External Analysis: Porter’s Five Forces (1/5)
Analyzing a business situation typically involves examining both the external environment and a company’s internal capabilities. In this session, we’ll begin by exploring frameworks specifically designed to assess the external environment.
Why the External Environment Matters
Understanding external factors—especially the competitive landscape—is essential for achieving long-term success. To illustrate this, let’s look at two quick examples.
The Cupcake Boom
After a brief feature in Sex and the City, cupcakes became a trendy business idea. Many rushed to open shops—but most struggled. Why? Fierce competition made survival tough.
IBM’s Exit from Personal PCs
IBM sold its ThinkPad line to Lenovo after predicting tougher competition and shrinking profit margins in the personal PC industry. Instead, IBM shifted its focus to more profitable areas such as cloud computing, data analytics, and enterprise services. It was a strategic and bold move based on a clear understanding of external environment.
Porter’s Five Forces: A Framework for External Competitive Analysis
One of the most widely used tools for assessing external competition is Porter’s Five Forces, developed by Michael E. Porter, a professor at Harvard Business School. This framework identifies five forces that shape the competitive landscape:
| Force | Description |
|---|---|
| 1. Competitive Rivalry | The intensity of competition among existing players in the same industry. |
| 2. Threat of New Entrants | The risk that new firms will enter the market and erode profits. |
| 3. Threat of Substitutes | The possibility that different industries or solutions could fulfill the same customer need. |
| 4. Bargaining Power of Suppliers | The influence suppliers have to raise prices or reduce the quality of goods and services. |
| 5. Bargaining Power of Buyers | The pressure customers can exert to lower prices or demand better service. |
1st Force: Competitive Rivalry
The first force is competitive rivalry, which assesses how fiercely firms compete within an industry. A key part of this analysis is determining whether that rivalry is destructive—where competition becomes so intense that it erodes profit margins across the board.
Recognizing destructive rivalry is quite challenging, especially from an outsider’s perspective. To more systematically determine whether rivalry is destructive, analysts often rely on specific warning signs:
- Low Industry Concentration: When an industry has many small players and no dominant firms, competition tends to be more intense. A common benchmark is whether the top 3 or 4 companies control over 50% of market share. If they do, the industry is considered concentrated and less prone to destructive rivalry. If not, it often signals a fragmented and highly competitive market.
- Low Product Differentiation: When products are largely interchangeable, firms are forced to compete mainly on price, squeezing margins.
- Shrinking Market Size: As demand declines, companies fight harder for a smaller customer base, often triggering price cuts and margin erosion.
- High Exit Barriers: If firms can’t leave the industry easily due to high sunk costs or regulatory constraints, they may continue operating despite losses—intensifying competition.
In reality, very few industries are entirely free from these warning signs. Assessing whether rivalry is truly destructive requires a comprehensive evaluation of these factors, and different analysts may reach different conclusions based on their insights and assumptions.
A Case in Point: Telecommunications
Consider the telecommunications industry. It is highly concentrated—a positive signal for profit margins. However, its services are often seen as difficult to differentiate, and demand appears saturated—a negative indicator. Determining whether this industry experiences destructive rivalry is not straightforward, as each factor points in a different direction.
Some may conclude that the industry does exhibit destructive rivalry due to its limited differentiation and stagnant demand. Others, however, might argue that this industry does not reflect destructive rivalry, since opportunities for differentiation still exist—through bundled offerings like streaming services (e.g., Disney+), cloud storage, or other value-added features. Furthermore, the demand landscape could expand with the growth of 5G applications in areas such as autonomous vehicles and smart cities.
In short, the evaluation of destructive rivalry can vary depending on how an analyst defines the market, identifies differentiation opportunities, and interprets future growth potential.
Strategic Responses to Destructive Rivalry
Whenever possible, it’s wise to enter industries with healthy margins and stable competitive dynamics. However, if operating in a market with destructive rivalry is unavoidable, companies must adopt deliberate strategies to survive and compete effectively:
- Cost Leadership: Improve efficiency through AI, automation, or process optimization to stay profitable despite pricing pressure.
- Product Differentiation: Offer unique value to shift customer focus away from price.
- Brand Loyalty: Build strong customer relationships to reduce price sensitivity and encourage repeat business.
Implementing these strategies in a highly competitive environment is challenging but essential. Success depends on a continuous effort to optimize costs, differentiate offerings, and strengthen customer loyalty—key pillars for long-term competitiveness and sustainable growth.
More about Porter’s five forces