Chapter 2 : Identifying Competitive Advantage (Porters 5 Forces Model)

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Porter's Five Forces Framework 

An business organization has to fully understand  the dynamics of its industries and markets in order to compete effectively and intensively in the marketplace. The forces which derive competition and attractiveness of a market, contending that the competitive environment is created by the interaction of these five different forces acting on a business. In addition to rivalry among existing firms and the threat of new entrants into the market, there are also the forces of supplier power, the power of buyers, and the threat of substitute products or services ( The Figure shown Porter's Five Forces Framework ). Michael E. Porter suggested that the intensity of competition is determined by the relative strengths of these forces. The Five Forces directly are interconnected with the effect on the company's ability.

Michael E. Porter

According to Porter’s Five Forces Model, if entry into a market is easy then rivalry is likely to be high. Considering McDonald’s competitive rivalry, there is intense competition in fast food industry that many small fast food businesses fight with each other to improve their customer base. This makes a competition the major focus between businesses. Although, McDonald’s, with more than 32,000 local restaurants serving more than 60 million people in 117 countries each day, has a number of fast food outlet competitors across the countries such as Burger King, Taco Bell, KFC, Wendy’s, it is currently the leader of the industry in market capitalization with a cap of $39.31 billion. Here are few additional details about Porter's model : 

1. Barriers to Entry

Economics of scale mean larger firms can produce at lower cost per unit. This tends to lower the number of firms in the industry and reduce competition.
For example : The telecommunication industry where to service a single phone in a town costs a huge amount of money. Lines must be laid,towers constructed and other infrastructure purchased to hook the phone up to local and long-distance lines. When the company is servicing a thousand  phones in the town, however the cost per phone of all the infrastructure is significantly lowered as the lines are already laid and the infrastructure is set, so it makes sense for the telecoms company to have all of its line/infrastructure to be used fully, rather than lay there redundant. 

Proprietary product differences are the characteristics that make a product appeal to a large market segment. But only those characteristics that cannot be copied at low cost by competitors will be a barrier to entry.
For example : Coca Cola have a secret formula for their cola soft drink that acts as a high barrier to entry. Very few firms try and compete head-to-head with Coke in the cola segment of the industry.

Brand identity is the extent to which buyers take the brand name into account when making purchase decisions.
For example : Customers are more interested in KFC than any other fast food because of its easily remembered tagline "So Good" which its previous tagline "Finger Lickin' Good" had been ditched in an attempt to improve its image.

Capital requirements are the total cost of acquiring the plant and equipment necessary to begin operating in the industry. 

2. Bargaining Power of Suppliers

Differentiation of inputs means that different suppliers provide different input characteristics for inputs that basically do the same job. The greater the degrees of differentiation among the suppliers the more bargaining power suppliers have.
For example : Drug industry relationship to the hospitals. Basically they have same goal which is to rehabilitate disease suffered by patients.
Presence of substitute inputs means the extent to which it is possible to switch to another supplier for an input (or a close substitute). The greater the number and closeness of substitute inputs the lower the bargaining power of suppliers.
For example : If the price of coffee rises substantially, a coffee drinker is likely to switch over to a beverage like nescafe because the products are so similar.
Supplier concentration is the degree of competition among suppliers. Usually the more concentrated the industry, the fewer suppliers and the more control suppliers have over the prices they charge. Greater power concentration often means greater supplier bargaining power.
For example : Intel is one of only a few providers of CPUs for the PC industry. This give them power over the PC industry.
Cost relative to total purchases in the industry refers to the amount your firms spends on input from a particular supplier compared to the total revenue of all firms in the supplier's industry. Lower expenditure usually implies more bargaining power for the supplier. The buyer's bargaining power falls as spending with a particular firm falls simply because the buyer's business is not as important to the supplier.

3. Threat of Substitute

Relative price performance of substitutes is the price of substitutes for your output compared to the price you are charging. If the prices of substitutes is lower, the competitive threat increases as the price differential increases.
For example : Few business people put cheap pens in their shirt pockets. They prefer a very expensive pen. The prestige factor is much higher for the higher-priced pen. The need being satisfied is not the ability to write, but the image being portrayed.
Switching costs refers to the cost to the buyer of switching from one seller to another. The greater the switching cost the lower the threat of substitutes because buyers have a stronger incentive to stick with a single supplier.
For example : In software industry, the switching costs are the time required to learn a new program. This make it less likely that a buyer would switch readily from Excel to Lotus. This buyer switching costs gives power to the software company.
Buyer propensity to substitute is the extent to which buyers are willing to consider other suppliers.
For example : Special interest groups forced McDonald's to switch from styrofoam containers to paper containers for carry out food.

4. Bargaining Power of Buyers

Buyer concentration versus firm concentration refers to the extent of  concentration in your industry. The more concentrated the buyer's industry relative to your industry the greater bargaining power of buyers.
For example : When DVD's were first released you could only get them in a few specialty shops who could  set DVD prices. Now DVD's are stocked in supermarkets, record shops, service stations. This has significantly reduced the ability of any one stockist to set price.
Buyer volume is the number of units of your product the buyer purchases from all sources. The greater buyer volume compared to the quantity purchased from you, the greater the bargaining power of buyers.
For example : A small doctor's surgery that uses only one ream of paper each quarter, they may just pop over to the local news agent to buy that ream of paper and not worry to much about how much it costs. Whereas a finance company who uses 50 reams of paper each week is more likely to want to get a good deal on their paper.
Buyer information is the state of information buyers have about your industry. The more information buyers have about industry the more bargaining power buyers have.
For example : The auto tire industry. Buyers (auto manufacturers) know what it takes to make a tire. Therefore, they have power over the tire industry. This is demonstrated by the relatively low margins in the tire industry.
Substitute products means the number and closeness of substitute available for your product. The greater the number of available substitute the more bargaining power buyers have.
Price of your product relative to total expenditures on all products. This is the fraction of total expenditure buyers spend on your products. The greater the fraction of total expenditure the greater the price  elasticity of demand and the more bargaining power buyers have.
Product references refers to the degree of differentiation between your product and other products in the market. The greater the differentiation of your product, the lower its price elasticity of demand and the less bargaining power buyers have.
Brand identity is the extent to which your brand name is recognized and sought out by buyers. The stronger your brand identity the less bargaining power buyers have.
For example : While high performance tire with a brand name seen on racing cars would favorably impact the brand identity of a very expensive sports car, a brand of tire that automobile assembly plants put on compact cars would negatively impact the brand identity of this car.

5. Rivalry Determinants

Industry growth is the speed at which the market is growing. Rapidly growing markets provide less incentive for firms to aggressively compete with each other.
Intermittent overcapacity is the amount demand fluctuates during a year (or over a business cycle) and the impact lower demand has on how efficiently the firm is able to use its plant and equipment. In some industries a decrease in demand leads to significant idle productive capacity, while other industries are not as susceptible to this factor. More intense rivalry is likely to be fostered in an industry in which firms face either large amounts of unused plant capacity or face frequent idle capacity.
For example : Sale of farm produce during harvest of a bumper crop
Concentration and balance is the number of firms in the industry and their relative size. An industry in which a few firms supply most of the output is likely to not be very competitive because the large firms will control the market.
For example : High-end jewelry stores reluctant to carry its watches, Timex moved into drugstores and other non-traditional outlets and cornered the low to mid-price watch market.