This is a way of analysing the attractiveness of an industry. In some industries, such as pharmaceuticals, profit margins are typically very high, while in other industries, such as retailing, profit margins are consistently lower. Five forces analysis explains why this is the case – and what a firm can do to make its industry more profitable.
Michael Porter was a junior faculty member at Harvard Business School in the mid-1970s, with a background in the micro-economic theories of ‘industrial organisation’. That body of literature was mostly concerned about how to prevent firms from making too much money (for example, by preventing them from getting monopoly power). Porter realised that he could reframe those ideas as a way of understanding why firms in some industries were so consistently profitable anyway. He wrote a number of academic papers showing how industrial organisation and strategic thinking could be reconciled. He also popularised his ideas through a classic article in the Harvard Business Review in 1979, called ‘How competitive forces shape strategy’. His book on the same subject, Competitive Strategy, was published the following year.
The five forces was the first rigorous framework for analysing the immediate industry in which a firm was competing. Before that, most managers had used ‘SWOT’ analysis (strengths, weaknesses, opportunities, threats), which is a useful but unstructured way of listing issues facing a firm.
Five forces analysis is a framework for analysing the level of competition within and around an industry, and thus its overall ‘attractiveness’ to the firms competing in it. Collectively, these competitors make up the micro-environment of forces close to the firm, in contrast to the macro-environment (such as geopolitical trends) that typically affect an industry indirectly or more slowly. The five forces are defined as follows:
Source: Adapted from Porter, M.E. (1979) ‘How competitive forces shape strategy’, Harvard Business Review, March/April: 21–38. Copyright © 1979 by the Harvard Business School Publishing Corporation, all rights reserved. Reprinted by permission of Harvard Business Review.
Taken together, these forces provide a comprehensive view of the attractiveness of an industry, measured in terms of the average level of profitability of the firms within it.
The five forces framework can be used in two ways: first as a way of describing the current situation in your industry and second as a way of stimulating ideas about how to improve your firm’s competitive position.
As a descriptive tool, it is useful to go through each of the forces in turn and assess how powerful they are, in your current situation. Michael Porter’s book, Competitive Strategy, provides a detailed checklist of items to think about when doing this analysis. This can be summarised, for example, by using a single ‘+’ sign for a force moderately in your favour, or ‘–’ for a force strongly against you. This analysis should help you understand why your industry is relatively attractive or relatively unattractive. It also pinpoints which forces represent the biggest threat. For example, doing this analysis in the pharmaceutical industry in Europe one would likely conclude that the bargaining power of buyers, and specifically governments, is the biggest single threat.
The second part of using the five forces is to use the analysis to brainstorm ways of improving your competitive position – so that you can ‘push back’ on the strongest forces affecting you. For example, in pharmaceuticals if the bargaining power of government buyers is very high, one way of pushing back is to increase your own bargaining power – either by coming up with a really exciting drug that consumers start clamouring for, or by becoming bigger and more powerful yourself (witness, for example, Pfizer’s attempts in 2014 to buy AstraZeneca).
First, make sure your analysis of the forces affecting your industry is accurate. One way to do this is to actually figure out the average profitability of the firms in your industry, and to then compare this to the overall average of all industries (for example the average return on invested capital in US industries in the period 2000–2008 was 12.4 per cent). If your industry is actually more profitable than the average, one would expect to see a relatively favourable set of forces.
Second, it makes sense to focus your effort on the one or two forces (out of five) that are the most critical to your future profitability. Your analysis might lead you to conclude, for example, that the bargaining power of customers and internal competitive rivalry are the biggest threats. Your subsequent strategy discussions should then focus on those topics.
The biggest pitfall analysts make is to think that they have done their job by describing the five forces. In reality, this analysis is just the starting point – it provides an understanding of the current situation, but it doesn’t tell you anything about what you should do differently.
The other pitfall is defining the boundaries of the industry incorrectly. You need to give a lot of thought to which companies are your immediate competitors. For example, this often means focusing on a specific country. If you work in banking, the relevant industry might be ‘retail banking in France’ or ‘commercial banking in Canada’, rather than just ‘banking’ as a whole.
Porter, M.E. (1979) ‘How competitive forces shape strategy’, Harvard Business Review, March–April: 21–38.
Porter, M.E. (1980) Competitive Strategy. New York: Free Press.
Porter, M.E. (1996) ‘What is strategy?’, Harvard Business Review, November–December: 61–78.