“The Five Competitive Forces That Shape Strategy” Summary and Application

SUMMARY

Narrow-minded business strategists may focus solely on existing competitors when complaining about decreasing returns in their industry but in “The Five Competitive Forces That Shape Strategy”, Michael E. Porter explains that there are several other forces in the competition for profits that the strategist should be aware of.  These five forces are explained in an “industry structure” model where the most successful businesses find the niche in the market where the forces are the weakest.  The industry structure is made of New Entrants, Suppliers, Buyers, Substitutes, and Existing Competitors.

Porter explains that all industries have gross differences in profitability regarding return on invested capital (14% median in USA, 1992-2006).  These returns, for instance 6% in Airlines versus 38% in Soft Drinks, have the five forces to thank. Porter does note that several combinations of forces can create a low or high return industry – a low return industry does not mandate that all five forces be powerful, but one force can disturb the profits in an entire industry.  Here we analyze the factors that make up the five forces.

The threat of entry depends on the height of entry barriers including economies/benefits of scale (supply/demand), switching costs, capital requirements, and access to distribution channels.  The threat of suppliers are powerful when there are few suppliers and a multitude of buyers, or when the supplier is also diversified into other industries, when switching costs are high, and there is no substitute.  The threat of buyers is high when there are few buyers as in offshore drilling, when industry products are standardized so there are many choices of manufacturer, when switching costs are low, or when buyers can even integrate backwards – creating the product themselves.  Porter also discusses when buyers are price sensitive: purchase represents large portion of overall cost structure and buyer is strapped for cash (group earns low profits). The threat of substitutes is high if cost of switching to the substitute is low for buyers, and the substitute offers an attractive price-performance tradeoff to the alternative.  Lastly, the rivalry of existing competitors depends on 1) intensity of competition, and 2) Basis on which competitors compete.  Intensity is greatest when there are many competitors with relatively equal size and power, when there is slow industry growth, high exit barriers, highly committed rivals despite performance, and when firms cannot read each other’s signals due to unfamiliarity.

APPLY

Applying Porter’s Five Forces to my company, Industrial Training International (ITI.com), and our industry, corporate crane, rigging, and heavy equipment training, I have uncovered a few new realities.  The industrial training industry serves customers from oil/gas and mining, to construction and power generation – though it is a very niche market, $40 million in the US.  What is surprising is that according to a quick (2-day) analysis, we are not really threatened very heavily at the moment, although it doesn’t necessarily feel that way.

Recently a new law was established by Federal OSHA (Occupational Safety and Health Administration) requiring crane operators on construction sites to have a nationally-accredited operator certification.  Prior to reading about Porter’s Forces I understood our industry was very easy to enter – this rule from OSHA exemplified that with dozens of new entrants in the past year.  Like many consulting industries there are low capital requirements and customer switching costs are jointly very low. When working with a large organization’s training budget, demand-side benefits of scale are in favor of incumbents, although the bubble we are currently experiencing did not stop many from entering the industry.  When it comes to suppliers and substitutes, there is little application to ITI as a service-based company.

An initial learning outcome is that buyers hold a great deal of power in this industry and to ITI.  Our company’s fees are sometimes double that of the nearest competitor due to the high-quality of personnel and curriculum we benefit our customers with. However, because switching costs are very low and buyers can integrate backwards by creating their own internal training programs, they indeed hold a great deal of power that keeps us in check.

The rivalry among existing competitors is not a major threat.  Although there are numerous competitors, industry growth is rather large due to the recent government mandate.  Despite the fact that there are few leaving the industry now, exit barriers are fairly low for the majority of competitors – most competitors do not invest heavily in things like heavy machinery, IT, data management, logistics systems.  They simply have 1-2 trainers conduct training at customer locations, on customer equipment.

Despite the rise of market entrants, price competition is very low thanks to ITI’s quality – customers agree that no other vendor of theirs offers the same quality of training.  This means that ITI’s product is not identical to competitors.  Interestingly, there is fierce price competition for low-quality, easy-to-conduct training programs like “Signal Person Training” (which was also mandated by the same OSHA law mentioned above).  Also restraining price competition are low fixed costs and large capacity expansions not being required in the industry.  So, despite what it feels like – numerous new entrants jumping in the industry – ITI is comfortable as the leading, high-quality provider in a growing industry.  The pie is growing and ITI is increasing its portion as it competes for the low-hanging fruit like Signal Person Training with e-learning and other high-investment advances other competitors cannot afford.