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The Five Competitive
Forces That Shape
Strategy
by Michael E. Porter
Included with this full-text Harvard Business Review article:
The Idea in Brief—the core idea
The Idea in Practice—putting the idea to work
1 Article Summary
2 The Five Competitive Forces That Shape Strategy
A list of related materials, with annotations to guide further
exploration of the article’s ideas and applications
18 Further Reading
Awareness of the five forces
can help a company
understand the structure of its
industry and stake out a
position that is more
profitable and less vulnerable
to attack.
Reprint R0801E
The Five Competitive Forces That Shape
Strategy
page 1
The Idea in Brief The Idea in Practice
COPYRIGHT © 2008 HARVARD BUSINESS SCHOOL PUBLISHING CORPORATION. ALL RIGHTS RESERVED.
You know that to sustain long-term profit- ability you must respond strategically to competition. And you naturally keep tabs on your established rivals. But as you scan the competitive arena, are you also looking beyond your direct competitors? As Porter explains in this update of his revolutionary 1979 HBR article, four additional competi- tive forces can hurt your prospective profits:
- Savvy customers can force down prices by playing you and your rivals against one another. - Powerful suppliers may constrain your profits if they charge higher prices. - Aspiring entrants, armed with new ca- pacity and hungry for market share, can ratchet up the investment required for you to stay in the game. - Substitute offerings can lure customers away. Consider commercial aviation: It’s one of the least profitable industries because all five forces are strong. Established rivals compete intensely on price. Customers are fickle, searching for the best deal regardless of carrier. Suppliers—plane and engine manufacturers, along with unionized labor forces—bargain away the lion’s share of air- lines’ profits. New players enter the indus- try in a constant stream. And substitutes are readily available—such as train or car travel. By analyzing all five competitive forces, you gain a complete picture of what’s influenc- ing profitability in your industry. You iden- tify game-changing trends early, so you can swiftly exploit them. And you spot ways to work around constraints on profitability— or even reshape the forces in your favor.
By understanding how the five competitive forces influence profitability in your industry, you can develop a strategy for enhancing your company’s long-term profits. Porter suggests the following:
POSITION YOUR COMPANY W HERE THE FORCES ARE WEAKEST Example: In the heavy-truck industry, many buyers operate large fleets and are highly moti- vated to drive down truck prices. Trucks are built to regulated standards and offer simi- lar features, so price competition is stiff; unions exercise considerable supplier power; and buyers can use substitutes such as cargo delivery by rail. To create and sustain long-term profitability within this industry, heavy-truck maker Pac- car chose to focus on one customer group where competitive forces are weakest: indi- vidual drivers who own their trucks and contract directly with suppliers. These oper- ators have limited clout as buyers and are less price sensitive because of their emo- tional ties to and economic dependence on their own trucks. For these customers, Paccar has developed such features as luxurious sleeper cabins, plush leather seats, and sleek exterior styl- ing. Buyers can select from thousands of options to put their personal signature on these built-to-order trucks. Customers pay Paccar a 10% premium, and the company has been profitable for 68 straight years and earned a long-run return on equity above 20%.
EXPLOIT CHANGES IN THE FORCES
Example: With the advent of the Internet and digital distribution of music, unauthorized down- loading created an illegal but potent substi- tute for record companies’ services. The record companies tried to develop technical platforms for digital distribution themselves, but major labels didn’t want to sell their music through a platform owned by a rival. Into this vacuum stepped Apple, with its iTunes music store supporting its iPod music player. The birth of this powerful new gate- keeper has whittled down the number of major labels from six in 1997 to four today.
RESHAPE THE FORCES IN YOUR FAVOR Use tactics designed specifically to reduce the share of profits leaking to other players. For example:
- To neutralize supplier power, standardize specifications for parts so your company can switch more easily among vendors. - To counter customer power, expand your services so it’s harder for customers to leave you for a rival. - To temper price wars initiated by estab- lished rivals, invest more heavily in prod- ucts that differ significantly from competi- tors’ offerings. - To scare off new entrants, elevate the fixed costs of competing; for instance, by escalat- ing your R&D expenditures. - To limit the threat of substitutes, offer bet- ter value through wider product accessibil- ity. Soft-drink producers did this by intro- ducing vending machines and convenience store channels, which dramat- ically improved the availability of soft drinks relative to other beverages.
investment. If the forces are benign, as they are in industries such as software, soft drinks, and toiletries, many companies are profitable. In- dustry structure drives competition and profit- ability, not whether an industry produces a product or service, is emerging or mature, high tech or low tech, regulated or unregulated. While a myriad of factors can affect industry profitability in the short run—including the weather and the business cycle—industry structure, manifested in the competitive forces, sets industry profitability in the medium and long run. (See the exhibit “Differences in In- dustry Profitability.”) Understanding the competitive forces, and their underlying causes, reveals the roots of an industry’s current profitability while providing a framework for anticipating and influencing competition (and profitability) over time. A healthy industry structure should be as much a competitive concern to strategists as their com- pany’s own position. Understanding industry structure is also essential to effective strategic positioning. As we will see, defending against the competitive forces and shaping them in a company’s favor are crucial to strategy.
