Porters five forces analysis is a framework for industry analysis, and business strategy development, formulated by Michael E. Porter of Harvard Business School in 1979.
When doing the SWOT analysis, and then considering strategic options, five forces analysis is a conceptual tool that strategic planning teams can use for evaluating the relative ‘attractiveness’ of an industry.
Porter five forces framework builds on the economic analysis of industrial organizations. Porter thinks that the intensity of competition influences the attractiveness of a segment of the market. However, he does not confine his idea of competitiveness just to the obvious rivalry among firms in the industry. This is just one of the five forces.
By industry attractiveness in this context, we refer to the overall industry profitability. An "unattractive" industry is one in which the combination of Porters five forces acts to drive down overall profitability. A very unattractive industry would be one in which profits for all businesses in the industry approach a level that would make alternative uses of the resources deployed seem more attractive.
We are not talking about the profit shown in the usual financial accounts. We are referring to the ‘economic profit’. This comes from subtracting all the cost of doing business, including attributing costs of capital from the sales revenue. These ‘total costs’ in effect include the opportunity cost of the inputs used.
In calculating economic profit, subtract opportunity costs from revenues taken in. Opportunity costs are the alternative returns given up by using the resources deployed in the current business. In some cases, you can appear to be earning an ‘accounting profit’ and yet be earning little or no economic profit.
For example, say you invest $200,000 to starting your own little enterprise. In the first year, you generate $240,000 in revenues, seemingly taking out $40,000 for yourself as ‘accounting profit’. Nevertheless, if you had stayed in your previous job in which you would have cleared $60,000 after taxes, you have an economic loss of $20,000 (240,000 - 200,000 - 60,000).
Earlier I mentioned that the obvious rivalry among industry participants was only one of the five forces. The forces are -
This diagram shows scheme of Porters five forces -
Those involved in strategic planning, especially consultants in the field may use the five forces framework model now and again. It can be useful as an adjunct checklist to a comprehensive SWOT analysis. It can help to challenge a planning team that is perhaps inward looking.
Like all such strategic planning tools, it can be used without sufficient examination of the real circumstances of a particular organization. It is easy to underestimate the complexity that is lost in trying to reduce the total situation of an industry into a simple model.
Porter himself cautioned against trying to use the framework to encompass the whole story of an industry sector. The five forces model is more applicable at the basic level of say a specific line of business. This involves identifying the specific products and or services that are very similar to one another across enterprises, and sold to recognizable customer groups. Therefore, for a diversified company, it needs to undertake an industry analysis or five forces mapping on a number of different lines of business. Many very large enterprises face carrying out dozens of five forces analyses.
At this level, the analyses using Porter’s five forces can then focus on the details of each of the forces. Thus, we have a richer picture of what is going on in the firm’s context, as depicted in this more complex version of the framework.
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