Refining Porter's Five Forces

Refining Porter’s Five Forces

I wrote this during the summer of 2013 but didn’t publish it because it seemed a little heavy on the analytics even for my blog. However, I ended up submitting it to the Marriott Student Review and it got published. Since they don’t have an online version, I figured that was sufficient justification to share it here so you can all enjoy. Only this post was submitted to the journal, not the “Further Examples” post that acts as an appendage to this one.

Now that I’ve taken 2 more advanced strategy classes and gotten more experience, this whole thing seems a tad silly, but not entirely unusable. I think it can at least be useful to starting students of strategy to get an idea of certain things to look out for.

Porter’s Five Forces

Back in 1979, a man named Michael Porter came up with a framework for analyzing the attractiveness of an industry in business.  The framework looked at 5 forces that act on an industry to affect its profitability, so it was logically named Porter’s Five Forces.

This was a bit of a breakthrough for its time since it helped business leaders zoom out from looking exclusively at their direct competitors when analyzing their industry.  Specifically, it taught them to look at:

1. Internal Rivalry
2. Buyer Power
3. Supplier Power
4. Threat of Entry
5. Threat of Substitution

This video, developed at BYU with the help of Jeff Dyer, does a great job explaining the five forces quickly and with more detail if you’re not yet familiar with them.

Although it was a breakthrough insight, many have happily pointed out its shortcoming and flaws over the last 30 years.  I did some searching and came up with a list of some of the most popular problems with the framework:

1. It ignores the possibility of compliments.  For example, when people buy more peanut butter, they also buy more jelly.  When doing an analysis on the jelly market, the Five Forces would miss that relationship.
2. It misses non-business influences.  Basically, everything found in a PEST analysis (Political, Economic, Social, Technological) gets missed in this framework.
3. It requires users to look at an industry sector in isolation, losing possible synergies that come from being part of the larger industry.  For example, the guitar industry is part of the larger music industry.
4. The Five Forces must be looked at independently for each industry a company participates in.  This can be difficult for large, multi-national firms that span multiple industries, like Yamaha or Berkshire Hathaway.
5. The Five Forces doesn’t allow for the possibility of creating a new market.  Things like tablet computers originally would have been analyzed as part of the same industry as laptops or portable music devices where we could now run an analysis for the tablet computer market on its own.
6. The Five Forces assumes that uncertainty is low in whatever market you’re analyzing.  If you did an analysis on the horse-and-buggy market the day before automobiles got big, you would have thought the industry was extremely attractive and would be lucrative forevermore.
7. The sources of strategic advantage in the Five Forces comes almost exclusively from industry structure creating barriers to entry.  An industry will only be attractive if the risk of others moving in on your turf in one way or another is low.
8. The Five Forces assumes that buyers, suppliers and competitors don’t interact or collude.  Such as when Intel ran their Intel Inside campaign.  Intel was a supplier to PC makers that interacted with the buyers of the PC makers to squeeze them.  I actually don’t think the Five Forces misses this point, since that simply contributed to greater supplier power in a different way than normal.
9. The Five Forces doesn’t connect very obviously with management action, especially when companies can have little influence over the forces.
10. It sets “industries” as entities with clearly defined boundaries.  Especially now, industries are getting increasingly complicated and interconnected with other things.
11. It doesn’t adequately address the influence that capital markets have due to the incredible changes the capital market has undergone since the creation of the Five Forces.  For example, various private equity strategies impact the threat of entry.

For more information about some of the shortcomings of the Five Forces, you can check out these articles:

From WikiCFO

From WikiAnswers

From YahooVoices

From an academic article from 2006

From an article in Ivy Business Journal in 2012

So Fix It

It was easy to find criticisms of the model, but except for the academic article from 2006, I didn’t find much in terms of improving or refining it.  Some suggested using it as part of other analysis, such as the SWOT analysis (Strengths, Weaknesses, Opportunities, Threats) or others, but one of the nice things about the Five Forces is that it provided a nice, simple laundry list of things to look for in an industry.  I figured it might be fun to look into just taking all the relevant forces that others have listed and sticking them together with a few added ways of conducting an analysis.  This way, the forces are in one spot, measured the same way.

The framework below covers problems 1 through 6, 8, and 10, though it seems like 8 and 11 can be addressed in the Five Forces framework as long as their effects on the power relationships are addressed during the analysis.

The Framework

The first thing I thought would be useful in refining the framework was splitting out the “opportunities” from the “threats.”  The Five Forces only addresses threats in an industry (which is what caused it to miss including “compliments” from the analysis.)  Doing so creates a new list:

Opportunities

For alliances and cooperation among rivals
For entry into other markets
For power over buyers
For power over suppliers
For compliment products

Threats

Of rivalry within the industry
Of new entry into the industry
Of buyer power
Of supplier power
Of substitute products

What this give us so far is the start of a more nuanced SWOT analysis.  From here, we can add in the “other” forces that act on a business that we find in a PEST analysis.  Splitting these into opportunities and threats we end up with:

Opportunities

For government assistance
For economic expansion (as it relates to the specific industry.  Inferior goods will find their industry expands when the greater economy contracts.)
For social norm synergies
For technological complementary

Threats

Of government interference
Of economic contraction
Of social norm friction
Of technological disruption

Visual representation of the z-axis, making it
painfully obvious that I do my graphics in Powerpoint

This brings us to a list of nine different values to look at across the basis of opportunities and threats.  The final addition to the list is what I call the “z-axis” since I can’t really come up with anything better for it.  It refers to the interaction between other levels of the industry, such as the guitar industry and music industry example mentioned above.

