.
Before we detail the steps involved in conducting a Five Forces analysis, it’s important to get an overview of the forces within this framework. These factors contribute significantly to an industry’s competitive intensity and potential profitability.
Competitive Rivalry
Competitive rivalry considers the intensity of competition among the current players in a given market or industry. The intensity of competition is driven by the number of competitors in an industry and their capabilities. Generally, industries with more competitors and a dispersed market share will be more competitive than those with few companies that own most of the market.
Industries without significant product differentiation across competitors result in more intense competition and lower margins as companies must woo consumers based on price. Competitors that can establish a cost advantage or differentiated products will earn best-in-class operating margins and establish customer loyalty, offsetting some of the competitive intensity.
Consider the following factors when evaluating competitive rivalry:
Number of competitors
Market concentration across competitors
Industry growth
Product quality and differentiation across competitors
Competitor reputation and customer loyalty
Switching costs
Fixed costs of operating in the industry
Threat of New Entrants
Barriers to entry are hurdles new companies must clear to enter a specific industry and become competitive. Barriers to entry may include regulatory requirements, start-up costs, and resource availability.
When an industry has low barriers to entry, and it’s easy for new competitors to enter the market, competitive intensity increases. When examining the threat of new entrants, these barriers to entry are in question. Industries with high barriers to entry make competition less intense as these industries are more difficult to enter protecting market share and pricing power of existing players while limiting the availability of substitutes from new entrants.
Consider the following factors when evaluating the threat of new entrants:
Start-up costs and capital requirements
Economies of scale
Regulatory requirements
Switching costs
Access to distribution networks
Access to competitive technology
Product differentiation
Customer loyalty
Threat of Substitutes
Substitute products are alternative options for customers provided by competing firms in an industry. Industries with price-sensitive consumers and commoditized product offerings have a high threat of substitution among competing firms. If customers perceive another product can offer them the same or greater benefits compared to your product, they are likely to switch.
It’s important to examine potential substitutes outside of the immediate product offering. Any product that fills a similar need might be considered a substitute for customers. For example, a bottled water company also faces substitution threats from juices, sodas, and other soft drinks. Finding ways to differentiate your product and build brand loyalty will help limit the threat of substitute products.
Consider the following factors when evaluating the threat of substitutes:
Number of substitutes available
Accessibility of substitute products
Pricing and quality of substitute products
Customer loyalty
Switching costs for customers
Bargaining Power of Suppliers
Suppliers can significantly influence the profit potential of an industry. If a supplier can increase pricing and affect output quality without fear of backlash from its customers (industry competitors), they have high bargaining power. In doing this, the supplier can reduce the profitability of the competing companies by shrinking margins. To maintain margins, additional costs may be passed on to consumers resulting in reduced purchase frequency or substitution, limiting profitability.
Suppliers will typically garner more bargaining power when there are a limited number of supplier choices, they produce materials of higher quality, or customers have high switching costs or long switching timelines. Forward integration also plays a role in supplier power, if they can forward integrate - or expand their business to incorporate the distribution of their products, they’ll increase their bargaining power.
Consider the following factors when evaluating the bargaining power of suppliers:
The number of suppliers
The uniqueness of product offerings
Switching costs and timelines
Supplier potential for forward integration
Industry potential for backward integration
Bargaining Power of Consumers
The last force Porter named is the bargaining power of consumers. Depending on the number of consumers, price sensitivity, the range of substitutes available, and how informed they are, consumers can pressure companies operating in an industry.
Consumers will have more bargaining power when there are fewer of them, many substitutes are available, or they make high-value purchases. To combat the influence of consumer buying power, industry participants should strive to create a strong brand reputation and increase customer loyalty with strategies including loyalty programs, product differentiation, and providing high-quality service to create perceived value compared to the competition.
Consider the following factors when evaluating the bargaining power of consumers:
Overall market size (number of consumers)
Average purchase size
Switching costs
Availability of substitutes
Consumer knowledge
Consumer price sensitivity
Completing the Five Forces Framework
With a firm understanding of the five forces, it is time to discuss the process for completing the framework and applying the analysis to strategic decisions within your company.
Define Your Industry and Market
The first step of completing the five forces framework is identifying the industry and markets in which your business competes. This might seem pretty obvious or straightforward, but depending on your industry, it might be more nuanced than it seems at first glance. You should decide if this analysis will be based on a broader industry or a specific sub-industry. Also consider whether you're competing in a local market, nationally, or globally.