Forces That Shape Competition
The configuration of the five forces differs by industry. In the market for commercial air- craft, fierce rivalry between dominant produc- ers Airbus and Boeing and the bargaining power of the airlines that place huge orders for aircraft are strong, while the threat of en- try, the threat of substitutes, and the power of suppliers are more benign. In the movie the- ater industry, the proliferation of substitute forms of entertainment and the power of the movie producers and distributors who supply movies, the critical input, are important. The strongest competitive force or forces de- termine the profitability of an industry and be- come the most important to strategy formula- tion. The most salient force, however, is not always obvious. For example, even though rivalry is often fierce in commodity industries, it may not be the factor limiting profitability. Low returns in the photographic film industry, for instance, are the result of a superior substitute prod- uct—as Kodak and Fuji, the world’s leading producers of photographic film, learned with the advent of digital photography. In such a sit- uation, coping with the substitute product be-
comes the number one strategic priority. Industry structure grows out of a set of eco- nomic and technical characteristics that deter- mine the strength of each competitive force. We will examine these drivers in the pages that follow, taking the perspective of an incumbent, or a company already present in the industry. The analysis can be readily extended to under- stand the challenges facing a potential entrant. Threat of entry. New entrants to an indus- try bring new capacity and a desire to gain market share that puts pressure on prices, costs, and the rate of investment necessary to compete. Particularly when new entrants are diversifying from other markets, they can le- verage existing capabilities and cash flows to shake up competition, as Pepsi did when it en- tered the bottled water industry, Microsoft did when it began to offer internet browsers, and Apple did when it entered the music distribu- tion business. The threat of entry, therefore, puts a cap on the profit potential of an industry. When the threat is high, incumbents must hold down their prices or boost investment to deter new competitors. In specialty coffee retailing, for example, relatively low entry barriers mean that Starbucks must invest aggressively in modernizing stores and menus. The threat of entry in an industry depends on the height of entry barriers that are present and on the reaction entrants can expect from incumbents. If entry barriers are low and new- comers expect little retaliation from the en- trenched competitors, the threat of entry is high and industry profitability is moderated. It is the threat of entry, not whether entry actu- ally occurs, that holds down profitability. Barriers to entry. Entry barriers are advan- tages that incumbents have relative to new en- trants. There are seven major sources:
- Supply-side economies of scale. These econ- omies arise when firms that produce at larger volumes enjoy lower costs per unit because they can spread fixed costs over more units, employ more efficient technology, or com- mand better terms from suppliers. Supply- side scale economies deter entry by forcing the aspiring entrant either to come into the industry on a large scale, which requires dis- lodging entrenched competitors, or to accept a cost disadvantage. Scale economies can be found in virtually every activity in the value chain; which ones
Michael E. Porter is the Bishop Will- iam Lawrence University Professor at Harvard University, based at Harvard Business School in Boston. He is a six- time McKinsey Award winner, includ- ing for his most recent HBR article, “Strategy and Society,” coauthored with Mark R. Kramer (December 2006).
are most important varies by industry.^1 In mi- croprocessors, incumbents such as Intel are protected by scale economies in research, chip fabrication, and consumer marketing. For lawn care companies like Scotts Miracle-Gro, the most important scale economies are found in the supply chain and media advertising. In small-package delivery, economies of scale arise in national logistical systems and infor- mation technology.
- Demand-side benefits of scale. These bene- fits, also known as network effects, arise in in- dustries where a buyer’s willingness to pay for a company’s product increases with the num- ber of other buyers who also patronize the company. Buyers may trust larger companies more for a crucial product: Recall the old adage that no one ever got fired for buying from IBM (when it was the dominant com- puter maker). Buyers may also value being in a “network” with a larger number of fellow cus- tomers. For instance, online auction partici- pants are attracted to eBay because it offers the most potential trading partners. Demand- side benefits of scale discourage entry by limit- ing the willingness of customers to buy from a newcomer and by reducing the price the new- comer can command until it builds up a large base of customers.
- Customer switching costs. Switching costs are fixed costs that buyers face when they
change suppliers. Such costs may arise because a buyer who switches vendors must, for exam- ple, alter product specifications, retrain em- ployees to use a new product, or modify pro- cesses or information systems. The larger the switching costs, the harder it will be for an en- trant to gain customers. Enterprise resource planning (ERP) software is an example of a product with very high switching costs. Once a company has installed SAP’s ERP system, for example, the costs of moving to a new vendor are astronomical because of embedded data, the fact that internal processes have been adapted to SAP, major retraining needs, and the mission-critical nature of the applications.
- Capital requirements. The need to invest large financial resources in order to compete can deter new entrants. Capital may be neces- sary not only for fixed facilities but also to ex- tend customer credit, build inventories, and fund start-up losses. The barrier is particularly great if the capital is required for unrecover- able and therefore harder-to-finance expendi- tures, such as up-front advertising or research and development. While major corporations have the financial resources to invade almost any industry, the huge capital requirements in certain fields limit the pool of likely entrants. Conversely, in such fields as tax preparation services or short-haul trucking, capital require- ments are minimal and potential entrants plentiful. It is important not to overstate the degree to which capital requirements alone deter entry. If industry returns are attractive and are ex- pected to remain so, and if capital markets are efficient, investors will provide entrants with the funds they need. For aspiring air carriers, for instance, financing is available to purchase expensive aircraft because of their high resale value, one reason why there have been numer- ous new airlines in almost every region.
