The essence of formulating competitive strategy is relating a company to its environment. The intensity of competition in an industry is rooted in its underlying economic structure. According to Michael Porter the state of competition in an industry depends on five basic competitive forces. The collective strength of these forces determines the ultimate profit potential in the industry, where profit potential is measured in terms of long run return on invested capital. Not all industries have the same potential. They differ fundamentally in their ultimate profit potential as the collective strength of the forces differs.
The goal of competitive strategy for a business unit in an industry is to find a position in the industry where the company can best defend itself against these competitive forces or can influence them in its favor. Since the collective strength of the forces may well be painfully apparent to all competitors, the key for developing strategy is to delve below the surface and analyze the sources of each. Knowledge of these underlying sources of competitive pressure highlights the critical strengths and weakness of the company, animates its positioning in its industry, clarifies the areas where strategic changes may yield the greatest payoff, and highlights the areas where industry trends promise to hold the greatest significance as either opportunities or threats.
Let us begin our analysis of the firm’s situation by taking a structured look at its industrial environment. We are using Porter’s Five Forces model to gain insights into the competitiveness of firm’s industry.
The Five Forces Model
This model constitutes five forces. They are:
This is the most effective competition. The head to head rivalry is between firms making similar products and selling them in the same market. Competition can be restricted to one dimension (e.g. price) or many (e.g. service, product quality etc)
Rivalry is usual when there are some of the following conditions:
1) As the number of competitors increase and as they become more equal in size and capability.
2) When demand for the product is growing slowly.
3) When competitors are tempted by industry conditions to use price cuts or other competitive weapons to boost unit volume.
4) When competitor’s products and services are so similar that customers incur low costs in switching form one brand to another.
Threat of Entry:
If it is easy to get into an industry then, as soon as profits look attractive, new firms will enter. If demand for the industry’s products does not rise to match the increased capacity that entry has caused, then prices and with them profits, are likely to fall. So, the threat of entry places an upper limit on an industry’s profitability. The most common barriers are:
1) Economies of scale: These are cost advantages that accrue through having large scale operations.
2) The existence of considerable cost benefits to be gained from experience. Here the advantages stem not from large scale facilities but from the experience gained through repeatedly producing the product or service many times.
3) Brand preference and customer loyalty makes it difficult for anew company to enter into business.
4) Cost disadvantages independent of sizes. These might be due, for example, to access to cheaper labor or raw materials.
5) If effective distribution is not done the competitors’ products may be sold better.
6) Capital requirements also act as a barrier to any industry.
Threat of Substitutes:
For our purposes, a substitute is something that meets the needs of the product produced in the industry. If the substitute becomes more attractive in terms of price, performance or both, then some buyers will be tempted to move their custom away from the firms in the industry. If substitutes pose a credible threat, then, firms in the industry will be prevented from raising their prices or from falling to develop and improve their products/ services.
The competition from substitutes is affected by the ease with which buyers can switch. A key consideration is usually the buyer’s switching costs.