Diagnosis: Understanding your industry structure and the competitive forces driving profits

A good place to start your diagnosis is with an overall understanding of your industry and the forces driving prices and therefore profitability. The concepts are taken primarily from Michael Porters’ book, “The Five Competitive Forces That Shape Strategy.” Mr. Porter is a professor at Harvard. The book is years old but the material is still relevant. This information will get you off on a good footing for diagnosing the problem.

Every industry is different but the underlying drivers of profitability are the same in every industry. These five forces will help you:

Asses industry attractiveness

See how trends will affect industry competition

Determine which industries a company should compete in

Visualize how companies can position themselves for success

Anticipate shifts in competition

See how industry structure evolves

Find better strategic positions within the industry

Following is a summary of the five forces that shape strategy.

One. The Bargaining Power of Buyers

How buyers can use their clout to force prices down or demand more services at existing prices. Therefore, capturing more value for themselves. Power is highest when buyers are large compared to competitors, products are undifferentiated and represent a significant cost to buyers, and there are few switching costs.

Two. The Bargaining Power of Suppliers

Powerful suppliers can use their negotiating leverage to charge higher prices or demand more favorable terms which lower industry profitability and switching suppliers can be difficult, expensive or time-consuming.

Three. The Threat Of New Entrants

This threat can keep prices down and cause the company to spend more to retain customers. Entry brings more supply and lower prices. The threat of entry puts a cap on the profit potential of an industry. The threat depends on the barriers to entry, economies of scale, cost of building awareness, government restrictions, etc.

Four. The Threat of Substitute Products or Services

When a new product or service meets the same basic customer need in a different way, industry profitability suffers. However, it depends on the price-performance trade-offs.

Five. Rivalry Among Existing Competitors

If rivalry is intense, it drives down prices or dissipates profits by raising the cost of competing companies. A rivalry tends to be fierce if:

Competitors are numerous or roughly equal in size and market position

Industry growth is slow

There are high fixed costs which are incentives for price-cutting

Exit barriers are high (e.g., high debt load)

Rivals are highly committed to the industry.

This analysis will give you a good foundation to move on to other analyses like the next one on Creating Blue Ocean strategies.