Competition goes beyond rivals

Managers often define competition too narrowly, seeing only direct competitors. But profit competition includes four other forces: customers, suppliers, potential entrants, and substitute products.

Five forces shape industry structure

The extended rivalry from all five forces defines an industry's structure and shapes competitive interaction. Understanding these forces reveals why some industries are profitable and others are not.

Structure determines profitability

Industry structure drives competition and profitability, not whether an industry produces a product or service, is emerging or mature, high tech or low tech, regulated or unregulated.

Profitability varies dramatically

Between nineteen ninety-two and two thousand six, average return on invested capital in U.S. industries ranged as low as zero or even negative to more than fifty percent.

Soft drinks beat airlines

At the high end are industries like soft drinks and prepackaged software, which have been almost six times more profitable than the airline industry over the period.

Threat of entry

New entrants bring new capacity and desire to gain market share, putting pressure on prices, costs, and investment. The threat of entry puts a cap on an industry's profit potential.

Seven barriers to entry

Entry barriers include supply-side economies of scale, demand-side benefits of scale, customer switching costs, capital requirements, incumbency advantages, unequal access to distribution channels, and restrictive government policy.

Scale economies protect incumbents

Firms producing at larger volumes enjoy lower costs per unit because they spread fixed costs over more units, employ more efficient technology, or command better supplier terms.

Network effects deter entry

Buyers trust larger companies more and value being in a network with more fellow customers. Demand-side benefits of scale discourage entry by limiting customers' willingness to buy from newcomers.

Switching costs lock in customers

Switching costs are fixed costs buyers face when changing suppliers, such as retraining employees or modifying processes. High switching costs make it harder for entrants to gain customers.

Supplier power captures value

Powerful suppliers capture more value by charging higher prices, limiting quality or services, or shifting costs to industry participants. They can squeeze profitability from industries unable to pass on cost increases.

When suppliers gain power

A supplier group is powerful if it is more concentrated than the industry it sells to, does not depend heavily on the industry for revenues, or offers differentiated products with no substitutes.

Buyer power forces concessions

Powerful customers force down prices, demand better quality or more service, and play industry participants against one another, all at the expense of industry profitability.

When buyers gain leverage

Buyers have negotiating leverage if there are few of them or each purchases in large volumes, products are standardized, they face few switching costs, or they can threaten backward integration.

Substitutes limit profit potential

A substitute performs the same or similar function as an industry's product by different means. Substitutes place a ceiling on prices and limit profit potential if the industry does not distance itself.

Rivalry destroys profitability

Rivalry among existing competitors takes many forms including price discounting, new product introductions, advertising campaigns, and service improvements. High rivalry limits industry profitability.

Price competition is most destructive

Rivalry is especially destructive to profitability if it gravitates solely to price because price competition transfers profits directly from an industry to its customers.

“Rivalry is especially destructive to profitability if it gravitates solely to price because price competition transfers profits directly from an industry to its customers.”

Growth does not guarantee profit

A common mistake is to assume fast-growing industries are always attractive. Growth can put suppliers in powerful positions and high growth with low entry barriers draws entrants.

Technology alone does not help

Advanced technology or innovations are not by themselves enough to make an industry structurally attractive. Mundane, low-technology industries with high switching costs are often more profitable.

Analyze government's real impact

Government is not a sixth force because government involvement is neither inherently good nor bad for profitability. Analyze how specific government policies affect the five competitive forces.