Welcome to Michael Porter's Five Forces, the most famous framework in business strategy. In this video, we'll cover three things. First, we'll look at why industry analysis is a critical skill.
Second, we'll define and analyze each of the five forces. Finally, we'll apply all five forces to an easy-to-understand, real-world example. First, the Five Forces framework is meant to highlight the external forces influencing a firm's profitability. So what is an industry? It's a group of firms that produce products or services that are close substitutes for one another.
In other words, one product fulfills the customer's needs about as well as the other. According to Porter, the structure of an industry has a critical effect on the profitability of firms within that industry. In this chart, each horizontal bar represents the long-term average profitability of that industry from 1992 to 2006. Let's take a look at the profitability of three common industries.
The first is soft drinks. The soft drink industry returned a staggering 37.6% each year during this time period. These outsized returns come from strong brand names and low competition.
While we hear a lot about the soda wars, big soda was actually quite profitable during this time period. Next, let's look at pharmaceuticals. Each new drug developed by a pharma company is protected by a patent for 20 years, giving the firm a de facto monopoly over production.
There are also relatively few pharma companies So competition is limited. It's no surprise, therefore, that returns exceeded 31% a year during this time period. Finally, let's look at airlines.
From 1992 to 2006, there were quite a few airlines, including Pan Am, Midwest, US Air, ATA, and a slew of others. High competition and low differentiation led to abysmal profits, making the airline industry unattractive for decades. When analyzing the five forces, it is common to take the perspective of the threat to profitability of a potential entrant to the industry.
The first force is the threat of buyers. Buyers are a threat when there are few potential buyers of your product. For example, if you have a lot of writers and only a few publishers to buy their books, the publishers are obviously going to have high buyer power.
Next, if your products are undifferentiated from your competitors, buyers can easily shop among different offerings for the best price. Finally, if it's easy to change to a new product offering, buyers have what we call low switching costs, making it easy to leave if you find a better deal. Now, imagine if your customer could dictate every aspect of the sales relationship. They can tell you how many of each product you have to produce, pay you months after delivery. That would be an awful customer, right?
Well, you'd be describing Walmart. Let's assume I run a generic denim company producing jeans. Walmart is the largest retailer in the world and actually one of the few potential buyers of my product. My products are relatively undifferentiated from other cheap jeans and Walmart can switch suppliers quite easily.
Therefore, Walmart presents an extremely high threat as a potential buyer of my products. Now, let's move on to the second force, the threat of suppliers. Suppliers are the companies that produce the products that you need in order to produce your own products or services. Suppliers are a threat when your supplier's industry is concentrated. In other words, you don't have many options to buy from.
They're also a threat when suppliers'products are unique or highly differentiated because a supplier may have a particular feature that you need and therefore must pay for. Finally, suppliers are a threat when their products have high switching costs. For example, if your workplace uses Windows computers, then Microsoft is one of your suppliers.
The cost of switching from Windows to Mac OS or Linux would be quite high. high. In the old days, IBM used to manufacture computers.
To do this, they needed a number of suppliers, including hard drive, motherboard, and processor manufacturers. And that's where Intel comes in. IBM was just a smaller player in the PC space. They competed with HP, Dell, Gateway, Apple, and Acer, just to name a few. Intel, on the other hand, was the 800-pound gorilla of processor manufacturers.
They sold over 80% of the highest-end computer processors. because they had the best manufacturing capabilities. Therefore, they could charge higher prices for their products.
So after decades of low profits, it's no wonder IBM threw in the towel in 2004 and sold their PC business to Lenovo. The third force is the threat of new entrants to the industry. Economists call these barriers to entry. High barriers to entry suggest that incumbent firms are protected from new competitors and therefore profits should generally be higher.
Industry structures with high High cost of entry include industries with high economies of scale. Manufacturing firms often benefit from cost savings from increased production volumes. Henry Ford's Model T assembly lines are a great example. Next is regulations. Newsflash, people.
Companies can be evil and lobby for regulations that increase or even prohibit entry by new competitors. Many municipal taxi organizations operated under this principle. Finally, there are cost advantages independent of scale. These include proprietary technology and brand name factors. Procter & Gamble is one of the undisputed masters of increasing barriers to entry.
in the consumer segments in which they operate. They use strong brand names developed through heavy advertising. They also produce products that require high economies of scale to manufacture.
