Porter’s five forces

What it means

Porter’s five forces is a frame for judging an industry, not a company. What sets the profitability of a market is rivalry among existing players, the threat of new entrants, the threat of substitutes and the bargaining power of suppliers and buyers.

It differs from a SWOT analysis in rating not your strengths but the structure of the market you stand in, and from a PEST analysis in looking at competitive relations inside an industry rather than the macro setting around it.

The result depends on how narrowly the industry is drawn. For a café on a housing estate the rival is another café on the same street, not the whole city’s food trade; draw it too wide and the conclusions turn generic, too narrow and substitutes slip past, such as petrol-station coffee or a capsule machine in the office.

How it works in practice

In practice it goes into the business plan for a bank or an investor, who want to know what stops someone else taking the margin. Each force is described with facts: how many suppliers, what share the largest customer holds, what switching costs.

Pricing and the value proposition both follow from the analysis. If entry is cheap and customers switch for nothing, competing on price is pointless and the company has to build on something harder to copy.

Some of the facts for the analysis sit in the books already. The open-items ledger shows the share of the largest customers and suppliers and their payment terms; a supplier shortening terms while a customer stretches them is bargaining power measured in days the company finances out of its own pocket.

What to watch out for

The usual mistake is doing the analysis once, as an annex to a loan application. A company where one customer makes up most of revenue pays for that buyer’s bargaining power out of its margin at renewal, while the fixed costs stay exactly where they were.

The second mistake is looking for substitutes only among similar products. An accounting firm is replaced not just by another firm but by accounting software that processes documents automatically; a business that misses this loses its smaller clients without ever seeing a competitor.