Determining Industry Attractiveness
As a potential buyer of a business, one of the most critical factors that will determine profitability is the industry which one buys into. Regardless of whether a firm is operationally effective or not, in the long run profits are largely determined by the industry structure. For example the average return on investment for companies in the airline industry is significantly lower than companies that operate within the pharmaceutical industry. The large discrepancy between the return on investment between the two industries is due to the different industry structures. In order to determine the attractiveness of an industry it is important to analyze the 5 forces of the industry: buyers, suppliers, substitutes, rivals, and threat of new entrants. The 5 forces analysis is an industry level analysis and does not focus on individual companies.
Power of Buyers
The power of the buyers have a large effect on industry profitability. If buyers have large amounts of power they can drive prices down and extract profitability from the industry. The power of the buyers is determined by the buyers’ price sensitivity and their bargaining strength. Some aspects which affect buyers’ price sensitivity are product differentiation across companies, the cost of the product, and the buyers’ profitability. The bargaining strength of buyers is determined by the switching costs buyers’ face, alternative products, availability of information, the volume of purchases made by buyers, and degree of concentration among buyers.
Power of Suppliers
Supplier power has an inverse relationship with industry profitability. The more power the supplier has, the higher the prices they can demand from companies within the industry. Supplier power is determined by product differentiation across suppliers, switching costs faced by buyers, information available to buyers, volume of supply, degree of concentration among suppliers, and substitute inputs.
Threat of Substitutes
Substitutes can create a cap on the prices that buyers will pay and floor on the prices that suppliers will require. Substitutes can take business from companies within the industry and thus lower profitability.
Degree of Rivalry
Industries where rivalry is intense can often have lower profitability. Whether rivalry will have a large impact on profitability can depend on whether there is growth within the industry, product differentiation, switching costs of buyers, concentration/balance of competitors, and if scale and learning economies exist.
Threat of New Entrants
New entrants into an industry can also have an impact on industry profitability. If there are low barriers to entry, new companies can easily emerge and take away market share from existing companies. The threat of new entrants is therefore dependent on economies of scale, product differentiation, brand Images, switching costs, access to distribution, and government policy.
The 5 forces analysis illustrates a general overview of the industry. When the forces are strong it means the industry is hostile and likely to result in low profitability. When the forces are benign it can result in higher return on investments. It is very beneficial to companies contemplating a merger or acquisition or companies within the industry who are looking to develop a strategic position.