Porter's Five Forces: a complete guide

Why do some industries make lots of money while others, full of capable people working just as hard, barely break even? Michael Porter’s answer was that the structure of the industry decides most of it, and that five forces shape that structure.

The Five Forces is one of the best-known frameworks in business, and one of the most often done badly. People list a few competitors, label everything “medium” and move on. Done properly, it tells you who takes the value your industry creates, and where you can position your business so less of it is taken from you.

Here’s a complete guide, as a set of questions and answers, with three figures, one of which you can use on your own industry.

What is Porter’s Five Forces?

A framework for analysing the competitive structure of an industry, and so its long-run profit potential. It looks at five sources of pressure: the rivalry between existing competitors, the threat of new entrants, the threat of substitutes, the bargaining power of buyers and the bargaining power of suppliers.

The idea is that competition for profit comes from more than your direct rivals. Customers, suppliers, possible newcomers and substitute products all compete with you for a share of the value your industry creates. The stronger those forces, the less of that value stays with the companies in it.

Where did it come from?

Michael E. Porter of Harvard Business School set it out in “How Competitive Forces Shape Strategy”, published in the Harvard Business Review in 1979, and expanded it in his book Competitive Strategy the following year (Wikipedia). It draws on industrial organisation economics, the branch of economics that studies how the structure of a market affects how firms behave and how well they perform.

Porter’s opening argument still holds up. The strategist’s job is to understand and cope with competition, and most managers define competition too narrowly, as if it only happened between today’s direct competitors.

In January 2008 he revisited the framework in “The Five Competitive Forces That Shape Strategy”, also in HBR. The forces stayed the same. What he added was more on how to use them, and a list of the mistakes people make, which we’ll come to.

Why does industry structure matter so much?

Because profitability varies enormously between industries, and it isn’t random. In the 2008 article, Porter compared the average return on invested capital across US industries between 1992 and 2006. Some industries averaged returns at or below zero, and others more than 50%. Soft drinks and prepackaged software were almost six times more profitable than airlines (Porter, 2008).

Airlines are the classic case. Customers compare fares in seconds and switch on price. Aircraft makers, fuel suppliers, airports and unionised staff all hold strong positions. Rivals add capacity, and high fixed costs push them to fill seats at almost any price. Plenty of value is created, since flying is extraordinarily useful, but very little of it is left for the airlines.

What are the five forces?

1. Rivalry among existing competitors

How hard do the companies already in the industry compete, and on what? Rivalry hurts profit most when it’s fought on price, because price cuts are easy to copy and simply hand value to customers. Competition on features, service or brand is less damaging, because it can grow the market and lets companies differ.

Rivalry tends to be intense when there are many competitors of similar size, industry growth is slow, exit barriers are high (specialised assets, long contracts, pride), products are hard to tell apart, fixed costs are high or capacity comes in big lumps, and the product is perishable, as an empty seat on a flight is.

2. Threat of new entrants

New entrants bring capacity and a hunger for market share, and they push prices and costs around. What matters is the threat of entry. If entry is easy, incumbents have to keep prices low or spend heavily to deter newcomers, even if nobody actually arrives.

The threat depends on the barriers to entry and on how hard incumbents are expected to fight back. Porter lists seven barriers:

• Supply-side economies of scale. Big producers have lower unit costs, so newcomers must come in big or accept a cost disadvantage.
• Demand-side benefits of scale, also called network effects. Buyers value a product more when lots of other people use it.
• Customer switching costs. The one-off costs a buyer faces in changing supplier: retraining, new systems, migration, risk.
• Capital requirements. The money needed to compete at all, especially when it’s spent on things you can’t get back, such as advertising or research.
• Incumbency advantages independent of size. Proprietary technology, the best locations, established brands, cumulative experience.
• Unequal access to distribution channels. Shelf space, retailer relationships, app store placement, preferred-supplier lists.
• Restrictive government policy. Licences, regulation, patents and limits on foreign investment.

3. Threat of substitutes

A substitute does the same job as your product in a different way. It sits outside your industry, which makes it easy to miss. A common example: for Coca-Cola, Pepsi is a rival, but tap water is a substitute.

