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Professor Michael Porter of the Harvard Business School developed a framework that aids in the development of an organizations competitive advantage.
Porter identified five basic forces that act on the organization;
The bargaining power of suppliers;
The bargaining power of buyers;
The threat of potential new entrants;
The threat of substitutes;
The extent of competitive rivalry.
The bargaining power of suppliers.
Suppliers can exert bargaining power over participants in an industry by threatening to raise prices or reduce the quality of purchased goods or services.
In every industry there are suppliers; Porter put forward the idea that suppliers are more powerful under the following conditions;
If it is dominated by a few companies and is more concentrated than the industry it sells to. This means it is difficult to switch suppliers if they start exerting power.
It is not obliged to contend with other substitute products for sale to the industry. This is the case if the suppliers role is technical and no other suppliers can offer this product/service.
The industry is not an important customer of the supplier group. If the industry that the supplier is selling to, does not represent a large proportion of its sales then it can exert power.
The supplierÐŽ¦s product is an important input to the buyers business. SupplierÐŽ¦s product is essential to the buyer then they can charge whatever price they wish, and the buyer will pay because the product is essential.
The bargaining power of buyers.
Buyers compete with the industry by forcing down prices, bargaining for higher quality or more services, and playing competitors against each other.
Porter put forward the idea, that buyers have more bargaining power under the following conditions;
It is concentrated or purchases large volumes relative to seller sales. The organisation has little or no choice but to bargain with buyers, as there are few alternative buyers in the industry.
The products it purchases from the industry represent a significant fraction of buyerÐŽ¦s costs or purchases. Buyers will shop around and get a better price and purchase selectively.
The products it purchases from the industry are standard or undifferentiated. If the buyer can easily switch products, without any great difficulty, then they will switch.
Buyers pose a creditable threat of backward integration. As with suppliers above, the buyers bargaining power is increased if the buyer is able to backward-integrate and take over the role of the organisation.
The buyer has full information. When the buyer has full information about the product (demand, market prices, supplier costs), being supplied they can exert their power to ensure they receive a favorable price.
The threat of potential new entrants.
New entrants to an industry bring new capacity, the desire to succeed and gain market share, and new ideas. New entrants will enter an industry where the profit margins are attractive and the barriers to entry are low. Porter put forward seven major barriers to entry;
Economies of Scale: refer to the declines in unit costs of a product as the absolute volume per period increases. Economies of scale deter entry by forcing the entrant to come in at large scale and risk strong reaction from existing firms or come in at a small scale and accept a cost disadvantage.
Product Differentiation: means that established firms have brand identification and customer loyalties, which stem from past advertising, customer service, product differences, or simply being first into the industry. Differentiation creates a barrier to entry by forcing entrants to spend heavily to overcome existing customer loyalties. IKEA
Capital Requirements: entry into some markets may involve major investment in technology, plant, distribution, service outlets and other areas. The ability to raise such finance and the risks associated with such outlays of capital will deter some companies.
Switching Costs: when a buyer is satisfied with the existing product or service, it is naturally difficult to switch that buyer to a new entrant. Switching costs may include; employee retraining costs, cost of new equipment and cost of testing.
Access to distribution channels: organizations cannot just produce quality products they must be able to distribute them to buyers through secure distribution channels. The new organizations operating within an industry must persuade distributors to deliver their products or services. SHELL
Cost disadvantages independent of scale: established firms may have cost advantages not easily replicated by potential entrants no matter what their size and attained economies of scale. The established firms know the market well, have the confidence of the main buyers, have invested heavily in infrastructure to service the market and have specialist expertise, new entrants will find it extremely difficult to gain a hold of the market. KIA CARS
Government Policy: governments can limit or even foreclose entry into industries with such controls as licensing requirements and limits on access to raw materials. Government policies can include; regulations on air and water pollution, and health and safety standards. CHINA TOYS
The threat of substitutes.
All firms within an industry are competing, in a broad sense, with industries producing substitute products. Threats from substitutes will depend upon the number available, and how easily it can be substituted for the other product. Substitutes can keep the prices within an industry down. The degree of competition from substitutes will depend on:
The possible threat of obsolescence,
The willingness of buyers to substitute,
The cost of