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Industry Analysis - Porter's 5 Forces

28 September 2015 |

What is an industry?

"Industry" refers to a sector of an economy, grouping together companies that are related in terms of their primary business activities. An example could be the automotive industry, which is the grouping together of companies focusing their business on the sale, manufacturing, production, design and marketing of motor vehicles.

What is an industry analysis?

An industry analysis aims to establish the attractiveness of a particular industry. Profit margins (the amount of profit generated per item after deducting the average cost of producing each item) vary between different industries, and tools used to analyse industries can pinpoint why that is the case. This helps to understand the competitive environment in which a company operates.

Why is it important to understand?

Case studies often present candidates with a hypothetical scenario in which a (fictional) client is looking to acquire a (fictional) company. Candidates are then often asked to state whether they think the acquisition of the company should go ahead, i.e. would be beneficial to the client. In such a case study interview it is crucial to possess the ability to account for the strengths and limitations of the industry within which the company being analysed operates. This understanding forms part of what is often referred to as a candidate"s commercial awareness. Commercial awareness includes the ability to understand the wider factors underlying, and potential limitations to, a company"s operations and profit potential.

Tools/models used to carry out an industry analysis

Understanding, and being able to apply, at least one simple framework for industry analysis will help candidates stand out in case study interviews and will also strengthen candidates" ability to analyse a business case.

Porters Five Forces

This framework identifies five factors to be crucial for understanding the strengths and limitations of a particular industry.

Industry Rivalry

  • This refers to the level of competition between existing companies within the industry. If there is high rivalry, companies will try to steal customers from each other, thus limiting profit potential for all companies in that industry. Industry rivalry is high when for instance: there are many companies within the industry; the product is commoditised* and it is thus easy for customers to switch between companies; customers are not loyal to a particular brand; it is a low switching cost** for consumers; exit costs (the costs incurred when exiting a business venture or an industry) are high; and there is excess production capacity***.

Threat of Substitutes

  • A substitute product is one the customer can buy from another industry to satisfy the same, or a similar, need. As customers can choose to buy the product from another industry, this decreases the potential for profit in the industry being analysed. For example, an industry analysis of the airline industry would have to consider the threat of the train, bus and ferry industries. The threat of substitutes is high when for instance: the substitutes are cheaper; the substitutes are of a higher quality; and there is a low switching cost for consumers.

Bargaining Power of Buyers

  • When the industry"s buyers are more powerful relative to the sellers (the sellers being the companies in the industry), the profit potential will be reduced, as buyers will demand lower prices or higher product/service quality. They play competitors against each other to succeed with such demands. Buyers have high bargaining power when, for instance: there are many suppliers but few buyers; the product is commoditised; it is easy for buyers to integrate into the supply chain****; and consumers buy large volumes of the product/service.

Bargaining Power of Suppliers

  • When the industry"s suppliers are more powerful relative to the buyers (the buyers being the companies in the industry), the profit potential will be reduced as suppliers can raise their prices or reduce their product quality without the buyer being able to easily meet their needs elsewhere. Suppliers have high bargaining power when, for instance: there are few suppliers but many buyers; the business from the industry being analysed is not crucial for the supplier; the suppliers" products form an important part of the buyer"s business; buyers face high switching costs; and the suppliers" products are differentiated*****.

Barriers to Entry/Threat of New Entrants

  • When the barriers to enter the industry are high, there is a low threat of new entrants. This means existing companies within the industry have a higher profit potential. Barriers to entry impose a cost element to companies wishing to enter the industry, which incumbent companies do not face. Factors that increase barriers to entry are, for instance: economies of scale****** enjoyed by incumbent companies; product differentiation (branding and customer loyalty are strong for existing companies); high capital requirements (e.g. for acquiring machinery, R&D, advertisement); and government policies which may limit the number of companies in a particular industry through imposing regulations such as licencing requirements.

Defined Terms

*Commoditised (Product)

When products are (almost) impossible to distinguish between. Examples include gold (one gram of gold is no different to another gram of gold), oil, cocoa, coal.

**Switching Costs

Monetary switching costs can be, for instance, the cost of cancelling a contract or initiation fees. Lifestyle switching costs could be, for instance, the perceived social cost of changing form driving a car to using public transportation.

***Excess Production Capacity

Where the industry is producing less than what is achievable or optimal. The demand is lower than what the industry collectively could produce.

****Integrate into the Supply Chain:

The supply chain is comprised of contributors involved in the process leading up to the sale of a product (e.g. manufacturers). Typically, each contributor will charge prices that include a profit margin. If one company takes control of two or more stages in the supply chain, it will not have to pay this additional margin and costs will consequently decrease.

*****Product Differentiation

The process by which a product is made more distinguishable from other (similar) products so as to avoid commoditisation (see above).

******Economies of Scale

The cost advantage gained as output increases. This cost advantage arises when fixed costs are spread across a greater quantity of sales.