The example we have provided below is where a fine-dining Italian restaurant. Since this will be the first location that this business is opening, there's no need to focus on the national market. We only need to zero in on the local market for the competitive analysis. It would be easy to say we want to focus on the restaurant industry for this example but multiple restaurant types fall within this industry - casual dining, fast food, and fine dining to name a few.
Since this fine-dining Italian restaurant isn’t competing with casual dining or fast food, we can focus on the fine dining sub-industry. Follow a similar thought process for your business.
Gather Data and Information
For each of the five forces mentioned above, you'll need to gather data and information to conduct a thorough analysis. Examples of data gathering would include Internet searches, industry reports, customer surveys, competitive analysis, and local or national economic factors depending on your chosen market. We've gathered and listed some examples of free data sources that you can utilize below:
Industry Reports and Data
U.S. Small Business Administration - The SBA offers many valuable free resources for small businesses and entrepreneurs including industry reports and data. Specific industry searches will deliver insights into relevant market size, trends, and competitor information.
U.S. Census Bureau - The Census Bureau owns a wealth of valuable demographic and economic data that you can utilize. Search data sets related to your target market, competitor locations, and consumer spending habits.
Bureau of Labor Statistics - this site offers industry-specific employment data, wage information, and occupational outlooks to help you understand the labor market and potential supplier costs within a specific industry.
Market Research and News
Google Scholar - Google Scholar allows you to search for academic papers, journals, and industry reports related to your specific market. Some of these resources may require payment to view, but many free, relevant publications can be found.
Industry Publications and Blogs - Most industries have trade publications that offer free content with valuable insights and market analysis. Industry-specific blogs can also be a valuable resource.
Government Websites - Government agencies like the ones mentioned above typically have industry-specific reports and data about regulations, licensing requirements, and economic trends.
Customer Insights
Social Media - Social media is a great, free resource for listening to customer conversations about your industry, competitors, and their specific needs.
Simple Surveys - Free survey tools like Google Forms for SurveyMonkey allow you to gather feedback directly from potential and existing customers. This can provide valuable insights into purchase preferences, decision processes, and needs.
Utilize multiple data sources when conducting your analysis to get a full picture of industry dynamics. Leveraging these resources allows you to complete a Five Forces framework backed by quality data to help you make informed strategic decisions.
Analyze the Strength of the Five Forces
With your industry and markets identified and the data gathered, you are now ready to complete the five forces framework and analyze the strengths of each factor contributing to competitive intensity.
Remember, as we covered above, the five forces to consider include:
Competitive Rivalry
Threat of New Entrants
Threat of Substitutes
Bargaining Power of Suppliers
Bargaining Power of Consumers
Optionally, you can score each of these strengths based on the significance that you believe it has in the competitive rivalry of the industry. Theoretically, this will help prioritize your strategic decision-making to address the most important factors first.
Develop and Implement Strategies for Competitive Advantage
With the framework completed, it’s time to analyze the strengths of the industry and identify ways to help your business establish a competitive advantage. Two ways to establish a competitive advantage are through cost advantage and differentiation.
A cost advantage results in your business operating with higher margins than the competition when selling goods at the same price. Examples of ways to obtain cost advantage include securing favorable contracts for raw materials, establishing highly efficient and lean operating processes, and utilizing a streamlined and efficient distribution network. Businesses with a cost advantage will have higher profitability with the same sales as other companies and can invest that extra profit into the business to propel faster growth.
A differentiation advantage is when customers feel your product has a higher perceived value than the competition’s product. Examples of ways to obtain a differentiation advantage include creating a superior quality product, delivering a unique experience, and delivering superior customer service. Companies with a differentiation advantage can charge higher prices than their competition because customers feel they receive better value from a differentiated product. These companies will also see higher profitability and can reinvest that extra profit for faster growth.
Below is a completed example of the Porter’s Five Force framework for an Italian fine-dining restaurant:
Click to download completed Porter’s Five Forces example.
Some potential strategies this company may use to establish competitive advantage include:
Strategically plan the menu to minimize waste by utilizing all parts of ingredients (cost advantage)
Establish relationships with local farmers and merchants to secure seasonal ingredients at potentially lower prices (cost advantage)
Offer interactive dining elements like pasta making, cooking demonstrations, and cheese and wine pairing workshops (differentiation)
Engineer the menu to highlight high-margin dishes and optimize the portion sizes for low-margin dishes (cost advantage)
Offer sommelier service and wine education paired with specially crafted menus for couples or groups (differentiation)
Employ a highly trained staff knowledgeable about Italian cuisine, history, and ingredients to deliver engaging customer experiences (differentiation)
Implement high-end technological solutions for scheduling, inventory, and point-of-sale to optimize operations efficiency (cost advantage)
These represent a few examples that could be implemented to help establish a competitive advantage for the Italian fine dining restaurant. When strategizing to establish a cost advantage, focus on quality and implementing sustainable solutions that will help the business thrive. To establish an advantage through product differentiation, focus on customer needs, and deliver a unique, high-quality product or service.