- Incumbency advantages independent of size. No matter what their size, incumbents may have cost or quality advantages not avail- able to potential rivals. These advantages can stem from such sources as proprietary technol- ogy, preferential access to the best raw mate- rial sources, preemption of the most favorable geographic locations, established brand identi- ties, or cumulative experience that has allowed incumbents to learn how to produce more effi- ciently. Entrants try to bypass such advantages. Upstart discounters such as Target and Wal-
The Five Forces That Shape Industry Competition
Bargaining Power of Suppliers
Threat of New Entrants
Bargaining Power of Buyers
Threat of Substitute Products or Services
Rivalry Among Existing Competitors
indirectly by funding basic research and mak- ing it available to all firms, new and old, reduc- ing scale economies. Entry barriers should be assessed relative to the capabilities of potential entrants, which may be start-ups, foreign firms, or companies in related industries. And, as some of our ex- amples illustrate, the strategist must be mind- ful of the creative ways newcomers might find to circumvent apparent barriers. Expected retaliation. How potential entrants believe incumbents may react will also influ- ence their decision to enter or stay out of an
industry. If reaction is vigorous and protracted enough, the profit potential of participating in the industry can fall below the cost of capital. Incumbents often use public statements and responses to one entrant to send a message to other prospective entrants about their com- mitment to defending market share. Newcomers are likely to fear expected retali- ation if:
- Incumbents have previously responded vigorously to new entrants.
- Incumbents possess substantial resources to fight back, including excess cash and unused borrowing power, available productive capac- ity, or clout with distribution channels and cus- tomers.
- Incumbents seem likely to cut prices be- cause they are committed to retaining market share at all costs or because the industry has high fixed costs, which create a strong motiva- tion to drop prices to fill excess capacity.
- Industry growth is slow so newcomers can gain volume only by taking it from incumbents. An analysis of barriers to entry and expected retaliation is obviously crucial for any com- pany contemplating entry into a new industry. The challenge is to find ways to surmount the entry barriers without nullifying, through heavy investment, the profitability of partici- pating in the industry. The power of suppliers. Powerful suppliers capture more of the value for themselves by charging higher prices, limiting quality or ser- vices, or shifting costs to industry participants. Powerful suppliers, including suppliers of la- bor, can squeeze profitability out of an indus- try that is unable to pass on cost increases in its own prices. Microsoft, for instance, has con- tributed to the erosion of profitability among personal computer makers by raising prices on operating systems. PC makers, competing fiercely for customers who can easily switch among them, have limited freedom to raise their prices accordingly. Companies depend on a wide range of differ- ent supplier groups for inputs. A supplier group is powerful if:
- It is more concentrated than the industry it sells to. Microsoft’s near monopoly in operating systems, coupled with the fragmentation of PC assemblers, exemplifies this situation.
- The supplier group does not depend heavily on the industry for its revenues. Suppli- ers serving many industries will not hesitate to
Industry Analysis in Practice
Good industry analysis looks rigor- ously at the structural underpinnings of profitability. A first step is to under- stand the appropriate time horizon. One of the essential tasks in industry analysis is to distinguish temporary or cyclical changes from structural changes. A good guideline for the appro- priate time horizon is the full business cycle for the particular industry. For most industries, a three-to-five-year hori- zon is appropriate, although in some in- dustries with long lead times, such as mining, the appropriate horizon might be a decade or more. It is average profit- ability over this period, not profitability in any particular year, that should be the focus of analysis. The point of industry analysis is not to declare the industry attractive or un- attractive but to understand the under- pinnings of competition and the root causes of profitability. As much as possi- ble, analysts should look at industry structure quantitatively, rather than be satisfied with lists of qualitative factors. Many elements of the five forces can be quantified: the percentage of the buyer’s total cost accounted for by the industry’s product (to understand buyer price sensi- tivity); the percentage of industry sales required to fill a plant or operate a logisti- cal network of efficient scale (to help as- sess barriers to entry); the buyer’s switch- ing cost (determining the inducement an entrant or rival must offer customers).
The strength of the competitive forces affects prices, costs, and the in- vestment required to compete; thus the forces are directly tied to the in- come statements and balance sheets of industry participants. Industry struc- ture defines the gap between revenues and costs. For example, intense rivalry drives down prices or elevates the costs of marketing, R&D, or customer service, re- ducing margins. How much? Strong sup- pliers drive up input costs. How much? Buyer power lowers prices or elevates the costs of meeting buyers’ demands, such as the requirement to hold more inven- tory or provide financing. How much? Low barriers to entry or close substitutes limit the level of sustainable prices. How much? It is these economic relationships that sharpen the strategist’s understand- ing of industry competition. Finally, good industry analysis does not just list pluses and minuses but sees an industry in overall, systemic terms. Which forces are underpinning (or constraining) today’s profitability? How might shifts in one competitive force trigger reactions in others? Answer- ing such questions is often the source of true strategic insights.
extract maximum profits from each one. If a particular industry accounts for a large portion of a supplier group’s volume or profit, however, suppliers will want to protect the industry through reasonable pricing and assist in activi- ties such as R&D and lobbying.
- Industry participants face switching costs in changing suppliers. For example, shifting suppliers is difficult if companies have invested heavily in specialized ancillary equipment or in learning how to operate a supplier’s equipment (as with Bloomberg terminals used by financial professionals). Or firms may have located their production lines adjacent to a supplier’s manu- facturing facilities (as in the case of some bever- age companies and container manufacturers). When switching costs are high, industry partic- ipants find it hard to play suppliers off against one another. (Note that suppliers may have switching costs as well. This limits their power.)
- Suppliers offer products that are differen- tiated. Pharmaceutical companies that offer patented drugs with distinctive medical bene- fits have more power over hospitals, health maintenance organizations, and other drug buyers, for example, than drug companies of- fering me-too or generic products.