Substitutes put a ceiling on price. Charge too much and customers find another way to get the job done. The threat is high when the substitute offers an attractive trade-off between price and performance, and when it costs the buyer little to switch. Videoconferencing is a substitute for business travel. Doing it yourself, or not doing it at all, is often a substitute too.

4. Bargaining power of buyers

Powerful buyers force prices down, demand more quality or service, and play suppliers off against each other. Buyers here can be end consumers or businesses further down the chain.

Buyers have more power when there are few of them or each buys a lot, when the product is standardised, when switching is cheap, and when they could credibly make the product themselves. They also push harder on price when your product is a big share of their costs, when they’re under profit pressure themselves, and when your product makes little difference to the quality of theirs.

5. Bargaining power of suppliers

The mirror image. Powerful suppliers keep more value for themselves by charging more, limiting quality or service, or shifting costs onto you. Suppliers include providers of labour, so a scarce skill or a strong union counts.

Suppliers have more power when they’re more concentrated than the industry they sell to, when they don’t depend heavily on it for their revenue, when switching supplier is costly, when what they sell is differentiated or has no substitute, and when they could credibly move into your industry themselves.

How do you rate your own industry?

Rate each force low, medium or high. The pie shows, roughly, how much of the value created stays with the companies in the industry. The two presets are our own rough readings of the industries in Figure 2.

Two things come out of playing with it. A single strong force can do a lot of damage on its own. And the forces combine, so an industry with no outstanding threat but four medium ones can still be a hard place to make money.

Try translation, the industry I know best. Rivalry is fierce among thousands of language service providers, many of them small. It’s cheap to start one. Machine translation and now AI are the substitute every buyer has heard of, and large buyers run procurement processes that push the price per word down. Only supplier power is moderate: freelance translators are plentiful in the big languages, though scarce specialists and the technology platforms everyone depends on hold more sway. Four strong forces out of five is why so many language companies are working hard to sell something other than words. If that’s your industry, Nobody asked the language industry and localization consulting say more.

How do you do a Five Forces analysis, step by step?

1. Define the industry. Decide which products and which geography you mean. This is the step that most often goes wrong, so take time over it. If two products differ a lot in their buyers, suppliers or barriers, treat them as separate industries.
2. Identify the players in each force: the competitors, the buyer groups, the supplier groups, the substitutes and the likely entrants.
3. Assess each force using the factors above, and use evidence where you can: market share data, margins, switching costs, the number of suppliers.
4. Find the forces that matter most. Usually one or two forces decide profitability. Say which, and why.
5. Look at the trend. Which forces are getting stronger or weaker, and what’s driving that? A force that is weak today and strengthening deserves more attention than one that is strong but stable.
6. Position yourself. Look for where the forces are weakest for your business, and decide how to defend yourself, exploit change, or reshape the forces in your favour.

A Five Forces analysis that stops at step 3 is a description. The value is in steps 4 to 6.

What do you do with the answer?

Porter’s 2008 article suggests three broad moves.

Position the company where the forces are weakest. Pick customers, products or segments where buyers are less price-sensitive, substitutes are weaker, or entry is harder. A supplier to an industry full of powerful buyers might focus on smaller customers who value service more than price.

Exploit industry change. Forces shift with technology, regulation and new business models. Spotting a shift early, before rivals do, can open a position that’s more profitable.

Shape the industry structure. Companies can change the forces themselves. You can raise switching costs with better integration, standardise inputs to weaken supplier power, or work with competitors to grow the whole market instead of fighting over share. Porter calls this expanding the profit pool.

What mistakes should you avoid?

Porter lists several in the 2008 article, and a couple more follow from the framework itself:

• Defining the industry too broadly or too narrowly. Too broad and you average away the differences that matter. Too narrow and you miss substitutes and entrants.
• Listing factors without analysing them. A list of everything that might affect the industry is not an analysis. The aim is to find which forces matter and why.
• Giving every force equal attention. One or two forces usually decide profitability. Spreading effort evenly hides them.
• Treating fast growth as a sign of a good industry. Growth attracts entrants and can increase supplier power. It doesn’t guarantee profit.
• Treating the analysis as a snapshot. The structure changes. The trend in each force matters as much as its level.
• Only counting today’s rivals. The biggest threat is often an entrant or a substitute that nobody in the industry is watching.
• Assuming the forces are fixed. Companies can shape them, and the best strategies often do.

