AP Business 4.4: Strategic Frameworks: Porter’s Five Forces and SWOT Analysis

Predict first

Two companies make cardboard boxes. Northgate Packaging sells all of its boxes to two national snack makers. Ridge Box Co. sells to about 4,000 small bakeries and gift shops. Whose customers have more power to push prices down?

Porter's Five Forces

Michael Porter's Five Forces is a framework for evaluating a competitive environment: how intense the competition is, how attractive the market is, and how much profit a business could potentially earn there. A business might use it when deciding which new market to enter or which pricing strategy to adopt.

The five forces that shape competition are existing competitive rivalry, the threat of new entrants, the threat of substitute products, customer power and supplier power. Each one describes how power held by a group of participants, such as customers or suppliers, can threaten a business's ability to compete successfully.

The five forces, and when each one is a strong threat
Force	What it describes	The threat is strong when
Competitive rivalry	How intensely the businesses already in the market compete, which depends on how many rivals there are, how differentiated their products are and how much pricing power they have	There are many direct competitors with equivalent products, and businesses have little pricing power
Threat of new entrants	How easily new businesses can enter the market, which depends on the barriers to entry	Barriers to entry are low, so new businesses can easily enter and capture market share
Threat of substitute products	How available substitutes are: products that meet the same customer needs but are not direct competitors	Customers can meet their needs with a variety of alternatives, especially ones that are cheaper, easier to get or higher quality
Customer power	Buyers' power to drive prices lower, shaped by the number of customers, customer acquisition costs and switching costs	There are few customers, each one is a large share of sales, acquisition costs are high and switching costs are low
Supplier power	Resource providers' power to raise input costs, the prices they charge for raw materials and component parts	There are few resource providers to choose from, and switching to a new one is costly

Reading the forces

Competitive rivalry is typically understood as the strongest determinant of competition in a market, so it is a good place to start. A town with eleven nail salons offering the same manicure at the same price has fierce rivalry, and none of them can raise prices without losing customers to the others.

Barriers to entry are obstacles that make it hard for new businesses to compete, such as patents, regulations that limit rivals, limited access to resource suppliers, high startup costs, and the low prices that come with operating at a large scale. Switching costs are the monetary and psychological costs a customer takes on when changing the product or brand they buy. Moving a restaurant's ordering, payments and reservations to new software costs money and weeks of retraining. Trying a different brand of paper towels costs nothing.

Customer acquisition cost belongs on the customer side because when winning a new customer is expensive, losing one you already have hurts more, so the customers you have can push harder for a better price. On the supplier side, what matters is how competitive the market for each resource is. The more businesses that sell a resource, the less power any one of them has to raise its price.

Put the five together and you have a verdict on the market. When the forces are strong, the market is less attractive, because they reduce the profit a business can potentially earn there. When they are weak, the market is more attractive.

Worked exampleShould Brightway enter Elmwood?

Brightway Pet Grooming runs two shops and is thinking about adding a mobile grooming van in the suburb of Elmwood. Its research found:

Three mobile groomers already serve Elmwood, with nearly identical services at nearly the same prices.
Starting up takes a grooming van, which costs about $70,000, and a standard business license. Nothing else keeps a newcomer out.
Pet stores in Elmwood have do-it-yourself dog-wash stations, and many owners bathe their dogs at home.
Customers are thousands of households, each a tiny share of sales, and switching groomers takes one phone call.
Many companies sell grooming supplies and vans.

Use the five forces to judge how attractive the Elmwood market is.

Competitive rivalry: strong. Three direct competitors sell nearly identical services at nearly the same price, so none of them has much pricing power.
Threat of new entrants: fairly strong. The van is a real expense, but it is the only barrier. No patents, special licenses or exclusive suppliers keep the next groomer out.
Threat of substitute products: strong for baths. Owners can wash a dog at home or at a pet store station for much less. Substitutes are weaker for full haircuts, which most owners can't do well themselves.
Customer power: mixed. Each household is a tiny share of sales, which keeps customer power down. But switching costs are close to zero, which pushes it up.
Supplier power: weak. Many companies sell grooming supplies and vans, so no single supplier can raise Brightway's input costs by much.

Answer.

Rivalry and substitutes are strong and new entrants are a real threat, so Elmwood is not an attractive market for basic grooming. If Brightway goes in, it needs something that rivals and do-it-yourself stations can't easily match, such as full haircuts by groomers known for handling nervous dogs.

SWOT analysis

SWOT analysis is a framework for evaluating the internal and external factors that influence a business's ability to accomplish its goals and remain competitive. Its four factors are strengths, weaknesses, opportunities and threats.

Strengths and weaknesses are internal: they are about the business itself. Opportunities and threats are external factors beyond the business's control. In a SWOT analysis, anything outside the business counts as external, including conditions in its own market such as a growing customer base or a rival closing its doors.

The four SWOT factors
Factor	What it is	Examples
Strengths	Internal advantages	Core competencies, brand recognition, intellectual property, product quality, ample funds, skilled employees, supply chain efficiency
Weaknesses	Internal disadvantages	Missing core competencies, low brand recognition, product flaws, limited funds, inability to staff skilled employees, poor customer service, outdated technology, supply chain risks
Opportunities	External factors beyond the business's control that may contribute to its success	Market growth, reduced competition, technology advancements, favorable changes in government regulation
Threats	External factors beyond the business's control that may hurt it	Rising input costs, natural disasters, unfavorable changes in government regulation, disruptive innovation that changes the way customers meet their needs

Sort it

Juniper Lane Candles makes soy candles and sells them online. Tap each finding from its SWOT analysis, then tap where it belongs.

Strengths

Weaknesses

Opportunities

Threats

Strength or weakness compared with what?

SWOT analysis looks at a business's internal capabilities: its financial, physical and human resources, and intangible assets such as brand recognition, reputation and intellectual property. Whether a capability counts as a strength or a weakness depends on what you compare it with, such as rivals, industry benchmarks, past performance or external factors. A hotel with an average guest rating of 4.3 out of 5 has a strength if the hotels nearby average 3.9, and a weakness if they average 4.7.

On the external side, SWOT analysis looks at the potential size of the market, customer preferences, the PESTEL factors (political, economic, social, technological, environmental and legal) and the five forces, to judge whether they create a favorable climate for the business. The two frameworks fit together: a Five Forces analysis feeds the opportunities and threats in a SWOT.

The analysis is only worth doing if it changes what the business does. Businesses use the results to make strategic decisions about how to:

build on strengths, as Juniper Lane could by putting its top-rated scents at the center of its holiday ads;
address weaknesses, such as fixing the website before the holiday rush;
capitalize on opportunities, such as reaching out to the customers of the rival that closed;
respond to threats, such as testing a wax blend that uses less soy.

Check your understanding

1

An analysis of the food truck market in a college town finds strong rivalry, low barriers to entry and many low-cost substitutes nearby. What does this suggest about the market for a new food truck?

2

Rosa's Bakery makes its best-known bread with a stone-ground flour that only one mill in the region produces. Switching to another mill would mean new shipping arrangements and months of recipe testing. Which force does this describe as strong?

3

A city bus system is studying the forces that affect it. Which of these is a substitute product rather than a direct competitor?

4

Which finding belongs under opportunities in a SWOT analysis for a regional solar-panel installer?

5

A bakery's SWOT analysis finds that its sourdough is a strength and that a large office park opening nearby next year is an opportunity. Which decision builds on the strength to capitalize on the opportunity?