- There is no substitute for what the sup- plier group provides. Pilots’ unions, for exam- ple, exercise considerable supplier power over airlines partly because there is no good alterna- tive to a well-trained pilot in the cockpit.
- The supplier group can credibly threaten to integrate forward into the industry. In that case, if industry participants make too much money relative to suppliers, they will induce suppliers to enter the market. The power of buyers. Powerful customers— the flip side of powerful suppliers—can cap- ture more value by forcing down prices, de- manding better quality or more service (thereby driving up costs), and generally playing industry participants off against one another, all at the ex- pense of industry profitability. Buyers are power- ful if they have negotiating leverage relative to industry participants, especially if they are price sensitive, using their clout primarily to pressure price reductions. As with suppliers, there may be distinct groups of customers who differ in bargaining power. A customer group has negotiating le- verage if:
- There are few buyers, or each one pur- chases in volumes that are large relative to the
size of a single vendor. Large-volume buyers are particularly powerful in industries with high fixed costs, such as telecommunications equip- ment, offshore drilling, and bulk chemicals. High fixed costs and low marginal costs amplify the pressure on rivals to keep capacity filled through discounting.
- The industry’s products are standardized or undifferentiated. If buyers believe they can always find an equivalent product, they tend to play one vendor against another.
- Buyers face few switching costs in chang- ing vendors.
- Buyers can credibly threaten to integrate backward and produce the industry’s product themselves if vendors are too profitable. Pro- ducers of soft drinks and beer have long con- trolled the power of packaging manufacturers by threatening to make, and at times actually making, packaging materials themselves. A buyer group is price sensitive if:
- The product it purchases from the indus- try represents a significant fraction of its cost structure or procurement budget. Here buyers are likely to shop around and bargain hard, as consumers do for home mortgages. Where the product sold by an industry is a small fraction of buyers’ costs or expenditures, buyers are usu- ally less price sensitive.
- The buyer group earns low profits, is strapped for cash, or is otherwise under pres- sure to trim its purchasing costs. Highly profit- able or cash-rich customers, in contrast, are generally less price sensitive (that is, of course, if the item does not represent a large fraction of their costs).
- The quality of buyers’ products or services is little affected by the industry’s product. Where quality is very much affected by the in- dustry’s product, buyers are generally less price sensitive. When purchasing or renting produc- tion quality cameras, for instance, makers of major motion pictures opt for highly reliable equipment with the latest features. They pay limited attention to price.
- The industry’s product has little effect on the buyer’s other costs. Here, buyers focus on price. Conversely, where an industry’s product or service can pay for itself many times over by improving performance or reducing labor, ma- terial, or other costs, buyers are usually more interested in quality than in price. Examples in- clude products and services like tax accounting or well logging (which measures below-ground
Industry structure drives
competition and
profitability, not whether
an industry is emerging
or mature, high tech or
low tech, regulated or
unregulated.
have major impacts on industry profitability. Of course the substitution threat can also shift in favor of an industry, which bodes well for its future profitability and growth potential. Rivalry among existing competitors. Rivalry among existing competitors takes many famil- iar forms, including price discounting, new product introductions, advertising campaigns, and service improvements. High rivalry limits the profitability of an industry. The degree to which rivalry drives down an industry’s profit potential depends, first, on the intensity with which companies compete and, second, on the basis on which they compete. The intensity of rivalry is greatest if:
- Competitors are numerous or are roughly equal in size and power. In such situations, ri- vals find it hard to avoid poaching business. Without an industry leader, practices desirable for the industry as a whole go unenforced.
- Industry growth is slow. Slow growth pre- cipitates fights for market share.
- Exit barriers are high. Exit barriers, the flip side of entry barriers, arise because of such things as highly specialized assets or manage- ment’s devotion to a particular business. These barriers keep companies in the market even though they may be earning low or negative re- turns. Excess capacity remains in use, and the profitability of healthy competitors suffers as the sick ones hang on.
- Rivals are highly committed to the busi- ness and have aspirations for leadership, espe- cially if they have goals that go beyond eco- nomic performance in the particular industry. High commitment to a business arises for a va- riety of reasons. For example, state-owned com- petitors may have goals that include employ- ment or prestige. Units of larger companies may participate in an industry for image rea- sons or to offer a full line. Clashes of personality and ego have sometimes exaggerated rivalry to the detriment of profitability in fields such as the media and high technology.
- Firms cannot read each other’s signals well because of lack of familiarity with one another, diverse approaches to competing, or differing goals. The strength of rivalry reflects not just the intensity of competition but also the basis of competition. The dimensions on which compe- tition takes place, and whether rivals converge to compete on the same dimensions , have a major influence on profitability.
Rivalry is especially destructive to profitabil- ity if it gravitates solely to price because price competition transfers profits directly from an industry to its customers. Price cuts are usually easy for competitors to see and match, making successive rounds of retaliation likely. Sus- tained price competition also trains customers to pay less attention to product features and service. Price competition is most liable to occur if:
- Products or services of rivals are nearly identical and there are few switching costs for buyers. This encourages competitors to cut prices to win new customers. Years of airline price wars reflect these circumstances in that industry.
- Fixed costs are high and marginal costs are low. This creates intense pressure for competi- tors to cut prices below their average costs, even close to their marginal costs, to steal incre- mental customers while still making some con- tribution to covering fixed costs. Many basic- materials businesses, such as paper and alumi- num, suffer from this problem, especially if de- mand is not growing. So do delivery companies with fixed networks of routes that must be served regardless of volume.