This leaves them with high profit margins on well-known consumer brands such as Old Spice, Crest, Bounce, Duracell, Pantene, Secret, and honestly dozens of others. The fourth force is the threat of substitutes. Students often have trouble with this one because Michael Porter defines substitutes in a slightly different manner than some other business strategists.
He defines a substitute product as a product from outside of the focal industry that fulfills customer needs in a different way. For example, driving to work, bicycling to work, and ride-sharing to work are all substitute products because they meet a user's transportation needs. But the car industry, the bicycle industry, and the ride-sharing industry are each quite distinct. Substitute products lower prices and limit profits because customers have more options to meet their needs.
The best substitute product example might be butter, representing the dairy industry, versus I can't believe it's not butter, which represents the congealed soybean oil industry. Sorry, Fabio. The last force is the threat of rivalry.
Rivalry refers to the intensity of competition among a firm's direct set of competitors. Rivalry within an industry is high. when there are numerous firms, when industry growth is slow, and of course, when firms are unable to differentiate their products. Farming is the quintessential high rivalry industry.
Agricultural products like corn are commodities, meaning there are thousands of similar producers, and industry growth, pun fully intended, is slow. Firms are, by definition, unable to differentiate the products that they produce. This leads to consistently low profits.
Other high-rivalry industries include restaurants, cattle ranching, and mining. On the other hand, low-rivalry industries usually have higher profits. For example, search engines have very low rivalry, with Google owning as much as 80% of the market and Bing controlling much of the rest. Due to low competition, Google can place ads wherever they want and charge what are effectively monopoly prices to advertisers.
Other low-rivalry industries include operating systems and social networking sites. To recap, here are the most salient five forces examples. Walmart is a powerful threat as a buyer. Intel is a powerful threat as a supplier. Procter & Gamble's ability to create strong brand names raises barriers to entry and poses threat to new entrants.
Lyft is an example of a substitute product to driving or biking. Finally, the highest rivalry industry in the world is farming, with tens of thousands of competitors growing standardized agricultural products. Now that we've gone over the forces individually, in part three I'll apply them to the market for denim jeans.
This is a denim industry value chain. It goes from raw cotton to jeans manufacturing to retail stores to the end consumer. Our focus will be on jeans manufacturing. So let's start with supplier power.
The main supplier to clothing manufacturers is raw cotton. Cotton is grown by many farmers who grow a standardized commodity product. Therefore, there are lots of similar suppliers and this results in a low threat to profitability of the jeans manufacturers. The next force is buyers. There are two effective buyers for the jeans.
In-consumers and the retail stores that sell them. In-consumers like you and me only buy a small amount of denim and since there are many of us, we have very low bargaining power. On the other hand, retail stores do.
The largest clothing store in America is Walmart. Target, Amazon, and H&M are up there as well. So the jeans retail industry is remarkably concentrated, indicating that there are indeed a threat to denim manufacturing profits. The next force is barriers to entry. I went to the Walmart website to look at their jeans selection.
I found this brand called Rustler, which I suspect is meant to be a generic for Wrangler. Their jeans are only $12.97. This leads me to believe that generic denim companies are common and able to produce quite cheaply. Therefore, the jeans industry has low barriers to entry, which results in higher threats to profit. The fourth force is substitute products.
For denim, pretty much any type of pants would be a substitute good. This could include joggers, tropical print chinos, capri pants, or my personal favorite, harem capri pants. Either way, there are many substitutes for denim leading to a higher threat to profits.
The last force is rivalry. As we saw with the rustler jeans, there are likely many cheap, generically branded denim producers. At the same time, competition for higher end or branded jeans is still pretty fierce, with well-known brands like Levi's, Wrangler, Lucky Brand, Diesel, and True Religion fighting it out in the $40 to $140 price point. Thus, Denim jeans are an example of high rivalry. All in all, if we look at each of the five forces, only supplier threat is favorable to a potential entrant.
All four of the other forces suggest a higher threat to profits, indicating that denim may not be such a good industry to enter. That's all for now. Check out the rest of the videos in my Intro to Strategy series. And finally, please like and comment below. Thanks so much for watching.