Why are some industries more profitable than others? What is it about the ways firms behave and interact with one another that influences their success or failure? An entire branch of economics, known as industrial economics, is dedicated to answering these questions. The leading figure in this field is Professor Michael E. Porter of Harvard Business School, whose industry structure analysis, "The Five Forces Model," can help businesses figure out how attractive an industry is from a profitability point of view.
Industry Structure Analysis Basics
As the management and leadership website Mind Tools reports, industry structure analysis is a corporate planning tool. Its purpose is to help business leaders develop their competitive strategy by relating the company to its environment, the core of which lies in the industry in which the organization competes.
According to industrial economics, the structure of an industry influences both the rules of the competition and the strategies that are potentially available to the company to help it improve a weak competitive position or take advantage of a strong one. It’s critical for a company to identify the structural characteristics of industries, as these determine the strength of the competitive forces acting upon the company and, consequently, the profitability of the industry as a whole.
Michael Porter named five competitive forces:
- Competition and rivalries in the industry
- Risk of new market entrants
- Bargaining power of customers
- Bargaining power of suppliers
- Threat from substitutes
Take a look at each of the Five Forces in more detail.
Competition and Rivalries
How many competitors does your business have? How does their product or service compare with yours? What tactics are they using to threaten or outperform your company?
When rivalry is intense, the players in an industry must fight for market share. Since it’s easy for customers to go elsewhere for their products and services, you typically have to attract them with aggressive price cuts or potent marketing campaigns – both of which have the potential to erode profits. High-rivalry types of industry structure also result in retaliation. According to Porter, an escalation of measures can lead to all competitors suffering, and in the end, everyone does worse than before.
On the other hand, where there are few competitive rivalries and no one is offering what you offer, the potential for profit is strong.
Risk of New Entry
A company's competitive power is also influenced by the risk of market entry. If it’s easy to get a foothold in your industry – because it doesn’t take much time, money or expertise to get started – then you can expect newcomers to flood your market. The Strategic CFO gives the example of the graphic design industry, where there are few barriers to entry; with a small software investment, you're up and running. A high threat of new entry weakens your company’s competitive position, often resulting in price wars that reduce profitability.
By contrast, an industry with strong barriers to entry is attractive for organizations that can take advantage of an environment with fewer competitors. The threat of new entries tends to be low when startup costs are high, where production requires an initial research and development investment, or where a company needs to raise capital to buy premises and manufacturing equipment. The barrier to entry is also high where accessing supply chains is difficult, proprietary materials, knowledge or technology is an issue, or where brand names are so well known that it would be challenging to encourage customers to switch to your new-and-unknown product.
Bargaining Power of Customers
The bargaining power of customers describes the ability of customers to drive down prices. It is influenced by how many customers a company has, how important each customer is, and how much it would cost a customer to switch from one company to another. Are your customers strong enough to dictate terms and prices to you?
For example, the bargaining power of customers in the airline industry is high. It’s easy for customers to hop online and compare the prices of different airline companies. Brand loyalty is not that high – a flight is a flight, and customers are generally happy to switch between carriers to get the best price. Some airline companies use frequent flyer programs to try and change this.
Bargaining Power of Suppliers
How many suppliers do you have? How unique is their product? How difficult or expensive would it be for your company to switch to another supplier? With selling power, suppliers can easily raise the prices of the goods and services you buy from them and squeeze profitability in those industries that are unable to pass on cost increases in their own prices.
Selling power is generally strong under the following conditions:
- A few companies dominate the supplier group and can dictate the price, quality and delivery conditions of their product.
- The supplier's product is an essential input for the buyer's business, and there are no or few substitute products available in the supply chain. This is especially relevant for perishable goods that the buying company cannot store.
- The supplier can credibly threaten forward integration, which The Corporate Finance Institute describes as the process of "acquiring or merging with business entities that were its customers, while still maintaining control over its initial business" – essentially cutting out the middle man. For instance, a company that sells clothing to your boutique could threaten to open or acquire its own boutique, instead of supplying yours. This threat limits the industry's ability to improve its purchasing conditions.
Threat of Replacement Products
Products or services that may be used in place of your products or services are a threat. For example, customers may currently rely on you to provide their washing powder, but it would be relatively simple and inexpensive for them to switch to another brand. Since the threat of replacement products is significant, the price you can sell your washing powder at is limited by the prices at which substitute washing powder products are available, thus putting a tight lid on potential profits.
A broader industry structure example can be found in the SaaS industry. Suppose you had a software product that automated an important bookkeeping process, such as Accounts Payable. If you price this product too high or the quality is not great, then customers could:
- Buy a similar product from another software provider
- Substitute your software by performing AP manually
- Outsource the work to a bookkeeper
The point is, customers have options. Where the threat of replacement products is high, profitability is threatened. A company may have to keep costs as low as possible to protect the profit margin, or there may be a push to increase brand loyalty through high-impact marketing.
On the other hand, when there is a reduced threat of substitutes, companies can get away with charging higher prices and don't have to pay such close attention to their cost structures. There’s much more potential in these industries to earn an above-average profit.