- Capacity must be expanded in large incre- ments to be efficient. The need for large capac- ity expansions, as in the polyvinyl chloride busi- ness, disrupts the industry’s supply-demand balance and often leads to long and recurring periods of overcapacity and price cutting.
- The product is perishable. Perishability creates a strong temptation to cut prices and sell a product while it still has value. More prod- ucts and services are perishable than is com- monly thought. Just as tomatoes are perishable because they rot, models of computers are per- ishable because they soon become obsolete, and information may be perishable if it diffuses rapidly or becomes outdated, thereby losing its value. Services such as hotel accommodations are perishable in the sense that unused capacity can never be recovered. Competition on dimensions other than price—on product features, support services, delivery time, or brand image, for instance—is less likely to erode profitability because it im- proves customer value and can support higher prices. Also, rivalry focused on such dimen- sions can improve value relative to substitutes or raise the barriers facing new entrants. While nonprice rivalry sometimes escalates to levels
Rivalry is especially
destructive to
profitability if it
gravitates solely to price
because price
competition transfers
profits directly from an
industry to its customers.
that undermine industry profitability, this is less likely to occur than it is with price rivalry. As important as the dimensions of rivalry is whether rivals compete on the same dimen- sions. When all or many competitors aim to meet the same needs or compete on the same attributes, the result is zero-sum competition. Here, one firm’s gain is often another’s loss, driving down profitability. While price compe- tition runs a stronger risk than nonprice com- petition of becoming zero sum, this may not happen if companies take care to segment their markets, targeting their low-price offer- ings to different customers. Rivalry can be positive sum, or actually in- crease the average profitability of an industry, when each competitor aims to serve the needs of different customer segments, with different mixes of price, products, services, features, or brand identities. Such competition can not only support higher average profitability but also expand the industry, as the needs of more customer groups are better met. The opportu- nity for positive-sum competition will be greater in industries serving diverse customer groups. With a clear understanding of the structural underpinnings of rivalry, strategists can sometimes take steps to shift the nature of competition in a more positive direction.
Factors, Not Forces
Industry structure, as manifested in the strength of the five competitive forces, deter- mines the industry’s long-run profit potential because it determines how the economic value created by the industry is divided—how much is retained by companies in the industry versus bargained away by customers and sup- pliers, limited by substitutes, or constrained by potential new entrants. By considering all five forces, a strategist keeps overall structure in mind instead of gravitating to any one ele- ment. In addition, the strategist’s attention re- mains focused on structural conditions rather than on fleeting factors. It is especially important to avoid the com- mon pitfall of mistaking certain visible at- tributes of an industry for its underlying struc- ture. Consider the following: Industry growth rate. A common mistake is to assume that fast-growing industries are al- ways attractive. Growth does tend to mute ri- valry, because an expanding pie offers oppor- tunities for all competitors. But fast growth
can put suppliers in a powerful position, and high growth with low entry barriers will draw in entrants. Even without new entrants, a high growth rate will not guarantee profitability if customers are powerful or substitutes are at- tractive. Indeed, some fast-growth businesses, such as personal computers, have been among the least profitable industries in recent years. A narrow focus on growth is one of the major causes of bad strategy decisions. Technology and innovation. Advanced tech- nology or innovations are not by themselves enough to make an industry structurally at- tractive (or unattractive). Mundane, low-tech- nology industries with price-insensitive buy- ers, high switching costs, or high entry barriers arising from scale economies are often far more profitable than sexy industries, such as software and internet technologies, that at- tract competitors.^2 Government. Government is not best un- derstood as a sixth force because government involvement is neither inherently good nor bad for industry profitability. The best way to understand the influence of government on competition is to analyze how specific govern- ment policies affect the five competitive forces. For instance, patents raise barriers to entry, boosting industry profit potential. Con- versely, government policies favoring unions may raise supplier power and diminish profit potential. Bankruptcy rules that allow failing companies to reorganize rather than exit can lead to excess capacity and intense rivalry. Government operates at multiple levels and through many different policies, each of which will affect structure in different ways. Complementary products and services. Complements are products or services used to- gether with an industry’s product. Comple- ments arise when the customer benefit of two products combined is greater than the sum of each product’s value in isolation. Computer hardware and software, for instance, are valu- able together and worthless when separated. In recent years, strategy researchers have highlighted the role of complements, espe- cially in high-technology industries where they are most obvious.^3 By no means, however, do complements appear only there. The value of a car, for example, is greater when the driver also has access to gasoline stations, roadside assis- tance, and auto insurance. Complements can be important when they
performance comparisons in one direction or the other. The earliest microwave ovens, for example, were large and priced above $2,000, making them poor substitutes for conven- tional ovens. With technological advances, they became serious substitutes. Flash com- puter memory has improved enough recently to become a meaningful substitute for low-ca- pacity hard-disk drives. Trends in the availabil- ity or performance of complementary produc- ers also shift the threat of substitutes. New bases of rivalry. Rivalry often intensi- fies naturally over time. As an industry ma- tures, growth slows. Competitors become more alike as industry conventions emerge, technology diffuses, and consumer tastes con- verge. Industry profitability falls, and weaker competitors are driven from the business. This story has played out in industry after industry; televisions, snowmobiles, and telecommunica- tions equipment are just a few examples. A trend toward intensifying price competi- tion and other forms of rivalry, however, is by no means inevitable. For example, there has been enormous competitive activity in the U.S. casino industry in recent decades, but most of it has been positive-sum competition directed toward new niches and geographic segments (such as riverboats, trophy properties, Native American reservations, international expan- sion, and novel customer groups like families). Head-to-head rivalry that lowers prices or boosts the payouts to winners has been lim- ited. The nature of rivalry in an industry is al- tered by mergers and acquisitions that intro- duce new capabilities and ways of competing. Or, technological innovation can reshape ri- valry. In the retail brokerage industry, the ad- vent of the internet lowered marginal costs and reduced differentiation, triggering far more intense competition on commissions and fees than in the past. In some industries, companies turn to merg- ers and consolidation not to improve cost and quality but to attempt to stop intense competi- tion. Eliminating rivals is a risky strategy, how- ever. The five competitive forces tell us that a profit windfall from removing today’s competi- tors often attracts new competitors and back- lash from customers and suppliers. In New York banking, for example, the 1980s and 1990s saw escalating consolidations of commercial and savings banks, including Manufacturers
Hanover, Chemical, Chase, and Dime Savings. But today the retail-banking landscape of Man- hattan is as diverse as ever, as new entrants such as Wachovia, Bank of America, and Wash- ington Mutual have entered the market.
