In the last blog on Michael Porter, we talked about being unique and how it is a competitive advantage. What really is the point of competition? We assume competition is a rivalry that operates in the same domain as us. For example, A shoe seller will assume its competition to be another shoe seller. But that is a very narrow perspective to look at. The point of competition is not to beat your rivals but to earn the most profits. This blog will aim to analyze the forces a company operates against to compete for competition.
The shoe seller competes against the other competitors, but that's not the case. The seller struggles for profits with his customers, who would always be happier to pay less and get more. He competes with his suppliers, who would always be happier to be paid more and deliver less. He competes with producers who make products that could, in a pinch, be substituted for his own. He competes with potential and existing rivals because even the threat of new entrants limits how much they can charge their customers.
Industry structure
Before we discuss the five forces, let's consider why they are so important.
Let's look at a bank and a pizza restaurant. Their industries and operations are completely different. You might think there are no similarities between the two businesses. You are right, but only at the surface level. Let's delve a bit deeper.
A Pizza restaurant, as does a bank, has competitors and fights to earn more money. Pizza restaurants have suppliers that supply cheese flour and tomatoes, and the restaurant tries its best to reduce costs. A bank gets its raw supplies from retailers who deposit money, and they try their best to give the lowest interest possible. A pizza restaurant is always threatened by a new pizza joint opening nearby or people starting to prefer healthy alternatives. A bank is always worried if a new competitor opens its branch nearby and under the threat of a customer preferring loans from NBFCs or new-age digital apps. A pizza restaurant will try to be different and charge the highest price possible from its customers to earn maximum profits. A bank will differentiate itself through technology and transparency and charge the highest interest possible.
If you think about it, there are a lot of similarities between a pizza restaurant and a bank branch. The ideas we talked about above are basically the five forces! All industries are different but still affected by the same fire forces, making it imperative to study these forces.
Secondly, the industry structure determines the profitability of a company. Not, as many people think, whether the industry is high growth or low, high tech or low, regulated or not, manufacturing or service. Structure trumps these other, more intuitive categories.
Third, the industry structure is surprisingly sticky. Despite the prevailing sense that business changes with incredible rapidity, Porter discovered that industry structure—once an industry passes beyond its emerging restructure phase—tends to be quite stable over time. New products come and go, and new technologies come and go. Things change all the time. However, structural change—and, therefore, changes in an industry's average profitability—usually takes a long time.
I hope we understand how essential industry structures are.
The golden equation:
Price-cost= Profit
All the forces come down to how they affect two things: price and cost. These affect a business's profitability and longevity and are, hence, the most important factors to look at.
1.Buyers
If a company has influential buyers, it has to bend to the whims of the buyers and end up shelling out more value than they plan on. Suppose you sell nuclear missiles, and you are not allowed to export them. The only viable buyer of the product is the government of India. What will you do if they demand the price be cut by 50%? You do not have another buyer in the market. You have already invested significant capital in the product and need to cash it out. Ultimately, you either sell and lose 50% of its value or sell nothing, have a cash crunch, and go bankrupt. B2B businesses can face these issues as monopolies downstream of your product can end up squeezing all the value in the value chain.
2. Suppliers
It has the same logic but the opposite. If there is a powerful supplier, they will use their leverage on you to charge higher prices. Do you know why Microsoft has been an enormous value creator while companies like Dell and HP have been value destroyers? All PCs in the 90s or so had little to no differentiation and hence had become commodity products. Meanwhile, Microsoft was the only operating software out there, which was good, and hence, it took advantage of this situation and squeezed all the value from the value chain. The only exception of a PC marker succeeding was Apple. Do you know why? Because it used its own OS, rid itself of a powerful supplier, and differentiated itself from its direct competitor.
How do you assess the power of buyers and suppliers?
Both suppliers and buyers tend to be powerful if:
They are large and concentrated relative to a fragmented industry. This means they become relatively larger than their suppliers/buyers and hence have a bigger clout to get their way. A way to know this objectively is by asking What percentage of an industry's purchases/sales does a supplier/buyer represent? How painful would it be to lose that supplier or that customer?
The industry needs them more than it needs them. Employee unions, too, become strong suppliers in many scenarios. Professionals such as Doctors and Pilots have a strong hold on their organizations. We have witnessed this recently with the mass cancellations of flights due to sick leaves by pilots working for Vistara.
Switching costs work in their favour. This occurs for a supplier when an industry is tied to it; for example, the PC industry has been tied to Microsoft, its dominant supplier of operating systems and software. Switching costs work in the buyer's favour when the buyer can quickly drop one vendor for another. The ease with which customers can switch from one airline to another on popular routes makes it hard for airlines to raise prices or cut service levels.
3. Substitutes
Any product or service that can meet the needs of an existing product is a threat. I am currently studying in San Francisco, and I find it challenging to get good Indian food nearby, but I was raised in Burmese, which tastes similar to Indian food, and a nearby Mediterranean place offers good spicy food. So I just go for these once in a while, then go far for Indian. This is basically substitution. If your product is strongly differentiated and nothing else can fulfil the purpose your product does, substitution is not going to be a problem. This threat is difficult to spot because it does not come from a direct competitor. Health awareness and substitutes cracked the fast food space in the US and other Western countries even though they were not direct rivals. Primarily, a threat of substitution arises from two areas: Innovation and cultural shifts.
4. New Entrants
Remember when dropshipping was all the cars and the best way to make easy money? Where is everyone now? It was indeed an excellent area to make money in, but once people raised that, everyone flooded the market, and the economics of the business changed. There is always a threat of new entrants when the entry barrier is low. How easy is it to start a dropshipping business vs. a cement business? Huge difference, right? The capital and expertise needed to start a cement business are high. What about a Bank? Even more difficult. It is so difficult to get a license and convince people to park money with you.
5. Rivalry
When competition is more intense, profitability will be lower. Rivalry can take various forms: price competition, advertising, new product introductions, and increased customer service. Drug companies, for example, have a history of intense competition in R&D and marketing, but they have steered clear of price competition.
This is the classic competition we know about, so I am not going into much detail.
The five forces framework applies in all industries because it encompasses relationships fundamental to all commerce: those between buyers and sellers, between sellers and suppliers, between rival sellers, and between supply and demand. Think about it. This covers all of the bases. The five forces are universal and fundamental.
I hope this blog explains the importance of understanding industry structure and how it shapes a company's profitability. Until then, let me know about any case study that witnesses tremendous force from any of these five factors!
Credits:
Magretta, Joan. Understanding Michael Porter: The Essential Guide to Competition and Strategy Harvard Business Review Press. Kindle Edition.
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