 What is Porter's Five Forces? It's a framework developed by Michael Porter, who happens to be a professor at Harvard University. And the purpose for this framework is to analyze the competitive dynamics of an industry. Simply put, Michael Porter wanted to know what makes an industry profitable. And as a result, if you know what makes the industry profitable, you can zoom in and know exactly what makes your company profitable. So he wanted to evaluate the root causes of profitability. Why certain industries are more profitable than others? What Porter's find out is this. Generally speaking, if there's more competition in a particular industry, and he's going to measure the competition through five different dimensions, there are less profit. So competition is up, profit down. And here are the five key forces. First is how stiff, how tough is the competition? In other words, how much do players in the industry hate each other, or they are friendly, or they are not as friendly, or they are enemies, or they are frenemies? How intense is that? Why? Because here's what's going to happen. If you work in an industry, if you are part of an industry, and the competition is stiff, the competition is difficult, the competition is tough, here's what's going to happen. When you're selling price, always your selling price is composed of part of it cost, part of it profit. So if you're selling an item for $100, if the competition is difficult, well, here's what's going to happen. If you keep selling it at $100, and your competition reduced your prices, what do you have to do? You have to reduce your prices. Therefore, when you reduce your prices, let's assume you reduce your prices to $60 to $80, you're going to still have $60 of cost, and now your profit is $20. So notice, as competition increases, you have to lower your prices, and when you lower your prices, you have to lower your profit. So more competition means less profit. Also, if you have a competition and you're selling something for $100, again, cost is $60, profit is $40, and you really want to keep, you really want to keep selling your product at $100. Well, if you choose to keep your product at $100, that's fine, but what you're going to have to do because of this competition, you have to differentiate yourself. You have to make a better product. You have to add features. You have to do more research and development. What does that mean? It means the cost rather than $60, your cost might go up to $80 because you're going to advertise more. You're going to do more R&D. You're going to maybe bundle other product with it to make your product look better appealing. You can keep your price at $100, or happen now your profit is only $20. Why? Because you had to increase your cost. So as you have more competition, you're going to generate less profit. How? You either have to lower your price, to lower your price as in this situation here, or you're going to have to increase your expenses. So this is what competition leads to. So the first force that we're going to be discussing is the intensity of competitive rivalry. And we're going to see exactly what constitute that. What are some indication of that? Two is the threat of new entrance. How easy new players to go into your industry? The easier it is, the more competition you have. The more competition you have, you either have to lower your prices, or you're going to have to spend more money on your product to make it more appealing. Three, the bargaining power of suppliers. Well, as a company, you need raw material. You need labor. Sometime it's a specialized labor. What is your relationship with these suppliers? Who has the upper hand? Do you have the upper hand? Or you can dictate prices? Or do they have the upper hand? Do you have more suppliers or less suppliers? That's going to determine your competitiveness. The bargaining power of buyers, your customers, do they have other options? Can they dictate their price? Can they kind of force you to sell at a certain price? Or you have a product that's so unique that and your customer base is so large that you don't care. What's that bargaining power? Do you have more or less? And the threat of substitutes. What's substitutes? Basically, if they don't like your product, they can go somewhere else. The customer have these options or not. And we're going to look at each one of those items and look at an example from the real world to illustrate the point. Now, why companies would need to understand this? This is going to help them create a better strategy and increase their profit. Because if they know what is the threat, if they know how to compete, then they can do better. So I'm going to start with each item separately, starting with how intense is the competitive environment. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool. That's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course, such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple-choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today. Intensity of competitive environment, basically, consider the level of competition among existing players. Are they, in some industries, companies are friendly or they kind of collude directly or indirectly with each other? For example, OPEC, OPEC, the organization for petroleum exporting countries, they basically coordinate the prices with each other versus a company like Coca-Cola and PepsiCo. Well, they fight with each other always on price. Why? Because they want to gain market share. So notice the competitive environment, same thing with the cell phone. Cell phone environment is very competitive. Always cell phones are coming up with new phones, new features, depending on your environment. So high competition can reduce profitability. As I said, how does it reduce it? Either you have to reduce your price or increase your expenses. So when I say reduce profitability, either reduce your price or increase your expenses. In both situations, you would reduce your profit. Well, you're gonna have to do, you're gonna have to do aggressive pricing, mean lowering pricing to gain market share of this competition. You might have to do research and development. Well, if you have to conduct research and development, also that's an increase in your expense because you want to develop new product, new feature, that's more cost. You have to spend