Implications for Strategy
Understanding the forces that shape industry competition is the starting point for develop- ing strategy. Every company should already know what the average profitability of its in- dustry is and how that has been changing over time. The five forces reveal why industry prof- itability is what it is. Only then can a company incorporate industry conditions into strategy. The forces reveal the most significant aspects of the competitive environment. They also pro- vide a baseline for sizing up a company’s strengths and weaknesses: Where does the company stand versus buyers, suppliers, en- trants, rivals, and substitutes? Most impor- tantly, an understanding of industry structure guides managers toward fruitful possibilities for strategic action, which may include any or all of the following: positioning the company to better cope with the current competitive forces; anticipating and exploiting shifts in the forces; and shaping the balance of forces to cre- ate a new industry structure that is more favor- able to the company. The best strategies ex- ploit more than one of these possibilities. Positioning the company. Strategy can be viewed as building defenses against the com- petitive forces or finding a position in the in- dustry where the forces are weakest. Consider, for instance, the position of Paccar in the mar- ket for heavy trucks. The heavy-truck industry is structurally challenging. Many buyers oper- ate large fleets or are large leasing companies, with both the leverage and the motivation to drive down the price of one of their largest purchases. Most trucks are built to regulated standards and offer similar features, so price competition is rampant. Capital intensity causes rivalry to be fierce, especially during the recurring cyclical downturns. Unions exer- cise considerable supplier power. Though there are few direct substitutes for an 18- wheeler, truck buyers face important substi- tutes for their services, such as cargo delivery by rail. In this setting, Paccar, a Bellevue, Washing- ton–based company with about 20% of the North American heavy-truck market, has cho-
Eliminating rivals is a
risky strategy. A profit
windfall from removing
today’s competitors often
attracts new competitors
and backlash from
customers and suppliers.
sen to focus on one group of customers: owner- operators—drivers who own their trucks and contract directly with shippers or serve as sub- contractors to larger trucking companies. Such small operators have limited clout as truck buyers. They are also less price sensitive be- cause of their strong emotional ties to and eco- nomic dependence on the product. They take great pride in their trucks, in which they spend most of their time. Paccar has invested heavily to develop an array of features with owner-operators in mind: luxurious sleeper cabins, plush leather seats, noise-insulated cabins, sleek exterior styl- ing, and so on. At the company’s extensive net- work of dealers, prospective buyers use soft- ware to select among thousands of options to put their personal signature on their trucks. These customized trucks are built to order, not to stock, and delivered in six to eight weeks. Paccar’s trucks also have aerodynamic designs that reduce fuel consumption, and they main- tain their resale value better than other trucks. Paccar’s roadside assistance program and IT- supported system for distributing spare parts reduce the time a truck is out of service. All these are crucial considerations for an owner- operator. Customers pay Paccar a 10% pre- mium, and its Kenworth and Peterbilt brands are considered status symbols at truck stops. Paccar illustrates the principles of position- ing a company within a given industry struc- ture. The firm has found a portion of its indus- try where the competitive forces are weaker— where it can avoid buyer power and price- based rivalry. And it has tailored every single part of the value chain to cope well with the forces in its segment. As a result, Paccar has been profitable for 68 years straight and has earned a long-run return on equity above 20%. In addition to revealing positioning opportu- nities within an existing industry, the five forces framework allows companies to rigor- ously analyze entry and exit. Both depend on answering the difficult question: “What is the potential of this business?” Exit is indicated when industry structure is poor or declining and the company has no prospect of a superior positioning. In considering entry into a new in- dustry, creative strategists can use the frame- work to spot an industry with a good future before this good future is reflected in the prices of acquisition candidates. Five forces analysis may also reveal industries that are not
necessarily attractive for the average entrant but in which a company has good reason to be- lieve it can surmount entry barriers at lower cost than most firms or has a unique ability to cope with the industry’s competitive forces. Exploiting industry change. Industry changes bring the opportunity to spot and claim prom- ising new strategic positions if the strategist has a sophisticated understanding of the com- petitive forces and their underpinnings. Con- sider, for instance, the evolution of the music industry during the past decade. With the ad- vent of the internet and the digital distribu- tion of music, some analysts predicted the birth of thousands of music labels (that is, record companies that develop artists and bring their music to market). This, the analysts argued, would break a pattern that had held since Edison invented the phonograph: Be- tween three and six major record companies had always dominated the industry. The inter- net would, they predicted, remove distribu- tion as a barrier to entry, unleashing a flood of new players into the music industry. A careful analysis, however, would have re- vealed that physical distribution was not the crucial barrier to entry. Rather, entry was barred by other benefits that large music labels enjoyed. Large labels could pool the risks of de- veloping new artists over many bets, cushion- ing the impact of inevitable failures. Even more important, they had advantages in break- ing through the clutter and getting their new artists heard. To do so, they could promise radio stations and record stores access to well- known artists in exchange for promotion of new artists. New labels would find this nearly impossible to match. The major labels stayed the course, and new music labels have been rare. This is not to say that the music industry is structurally unchanged by digital distribution. Unauthorized downloading created an illegal but potent substitute. The labels tried for years to develop technical platforms for digital distri- bution themselves, but major companies hesi- tated to sell their music through a platform owned by a rival. Into this vacuum stepped Apple with its iTunes music store, launched in 2003 to support its iPod music player. By per- mitting the creation of a powerful new gate- keeper, the major labels allowed industry structure to shift against them. The number of major record companies has actually de-
Using the five forces
framework, creative
strategists may be able to
spot an industry with a
good future before this
good future is reflected in
the prices of acquisition
candidates.
