Porter's five forces: what makes your industry profitable

Two owners can work equally hard and price equally sharply, and still end the year with very different profits because they are in different industries. One installer turns work away; one gym owner fights a budget chain for every member. Porter's five forces explain the difference: the structure of an industry decides how much of the value it creates stays with the companies in it.

The effect is large. McKinsey found that about 50 percent of a company's position on the profit curve is driven by its industry (source: McKinsey, February 2018). Your own choices still matter, but you should know which forces push on your margins before you decide where and how to compete.

What Porter's five forces model says

Michael Porter, then a young associate professor at Harvard Business School, set out the model in How Competitive Forces Shape Strategy (Harvard Business Review, March 1979) and returned to it in The Five Competitive Forces That Shape Strategy (Harvard Business Review, January 2008). His starting point is that competition for profit goes beyond the rivals you know: customers, suppliers, potential entrants and substitutes all compete for the same value.

The five forces are the threat of new entrants, the bargaining power of suppliers, the bargaining power of buyers, the threat of substitutes and the rivalry among existing competitors. Together they determine how the economic value an industry creates is divided. Porter's institute at Harvard puts it simply: industry structure and a company's relative position within the industry are the two basic drivers of profitability. The five forces cover the first; your strategy covers the second.

First define the industry you analyse

The most common error comes before the analysis starts: drawing the boundary of the industry in the wrong place. Porter defines the relevant industry along two lines, the range of products or services and the geographic area. If the forces differ between two product groups or two regions, treat them as separate industries.

Two tests help. If you raised your price, where would customers go? Those suppliers belong in your industry. And would a newcomer need different skills, customers or suppliers to compete with you? Then the forces probably differ. A heating installer working for households and one fitting out offices for large contractors face different buyers, so they deserve separate analyses even though they hold the same licences.

The five forces: questions and indicators per force

Factors, not forces: government, technology, growth and complements

Is government the sixth force? Porter says no. In his 2008 article he treats industry growth, technology and innovation, government, and complementary products and services as factors that work through the five forces. A new regulation matters because it changes the intensity of rivalry or the height of entry barriers; a new technology matters because it makes entry or substitution more or less likely.

Adam Brandenburger and Barry Nalebuff give complements more weight. They describe a complementor as someone who makes your products and services more rather than less valuable, the opposite of a competitor. Whether or not you call it a sixth force, list your complements separately: a scarce complement can hold back demand even when every force looks favourable.

Five forces example: installers and gyms side by side

The table rates two industries in the same mid-sized city. It shows how differently the same five questions can turn out.

The arithmetic shows where the pressure lands. Take a gym with revenue of €600,000 and a profit of €48,000. At lease renewal the landlord raises the rent of €120,000 by 15%, or €18,000. Members can walk to a budget chain, so the gym cannot pass the increase on, and profit falls to €30,000: more than a third lower.

Now an installer with revenue of €2.4 million and a profit of €216,000. To keep its twelve technicians it raises their pay by €3,000 each, €36,000 a year in total. Its order book is full and customers wait for a slot, so it adds 2% to its rates on €1.5 million of labour revenue, which brings in €30,000. Profit ends at €210,000.

The gym faces three strong forces at once and needs a position that weakens them: a niche such as rehabilitation, older adults or one sport, coaching that an app cannot replace, and a lease negotiated well before renewal. For the installer the decisive force is the labour market, so training and keeping technicians matters more than any price move. How to choose such a position is the subject of Porter's generic strategies.

Fictitious Firmfocus example. The ratings are indicative and differ by country and region; compare real margins and cost structures in the industry figures. The logic works in any currency.

Seven pitfalls Porter warns about

• Defining the industry too broadly or too narrowly: the boundary decides which forces you see.
• Making lists instead of analysing: a list of every factor is not an analysis; measure where you can, for example concentration, margins and switching costs.
• Giving every force equal attention: dig deep into the two or three forces that really set profit.
• Confusing effect with cause: price-sensitive customers are an effect; the cause lies in their economics, such as how large your product looms in their costs.
• Static analysis: look at where each force is heading over the coming years, as well as where it stands today.
• Mistaking a cyclical dip for structural change: one bad year is not a new industry structure.
• Labelling instead of choosing: the point is not to call an industry attractive or unattractive, but to decide where and how to compete in it.

What the five forces model does not explain

The model explains the average profitability of an industry, not why one firm in it earns far more than another. That depends on position, such as lower costs, a differentiated offer or a well-chosen niche, and on capabilities that rivals find hard to copy (see core competences and VRIO). The model also focuses on competition and says little about cooperation, which is why the thinking on complementors is a useful addition. Where industry boundaries blur, for example when a platform links buyers and sellers from many sectors, you may need several analyses side by side.

Five forces in a small business and in a larger organisation

The five forces sit between the PESTLE analysis of the wider world and the competitor analysis of individual rivals, and their outcome feeds the SWOT analysis. All models are in strategic analysis, and every other topic in Strategy.