Normally, when looking at different cross-sections of an industry, one would need to do different Five Forces analyses (see the picture to get a visual idea of this.)  Including the z-axis as a primary part of the analysis helps address not only the influences of sub- or super-industries have on the cross-section we analyze, but addresses the fact that industry boundaries can be somewhat fluid or fuzzy.  If something wasn’t included in the definition of the industry that should have been there, it may be caught in the z-axis portion of the analysis.

What to Measure

Now that we know the dimensions we’re measuring, the final piece is to establish what we should measure within each dimension.  Porter’s Five Forces measured the threat level of each force with a “high, moderate, low” hierarchy.  Since I’m splitting up the threats and opportunities, we wont be measuring the threats each time, but I think a “high, moderate, low” approach works well for opportunities as well.

To address the dynamism and uncertainty of the marketplace, I also decided to measure the perceived certainty of each measure as well.  By definition, we won’t know the uncertainty of the measure, but we can make educated guesses at where things might be more uncertain or where there is more risk of volatility toppling the industry.

In short, each dimension gets measured with a “high, moderate, low” level of strength, as well as a “high, moderate, low” level of expected uncertainty or volatility.

Some Examples

Let’s give it a shot and see how this might work.  I put all 10 indicators into a simple chart thusly:

Then, I added arrows and colors to indicate the strengths and uncertainty.  An up arrow indicates “high,” a down arrow “low,” and the sideways arrows indicate “moderate.”  To indicate the level of certainty, each arrow is either green for a “high” level of certainty (low expected volatility,) orange for a “moderate” level of certainty, and red for a “low” level of certainty (high expected volatility.)

Right now I’m in Peru evaluating an organization that’s working to help a village escape poverty.  The village is called the Ciudad de Noé (City of Noah) and one of the biggest industries there is the making and selling of Chicha.  Chicha is a slightly alcoholic drink made from yellow corn, supposedly a staple of Inca life.  Just about every other housewife in the city makes and sells Chicha, usually once every two weeks due to the amount of time it takes to make.

Let’s apply the framework to the Chicha market in the Ciudad de Noé.

Internal alliance/competition

There is actually great opportunity for alliances among the many rivals in Noe.  They already collude to make sure each person has an established day for selling their Chicha so that neighbors don’t overlap and compete on the same day.  With further alliances, they may be able to realize some economies of scale, gain some power over buyers and suppliers (the dimensions should overlap some,) and overall increase their margin.  This opportunity has a great deal of uncertainty however, since past efforts to create cooperatives in the town ended in bitter failure.

There’s also a huge and very certain amount of rivalry.  I would estimate that 50%-80% of households make and sell Chicha.  It’s extremely easy for customers to go to someone else if one person makes Chicha of low quality or tries to increase their prices.

Entry

The opportunity to enter other markets using Chicha as a foundation is reasonably high.  If they open a restaurant that includes Chicha as a beverage, they will be able to pull in many of the same customers they have now (experiencing some nice network effects for a commodity market.)  They could also experience synergies by integrating other portions of the corn growing or refining process, or offering a greater variety of beverage choices.

The threat of new entrants is also very high, as it seems to be the thing to do.  Whenever someone can’t find enough work, the solution is to start making and selling Chicha.  New entrants are fairly constant, and thus far, no one has established any effective barriers to entry or imitation.

Compliments/Substitutes

Inca heritage

Perhaps I just lack sufficient imagination, but I can’t think of any great compliments to Chicha.  There isn’t really anything that people buy with it, or any products that cause people to want or need more of it.  As such, the opportunity for compliments in the Chicha market is a certain low.

Substitutes however, get a solid “meh” for “moderate.”  Pretty much any digestible liquid could be used in place of Chicha’s refreshment properties, and there’s no shortage of alcoholic beverages to satisfy their desire for mild intoxication.  However, Chicha also does the job of making the people of Noe feel connected to their Inca heritage.  No soda (even Inca Cola) or German beer will get that job done for them.

Buyer Relations

The opportunity to gain bargaining power over buyers is pretty darn low, but there’s some level of uncertainty with regards to how long it can stay that way.  If the Chicha makers take the opportunity to form alliances and cooperatives, they may be able to gain some power over them in the future.  However, in the absence of such cooperation, the sheer number of Chicha providers caps the provider’s ability to gain any sort of leverage over the buyers.