determine which force or forces are currently constraining industry profitability and address them. A company can potentially influence all of the competitive forces. The strategist’s goal here is to reduce the share of profits that leak to suppliers, buyers, and substitutes or are sac- rificed to deter entrants. To neutralize supplier power, for example, a firm can standardize specifications for parts to make it easier to switch among suppliers. It can cultivate additional vendors, or alter tech- nology to avoid a powerful supplier group alto- gether. To counter customer power, companies may expand services that raise buyers’ switch- ing costs or find alternative means of reaching customers to neutralize powerful channels. To temper profit-eroding price rivalry, companies can invest more heavily in unique products, as pharmaceutical firms have done, or expand support services to customers. To scare off en- trants, incumbents can elevate the fixed cost of competing—for instance, by escalating their R&D or marketing expenditures. To limit the threat of substitutes, companies can offer bet- ter value through new features or wider prod- uct accessibility. When soft-drink producers in- troduced vending machines and convenience store channels, for example, they dramatically improved the availability of soft drinks relative
to other beverages. Sysco, the largest food-service distributor in North America, offers a revealing example of how an industry leader can change the struc- ture of an industry for the better. Food-service distributors purchase food and related items from farmers and food processors. They then warehouse and deliver these items to restau- rants, hospitals, employer cafeterias, schools, and other food-service institutions. Given low barriers to entry, the food-service distribution industry has historically been highly frag- mented, with numerous local competitors. While rivals try to cultivate customer relation- ships, buyers are price sensitive because food represents a large share of their costs. Buyers can also choose the substitute approaches of purchasing directly from manufacturers or using retail sources, avoiding distributors alto- gether. Suppliers wield bargaining power: They are often large companies with strong brand names that food preparers and consum- ers recognize. Average profitability in the in- dustry has been modest. Sysco recognized that, given its size and na- tional reach, it might change this state of af- fairs. It led the move to introduce private-label distributor brands with specifications tailored to the food-service market, moderating sup- plier power. Sysco emphasized value-added services to buyers such as credit, menu plan- ning, and inventory management to shift the basis of competition away from just price. These moves, together with stepped-up invest- ments in information technology and regional distribution centers, substantially raised the bar for new entrants while making the substi- tutes less attractive. Not surprisingly, the in- dustry has been consolidating, and industry profitability appears to be rising. Industry leaders have a special responsibility for improving industry structure. Doing so often requires resources that only large players possess. Moreover, an improved industry struc- ture is a public good because it benefits every firm in the industry, not just the company that initiated the improvement. Often, it is more in the interests of an industry leader than any other participant to invest for the common good because leaders will usually benefit the most. Indeed, improving the industry may be a leader’s most profitable strategic opportunity, in part because attempts to gain further mar- ket share can trigger strong reactions from ri-
Typical Steps in Industry Analysis
Define the relevant industry:
- What products are in it? Which ones are part of another distinct indus- try? - What is the geographic scope of competition?
Identify the participants and segment them into groups, if appropriate: Who are
- the buyers and buyer groups? - the suppliers and supplier groups? - the competitors? - the substitutes? - the potential entrants?
Assess the underlying drivers of each competitive force to determine which forces are strong and which are weak and why.
Determine overall industry structure, and test the analysis for consistency:
- Why is the level of profitability what it is? - Which are the controlling forces for profitability? - Is the industry analysis consistent with actual long-run profitability? - Are more-profitable players better positioned in relation to the five forces?
Analyze recent and likely future changes in each force, both positive and negative.
