How do the five forces of competition in an industry affect its profitability potential explain?

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Industry analysis—also known as Porter’s Five Forces Analysis—is a very useful tool for business strategists. It is based on the observation that profit margins vary between industries, which can be explained by the structure of an industry.

The Five Forces primary purpose is to determine the attractiveness of an industry. However, the analysis also provides a starting point for formulating strategy and understanding the competitive landscape in which a company operates.

Porter’s Five Forces Analysis

The framework for the Five Forces Analysis consists of these competitive forces:

• Industry rivalry (degree of competition among existing firms)—intense competition leads to reduced profit potential for companies in the same industry
• Threat of substitutes (products or services)—availability of substitute products will limit your ability to raise prices
• Bargaining power of buyers—powerful buyers have a significant impact on prices
• Bargaining power of suppliers—powerful suppliers can demand premium prices and limit your profit
• Barriers to entry (threat of new entrants)—act as a deterrent against new competitors

Industry analysis and competition

Competition within an industry is grounded in its underlying economic structure. It goes beyond the behaviour of current competitors.

The state of competition in an industry depends upon five basic competitive forces. The collective strength of these forces determines profit potential in the industry. Profit potential is measured

in terms of long-term return on invested capital. Different industries have different profit potential—just as the collective strength of the five forces differs between industries.

Industry analysis as a tool to develop a competitive strategy

Industry analysis enables a company to develop a competitive strategy that best defends against the competitive forces or influences them in its favour. The key to developing a competitive strategy is to understand the sources of the competitive forces. By developing an understanding of these competitive forces, the company can:

• Highlight the company’s critical strengths and weaknesses (SWOT analysis)
• Animate its position in the industry
• Clarify areas where strategic changes will result in the greatest payoffs
• Emphasize areas where industry trends indicate the greatest significance as either opportunities or threats

Industry analysis and structure

The five competitive forces reveal that competition extends beyond current competitors. Customers, suppliers, substitutes and potential entrants—collectively referred to as an extended rivalry—are competitors to companies within an industry.

The five competitive forces jointly determine the strength of industry competition and profitability. The strongest force (or forces) rules and should be the focal point of any industry analysis and resulting competitive strategy.

Short-term factors that affect competition and profitability should be distinguished from the competitive forces that form the underlying structure of an industry. Although these short-term factors may have some tactical significance, analysis should focus on the industry’s underlying characteristics.

Read next: Barriers to entry: Factors preventing startups from entering a market

References

Porter, M. (1998). Competitive Strategy. New York: Free Press, pp. 3-5.

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