Benefits of a Five Forces Analysis
Completing the process above will deliver significant benefits for your business. Gaining a deeper understanding of the competitive landscape and market dynamics that influence competitive rivalry in your industry can help a management team make more informed strategic decisions and establish a competitive advantage, promoting long-term success. Benefits of completing Porter’s Five Forces framework include:
Deeper Market Knowledge: analyzing the competitive rivalry, consumer behaviors, and supplier leverage within your industry facilitates a deeper understanding of the factors that drive competition and shape business decisions.
Improved Strategic Planning: completing this comprehensive analysis gives business owners valuable insights to anticipate challenges and guide strategic decisions about marketing, pricing, product development, and resource allocation to capitalize on opportunities within the market and establish a competitive advantage.
Identify Profit Opportunities: the framework can help identify the most profitable segments of an industry or segments that are less vulnerable to attack by competitive forces. This information can be used to allocate resources and develop strategies for the most lucrative segments of an industry.
Anticipate Industry Changes: Porter's Five Forces framework forces small business owners to evaluate the future and consider potential shifts in industry activity and trends, such as new entrants or technological advancements that could introduce substitute products. This foresight allows companies to prepare and adapt more effectively.
Refined Negotiation and Pricing Strategies: analyzing the bargaining power of suppliers and consumers with the threat of substitutes and new entrants helps small business owners and entrepreneurs understand which industry participants wield the most power. This can influence negotiation strategies, pricing, and value chain optimization.
Each of the benefits above can contribute to helping your company establish a competitive advantage and become more strongly positioned for long-term success within your industry.
Limitations of a Five Forces Analysis
Despite the significant benefits mentioned above, there are some limitations to consider when completing the Five Forces framework:
Focus on Industry-Level Forces: the framework focuses on forces impacting the industry at large, but it doesn’t specifically address the strengths and weaknesses of individual companies. By potentially overlooking the capabilities of their business, management teams may develop strategies that cannot be implemented successfully. This framework should be paired with a SWOT analysis which considers company-specific capabilities.
It is a Static Analysis: this analysis captures the industry at a specific moment. Industry conditions can change rapidly, especially with today’s rapid technological advancement and the potential for regulatory and legislative changes. Periodically refresh this analysis to ensure your strategies factor in the latest industry forces.
Does Not Consider Non-Competitive Forces: by focusing on forces that shape competitive rivalry within an industry, non-competitive forces like social, political, environmental, and macroeconomic factors that impact industry participants’ potential profitability may be overlooked, leading to inadequate strategic decisions.
Overemphasis on Competition: thoroughly examining the competitive forces in an industry may lead management to overemphasize strategies to combat competition at the expense of collaborative strategies that can be mutually beneficial for industry participants. Joint ventures, strategic partnerships, and other collaborative efforts can help traditional competitors thrive.
Oversimplification and Subjectivity: some of the power dynamics identified in the industry might be driven by complex, multifaceted relationships that get oversimplified during the analysis. Combined with the potential for subjectivity based on individual or team perspectives and industry knowledge, the output from this analysis may be biased or present an incomplete picture.
Being aware of these limitations and taking steps to address them will ensure the Five Forces analysis is still a valuable tool for your business.
The limitations can be mitigated by including a variety of team members with differing perspectives, combining the Porter’s Five Forces framework with other tools like SWOT analysis to identify internal capabilities and weaknesses, or the PESTEL analysis for a more comprehensive view of the external environment, and focusing on the strategies the SWOT analysis can inform - a completed SWOT framework doesn’t mean the job is done.
Improving Strategy with Porter's Five Forces
Porter's Five Forces framework equips small business owners and entrepreneurs with the knowledge to assess the competitive landscape, identify potential threats and opportunities, and make informed decisions that propel the business toward success.
By understanding the bargaining power of suppliers and buyers, the threat of new entrants and substitutes, and the intensity of competitive rivalry within your industry, you gain the power to develop a winning strategy and establish a competitive advantage.
While Porter's Five Forces has limitations, it remains a powerful tool for strategic analysis. Download our free Porter's Five Forces template today and take the first step towards gaining a deeper understanding of the competitive forces shaping your industry.
Are you struggling to complete a Five Forces framework for your organization? Schedule a discovery session today to see how we can help you!