Identify aspects of industry structure that might be influenced by competitors, by new entrants, or by your company.
vals, customers, and even suppliers. There is a dark side to shaping industry structure that is equally important to under- stand. Ill-advised changes in competitive posi- tioning and operating practices can undermine industry structure. Faced with pressures to gain market share or enamored with innova- tion for its own sake, managers may trigger new kinds of competition that no incumbent can win. When taking actions to improve their own company’s competitive advantage, then, strategists should ask whether they are setting in motion dynamics that will undermine indus- try structure in the long run. In the early days of the personal computer industry, for in- stance, IBM tried to make up for its late entry by offering an open architecture that would set industry standards and attract complementary makers of application software and peripher- als. In the process, it ceded ownership of the critical components of the PC—the operating system and the microprocessor—to Microsoft and Intel. By standardizing PCs, it encouraged price-based rivalry and shifted power to suppli- ers. Consequently, IBM became the tempo- rarily dominant firm in an industry with an en- duringly unattractive structure. Expanding the profit pool. When overall de- mand grows, the industry’s quality level rises, intrinsic costs are reduced, or waste is elimi- nated, the pie expands. The total pool of value available to competitors, suppliers, and buyers grows. The total profit pool expands, for exam- ple, when channels become more competitive or when an industry discovers latent buyers for its product that are not currently being served. When soft-drink producers rational- ized their independent bottler networks to make them more efficient and effective, both the soft-drink companies and the bottlers ben- efited. Overall value can also expand when firms work collaboratively with suppliers to improve coordination and limit unnecessary costs incurred in the supply chain. This lowers the inherent cost structure of the industry, al- lowing higher profit, greater demand through lower prices, or both. Or, agreeing on quality standards can bring up industrywide quality and service levels, and hence prices, benefiting rivals, suppliers, and customers. Expanding the overall profit pool creates win-win opportunities for multiple industry participants. It can also reduce the risk of de- structive rivalry that arises when incumbents
attempt to shift bargaining power or capture more market share. However, expanding the pie does not reduce the importance of industry structure. How the expanded pie is divided will ultimately be determined by the five forces. The most successful companies are those that expand the industry profit pool in ways that allow them to share disproportionately in the benefits. Defining the industry. The five competitive forces also hold the key to defining the rele- vant industry (or industries) in which a com- pany competes. Drawing industry boundaries correctly, around the arena in which competi- tion actually takes place, will clarify the causes of profitability and the appropriate unit for setting strategy. A company needs a separate strategy for each distinct industry. Mistakes in industry definition made by competitors present opportunities for staking out superior strategic positions. (See the sidebar “Defining the Relevant Industry.”)
Competition and Value
The competitive forces reveal the drivers of in- dustry competition. A company strategist who understands that competition extends well be- yond existing rivals will detect wider competi- tive threats and be better equipped to address them. At the same time, thinking comprehen- sively about an industry’s structure can un- cover opportunities: differences in customers, suppliers, substitutes, potential entrants, and rivals that can become the basis for distinct strategies yielding superior performance. In a world of more open competition and relent- less change, it is more important than ever to think structurally about competition. Understanding industry structure is equally important for investors as for managers. The five competitive forces reveal whether an in- dustry is truly attractive, and they help inves- tors anticipate positive or negative shifts in in- dustry structure before they are obvious. The five forces distinguish short-term blips from structural changes and allow investors to take advantage of undue pessimism or optimism. Those companies whose strategies have indus- try-transforming potential become far clearer. This deeper thinking about competition is a more powerful way to achieve genuine invest- ment success than the financial projections and trend extrapolation that dominate today’s investment analysis.
Common Pitfalls
In conducting the analysis avoid the following common mistakes:
- Defining the industry too broadly or too narrowly. - Making lists instead of engaging in rigorous analysis. - Paying equal attention to all of the forces rather than digging deeply into the most important ones. - Confusing effect (price sensitiv- ity) with cause (buyer econom- ics). - Using static analysis that ignores industry trends. - Confusing cyclical or transient changes with true structural changes. - Using the framework to declare an industry attractive or unat- tractive rather than using it to guide strategic choices.
The Five Competitive Forces That Shape
Strategy
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Further Reading A R T I C L E What Is Strategy? by Michael E. Porter Harvard Business Review February 2000 Product no. 4134 By analyzing the five competitive forces, you uncover opportunities to position your com- pany strategically; that is, to gain a sustainable advantage over rivals by preserving what’s distinctive about your company. Your strategic position hinges on performing different activi- ties from competitors or performing similar activities, but in different ways. It emerges from three sources: 1) serving few needs of many customers (for example, Jiffy Lube pro- vides only auto lubricants), 2) serving broad needs of few customers (Bessemer Trust tar- gets only very high-wealth clients), or 3) serv- ing broad needs of many customers in a nar- row market (Carmike Cinemas operates only in cities with a population under 200,000). B O O K S Redefining Health Care: Creating Value- Based Competition on Results by Michael E. Porter and Elizabeth Olmsted Teisberg Harvard Business School Press May 2006 Product no. 7782 In this book Porter and Teisberg analyze the competitive forces responsible for the current crisis in U.S. health care. The authors argue that participants in the health care system have competed to shift costs, accumulate bar- gaining power, and restrict services rather than create value for patients. This zero-sum competition takes place at the wrong level— among health plans, networks, and hospi- tals—rather than where it matters most: in the diagnosis, treatment, and prevention of spe- cific health conditions. Redefining Health Care lays out a breakthrough framework for rede- fining health care competition based on pa- tient value. With specific recommendations
for hospitals, doctors, health plans, employers, and policy makers, this book shows how to move to a positive-sum competition that will unleash stunning improvements in quality and efficiency. On Competition by Michael E. Porter Harvard Business School Press September 1998 Product no. 7951 Porter’s work, which began with his original formulation of the five forces, has defined our fundamental understanding of competition and competitive strategy. This book is a com- pilation of a dozen Porter articles: two new ar- ticles and ten of his articles from Harvard Busi- ness Review. Together, these essays provide a complete picture of Porter’s perspective on modern competition. Organized around three primary categories: Competition and Strategy: Core Concepts, The Competitiveness of Loca- tion, and Competitive Solutions to Societal Problems, these articles develop the building blocks that define competitive strategy.