The opportunities and threats with buyer and supplier relations tend to have a strong inverse relationship.  If the opportunity is low, the threat will tend to be high, and for the same reasons.  The Chicha market is no exception.

Supplier Relations

The opportunity to gain power over suppliers is also low due to the volume of Chicha makers.  The is a moderate level of uncertainty that this will perpetuate forever for the same reasons as listed in the “buyer relations” section.  This opportunity has even less hope however, since the main input is corn, and if the Chicha makers want to pay less for corn, they will have to compete with every other product that uses corn as an input that may be willing to pay a slightly higher price.  Chicha makers will need to form a collective large enough to purchase in ginormous quantities to gain some power over suppliers.

Government

There’s not a lot of hope that the government will do much to directly intervene and assist Chicha producers.  However, since the producers are nearly entirely from poor populations, there is a small chance that the government would aid the industry through other programs.  The NGO I’m evaluating, Eagle Condor, is helping Noe partly as a result of the government.  Soon, micro-loans will be distributed through Eagle Condor, much of which will go to increasing the productive ability of these Chicha producers.  It’s quite unsure how long this will continue, and the government’s participation is relatively marginal, but it’s there, and there may be potential for more aid to the Chicha business.

Being mostly ignored by the regional government, they don’t currently have a lot to worry about in terms of interference.  Government can be very volatile however, and as soon as the government decides to run harder health or sanitation checks on food products in businesses, Chicha producers will be hard hit.

Economic Effects

The economy currently isn’t great, but it is on an upswing.  As such, it earns a moderate opportunity rating as growth may come, but the Chicha market is still squeezed as a result of low incomes.  Since the Chicha market is a bit of a fringe luxury item, the effects of an economy with a fair amount of risk (especially after Bernanke’s recent announcement of plans to reduce its quantitative easing) on the Chicha market is fairly uncertain.

On the other hand, while opportunities are unsure, threats are even more uncertain for the future, but currently high.  Most Chicha customers are locals who share in the poverty of the region and there’s limited opportunities to sell to other entities.  Economic threats to the market are strong.

Social Norms

Chicha benefits from a long history of being part of the culture.  Of all the beverages the locals could make, they choose Chicha for the societal value that it holds.  As long as the village remains a relatively isolated unit, that tradition will likely stand.

Threats to the social norm are low.  Unless they all start joining the Mormon church and abstaining from alcohol, no one is likely to ostracize the use of Chicha.

Technology

It’s hard to say much about technological opportunities in the Chicha market.  There might be ways to advance the manufacturing process to make it cheaper, though its already pretty cheap.  Any advance in farming techniques in the region would help as well, though the area is a bit of a slow adapter to farming improvements.

In terms of threats, technology is equally uncertain and of a moderate risk.  Manufacturing advanes will quite possibly mean the consolidation of Chicha manufacturers into one entity, but perhaps not.  Better ways of distribution may cut the small businesses off from their clients, but no one seems to be in a rush to bring the drink to other customers.

Z-axis

Chicha is part of the larger industry of beverages and food.  There could be great opportunities for vertical integration of the production of corn and the distribution of beverages available through step-wise expansion.  Once other parts of the process are integrated into a single entity, earnings could be reinvested to expand further and start producing or refining corn for other purposes as well.  Other beverages may also be well integrated into the Chicha drink, opening up possibilities for variety in the product, and variety of offerings from the business.

There aren’t a ton of threats to this sector of the industry from other cross-sections, but as food and drink continually get bigger and better integrated, Chicha may get further squeezed by its competitors and other forms of substitution.  Even just getting clean, running water to the towns where Chicha is made may deeply impact the Chicha market.

Strategic Analysis of Strategic Analyses

So doing that analysis was fun for me, but in coming up with a framework, one needs to step back and look at the benefits and problems associated with it and understand the niche the framework covers.

In the case of Porter’s Five Forces, it did a great job being simple to understand, while expanding the scope of thought for business leaders.  It simply articulated and depicted other threats to take into account when looking at an industry.  It did not provide excellent tools for addressing the threats, nor did it provide a very in-depth analysis.  It also provided little value to an individual firm already in the industry.

The framework I used above sacrifices a fair amount of simplicity and ease.  After all, we went from 5 indicators to essentially 40 if you take all 10 indicators split into 2 categories receiving two measurements in each category.  The added complexity does, however, provide a slightly more holistic view of an industry, and quickly provides information as to how certain we expect the information to stay.  Doing this analysis didn’t take a ton longer than the Five Forces, and anyone already planning on doing a PEST or SWOT analysis in conjunction with each other might as well display them together.

The other issue is that a lot of this is fairly academic.  The Five Forces isn’t really used in practicality.  But it does provide some high level insight as to why companies do what they do.  In another post I have some additional examples of using this framework (this post is long enough without them) that can demonstrate a little more at how such a framework can be useful for getting one’s feet wet in an industry.

 

Keep seeking truth.


You may also be interested in:
Further Examples of the 10 Forces
Tips for Charitable Giving
Peru Post 4: The Work




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