more money to change the perception of the customers or potential customers or to gain brand loyalty, more cost. All of those would reduce your profit. You also might have to do product differentiation, maybe adding, you know, bundling your product with something else. Also, what determine how competitive you are is how is your alliance with your suppliers? Do you have friendly suppliers or not friendly suppliers? Do you have access to many suppliers or less suppliers? Do you have any strategic relationship with your suppliers? Because if you do, they might give you favorable pricing, they might give you favorable product in some way or another favorable relationship which is gonna put you at a competitive advantage. So another example other than PepsiCo as I told you the smartphone industry is a prime example with many manufacturers competing fiercely for market dominance. Now obviously in the US, Apple dominate, but throughout the world you have other options and that's why cell phone companies they will need to do more R&D, more R&D to create more innovations. They have to spend more money to kind of make you feel their product is different than others and there's always a price war. Also if the market is limited or shrinking, you're gonna have intense competition which means lower profit. Also what makes competition high is there's a high exit cost. High exit cost means no one wants to leave. Now why? If there's a lot of competition, I want to leave this industry, it's not the best for me. Well yes, you like to leave the industry but sometimes it's not as easy. Sometime you might have high cost or long term agreements and loans that you cannot just close your door and walk away. For example, an airline company, it takes a lot of time to start an airline company and you incur a lot of cost and there's a lot of long term agreement between you and the Boeing, the companies that's providing those airplanes maybe between you and the labor union and the pilot union. So there's a long term agreement, high fixed cost. You cannot just exit. When that's the case, you have to kind of divide the bullet and take lower profit. Okay? So this is the intensity of competition. Again, simply put, more competition, less profit. Threat of new entrants, what does that mean? Well, in the prior session, we looked at people who are already in the industry and how intense is the competition. Also you want to look at how easy for new competitors to come in, the threat of new entrants. Well, what you want to do in your industry, if you are already inside, you want to keep your barriers high to keep any new companies from coming in, okay? So this force assesses the barriers to entry for new companies, low, medium or high. For example, if you want to start a tax preparation business, it's easy. You just open a store, put a sign, I'm preparing taxes. If you want to manufacture cars, well, you need billions and billions of dollars to buy equipment, machinery, hire labor. So it all depends on how high is the barrier, okay? High barriers would exist in a monopoly or a legopoly. It make it difficult for new competitors to enter, reducing the threat to existing players and this is what you want. But what could be some indicators that you have a high barriers? If your business require high capital requirement, what is high capital requirement? You need a lot of money to start a business. Like if you want to manufacture cars, I always give this example, or you want to start an airline company, you need billions of dollars. If there's a strong brand loyalty, you don't really want to go into this industry. Why? Because to overcome the brand loyalty of the existing players, you have to spend a lot of money. And that's sometimes by itself, a barrier, I don't wanna get into this. To make a name for myself, I have to spend a lot of money only on advertising and advertising is a risky business. Sometimes you don't get what you want. If there's an economy of scale, if the existing players are producing at a scale, a large quantity of things, which is a high capital requirement, it will keep competitors out. Government regulation. If you need government approval and that's a long process, well, you're gonna stay out because you don't wanna go through this. As I said, airline companies have significant barriers to entry due to high cost of purchasing, maintaining aircraft, obtaining necessary permit and licenses, and building a network of routes. So you just stay out. Same concept with auto manufacturing, Big Pharma, McDonald's, Burger King, okay? Low barriers make it easy for anyone to join, but in low barriers industries, profit is lower and the reason is simple. Everybody can come in and open the a tax preparation firm or cut grass. You can always start this. You can buy a pickup truck, hire a crew, advertise and start the business. So it's easy if you want to cut grass, but if you want to build cars, it's difficult. Less competition, equal to more profit and higher value for the company. But bear in mind, high barrier companies because they have a high capital cost, sometime that could work against them when the economy is not doing good. When the economy is not doing good, those companies cannot kind of basically turn around very quickly because they have a high fixed cost. A high fixed cost means what? You have to cover that fixed cost and if you can't do that, you would operating at a loss. So high barrier companies also they have large risk because they have a high capital intensive company. Let's take a look at bargaining power of suppliers. No company can exist without employees and without someone supplying their product. Even if they supply their own product, you still need employees to manufacture it and the fact that you are supplying your own product it's a risk by itself because you may need specialized knowledge. So this force examined the power of suppliers and when I mean suppliers, we also include labor because a specialized labor is expensive, it's rare. The supply is not a lot, for example, if you're looking for nurses, for CPA, for people in the IT industry, artificial intelligence, you cannot find them easily or if the labor is organized labor like the pilot union, you have to pay them extra money. They could have more demands. So labor and material are sources for you to conduct your business. So the suppliers can