Is there a sixth force?

People often add one. The usual candidate is complementors, the makers of complementary goods: products that make yours more valuable, such as apps for a phone or software for a computer. Adam Brandenburger and Barry Nalebuff developed the idea through game theory in the mid-1990s, in their book Co-opetition, and it’s often called the sixth force.

Others suggest government, or technology. Porter’s view, in the 2008 article, is that these aren’t forces in their own right. Government, technology, growth and complements matter because of how they affect the five forces, so analyse them through the forces rather than alongside them.

What are its limits?

It’s an outside-in tool. It tells you how attractive an industry is, and very little about your own company’s strengths. Pair it with an inside-out view, such as the resource-based view of the firm, which looks at the capabilities that make a company hard to copy (Wernerfelt, 1984).

Critics also point to its assumptions. A 1996 McKinsey Quarterly article by Kevin Coyne and Somu Subramaniam argued that it assumes buyers, competitors and suppliers don’t interact or collude, that advantage comes mainly from structure, and that uncertainty is low enough to predict how the industry will behave (Wikipedia). In fast-moving industries, where boundaries blur and companies are both partners and competitors, those assumptions are weaker.

And it doesn’t tell you what to do. It describes the pressures. You still need a strategy.

It’s still one of the most useful tools there is, as long as you use it alongside others.

How does it fit with PESTLE, SWOT and the Business Model Canvas?

They answer different questions, and they work well together.

• A PESTLE analysis looks at the wider environment: political, economic, social, technological, legal and environmental change. It tells you what’s driving the forces to shift.
• The Five Forces looks at the industry: who takes the value.
• The Business Model Canvas looks at your company: how you create, deliver and capture value.
• A SWOT pulls it together. The opportunities and threats come from PESTLE and the Five Forces; the strengths and weaknesses come from the inside.

Run them roughly in that order, then turn the result into a plan, for example with the 3-12-6 framework.

How can you use it with key accounts?

As with the Business Model Canvas, the most useful version is often the one you do for your customer.

Run a Five Forces on your key customer’s industry. Which force is squeezing them hardest? Are their own customers gaining power? Is a substitute eating into their market? Are suppliers raising prices? When you know that, you know what your customer’s leadership is worrying about, and you can ask whether what you sell eases that pressure. If you help them hold their price against powerful buyers, or reduce their dependence on a powerful supplier, you’re talking about something that matters to them.

You can also do it from the other direction. You’re one of your customer’s suppliers. How much power do you have, and how much do they? The answer explains a lot about the negotiations you have every year.

Can AI help?

Yes. An AI assistant can draft a first Five Forces from public information in minutes, suggest substitutes and possible entrants you hadn’t thought of, and summarise annual reports and industry news for evidence. That’s a good start for a workshop.

Check the facts it gives you, especially market shares and numbers. And remember that the judgement in steps 4 to 6, which forces matter and what to do about them, is still yours.

Where should you start?

Pick the industry that earns most of your money, and define it carefully. Rate the five forces with the people who know it best, then ask the question Porter’s framework was built to answer: who’s taking the value we create, and what can we do about it?

This guide is step 2 of a strategy toolkit: five tools, in order, that take a team from what’s changing in the world to a plan with dates on it.

Sources: Wikipedia, Porter’s five forces analysis; Porter, M.E. (1979) “How Competitive Forces Shape Strategy”, Harvard Business Review, 57(2), pp. 137–145; Porter, M.E. (1980) Competitive Strategy, Free Press; Porter, M.E. (2008) “The Five Competitive Forces That Shape Strategy”, Harvard Business Review, 86(1), pp. 78–93; Brandenburger, A. and Nalebuff, B. (1996) Co-opetition, Doubleday; Coyne, K.P. and Subramaniam, S. (1996) “Bringing discipline to strategy”, McKinsey Quarterly, cited in Wikipedia; Wernerfelt, B. (1984) “A resource-based view of the firm”, Strategic Management Journal, 5(2), pp. 171–180.