Leaders today know that staying competitive in their industry requires constant innovation and outsmarting the competition. But while leaders may understand what drives success, they often don’t know how to build a lasting competitive advantage. Most of the analysis takes place at the company level to identify the distinguishing characteristics that set that company apart. However, company analysis can only give you so much info. As a result, you may still be asking yourself why are some companies more profitable than others? The answer may surprise you since it is an often-overlooked area of analysis – the industry the company is operating within.
The most popular model for examining industry attractiveness was created in 1979 by Michael E. Porter of Harvard Business School. It examines five specific factors that determine whether or not a business can be profitable in relation to other companies in its industry. According to Porter’s theory, understanding the competitive forces at play and the overall industry structure is essential for strategic decision-making and developing a compelling future competitive strategy.
To use the five forces, Professor Michael Roberto, author of Know What You Don’t Know: How Great Leaders Prevent Problems Before They Happen, states you first need to define the industry you want to analyze, identify the players and understand the critical future industry trends. The five forces, according to Porter’s model, are the following:
- Barriers to entry – is it easy for competitors to enter the industry when demand and profits are high? The industry is more attractive with higher barriers to entry.
- Bargaining power of customers – do the buyers have leverage and power over price? If buyers don’t see much difference among competitors, they will be more price sensitive and have more bargaining power.
- Bargaining power of suppliers – what kind of power do the suppliers of critical inputs have over you? The fewer suppliers, the more power they have in controlling the prices of those key inputs, which increases your costs.
- Rivalry among existing competitors – do price wars happen in the industry? If so, then likely that industries products are very similar and not differentiated.
- Threat of substitutes – how easy is switching from one product to a competitor’s product?
Attractive industries have high barriers to entry, low bargaining power of customers and suppliers, low rivalry among competitors, and low threat of substitutes.
In his program with The Institute for Management Studies, Professor Michael Roberto uses this model to analyze industry attractiveness. He admits this framework has shortcomings, such as it doesn’t address complements, does not account for non-price rivalry, and sometimes it is challenging to define industry boundaries. With that being said, it still can provide insights into why certain companies are more profitable than others.
For example, the pharmaceutical industry is very attractive according to Porter’s Five Forces.
- Barriers to entry are high due to the costs of bringing a new drug to market.
- The threat of substitutes is very low initially until generic substitutes are produced.
- Rivalry among competitors is low due to patents and federal regulations.
- The bargaining power of the customer is low since we often don’t even see the price, just the insurance copay.
- The bargaining power of suppliers is low since the compounds that comprise most drugs are commodities that can be bought from many suppliers. The value is in the way these compounds are combined.
Where does your industry rank in this model? An even more interesting question is how certain companies have a sustainable competitive advantage in industries considered unattractive, such as Southwest Airlines and Trader Joe’s.
For more tips and techniques on what makes exceptional leaders stand out, listen to my interview with Professor Michael Roberto, where we explore more strategies and techniques of sustainable competitive advantage. You can also listen to my interview with Dr. Julia Sloan which gives practical tips on how to become a better strategic thinker and read the corresponding article I wrote on how to become a better strategic thinker.
ABOUT CHARLES GOOD
Charles Good is the president of The Institute for Management Studies, which provides transformational learning experiences that drive behavioral change and develop exceptional leaders. Charles is an innovative and resourceful leader who specializes in bringing people together to develop creative organizational and talent strategies that enable business results. His areas of expertise include assessing organizational skill gaps and leading the design, creation and delivery of high impact, innovative learning solutions that achieve business goals.