influence profitability by controlling prices, quality and access to your input, the availability of your input. So basically they have some saying in your profit, why? Because if they feel they have the upper hand, what would they do? They will raise their prices and when they raise their prices, well, you have to take a lower profit because if your cost is high, your profit is low. On the other hand, it could be the opposite. It could be where the business dictate. Tell the supplier what they're going to pay. A company like Walmart, they forced it, they tell their supplier this is how much we're gonna pay. If you don't like it, we'll go somewhere else and if there's no somewhere else, we're gonna manufacture it ourselves. So suppliers, they will have, if they want to sell to Walmart and sell billions of dollars, have a large account, they have to listen to what Walmart has to say. But that's not all businesses. Some businesses, the suppliers can influence them. If there are few suppliers alternative or switching costs are high, suppliers will have more power. If the suppliers have more power, they know it. And when they know it, they will increase their prices. And when they increase their prices, they make more profit, you make less profit. Or you cannot change easily. You cannot change from one supplier to the others. For example, major automobile manufacturers rely on a vast network of suppliers for various components such as engine, tires, and electronics. If these suppliers have few alternatives, in other words, there's not many of them or possess a unique expertise, then they can exert power by raising prices or limiting the availability of critical product, affecting the profitability of the manufacturers. So that's why you have to look at your suppliers. Who has the upper hand? Same thing with suppliers, you wanna sell to customers. Who has the upper hand? Do you have the upper hand or do customers have the upper hand? This force here examined the power of buyers to negotiate for lower prices, demand better quality, or seek more favorable terms from company within the industry. Simply put, if the customer says, I don't like this, I can go somewhere else, they have more power. Or if they cannot say this, they said, you know what, I'm gonna buy the bullet on this and I'm gonna pay your price, then you have more bargaining power. Depending on what you are selling, are you selling something generic? Are you selling something that you can find anywhere or are you selling something that's unique? And that's hard to tell because it all depends on the perception of the buyer as well because you're always, you're gonna see, I'm gonna show you, there's always a substitutes, but is that acceptable for the customer or not? The stronger the bargaining power of buyers, the more influence they have in shaping the dynamics and profitability of the industry. So if the customers are strong, you're gonna have lower profit. Lower profit. Also concentration of buyers. Do you have a few buyers in this industry? Few buyers or large volume of buyers? Which one do you have? If you have a few buyers, then that's risky because if you have few buyers and one or two of them or 10% of them or 20% of them don't like you, don't like your product, you're in trouble. But if you have large volume of buyers and for example, you're selling a subscription. For example, I'm selling, you know, Farhat lecture subscription. My subscription is, will appeal to many people because it's a, it's a 20, let's think about this. If you are looking to buy a CPA course, there's one course where you, where you have to pay upfront $1,500, okay? Not many people are willing to pay $1,500 or $2,000 versus my subscription is $30 per month. For $30 per month, I'm gonna find more people taking the subscription, at least trying it, versus paying you upfront $1,500. So I will have a larger volume of buyers with my subscription rather than having one large price where you have to pay upfront. I'm gonna have fewer buyers. So in other words, since I have more buyers, if one buyer don't like the $30, that's fine. I have hundreds of them that will like it. But if I have only five buyers for the upfront large cost and two of them decided not to go with it, then I'm gonna be losing a lot of sales. Availability of substitutes, we're gonna talk about that later. Again, do the customer have more options or less options? For example, smartphones, right? If they don't like the iPhone, they can go with something else. That's fine, there are options. Also how price sensitive they are. Are they have high sensitivity? If they have high sensitivity, the price, you might wanna provide them discount to attract them because they look at the price, the price what matters. Then you have lower profit. If they are not sensitive to price, for example, in the pharmaceutical industry. Well, I mean, without government regulation, basically pharmaceutical companies can charge any number, any price. But you can do that because government will be like, yeah, this is too much. Switching cost, is it easy for the buyer to switch from one company to another? For example, how easy it is to switch from Netflix to Amazon Prime? Very easy, sitting on my couch, I can cancel Netflix and subscribe to Amazon. I don't have to even move. How informed is the buyer? Now the buyer should be well informed because of the internet and artificial intelligence. I'll tell you this story. I just, that's why I had the car dealership here because my cousin, back in the 1990s, mid-1990s, he was in his mid-40s. And he was relatively not young when the internet came out. And he did not like to use computers in the first place. Now what happened is he used to buy and sell cars as a part-time work. So he'd buy an old car, put it in a newspaper, sell it. If he sees someone selling a car in the newspaper, he will buy it and resell it. So he was a car dealer on a part-time basis. So when the internet started to be a common tool with everyone, everyone was looking up prices, looking up what's the recent trend in prices, what's the latest car was sold for in your area, so on and so forth. They have access to the blueprint. He hated the internet. I remember talking to him back then, he said, I don't like the internet. I don't like the internet. I said, why? Because he said, before he would be able to tell customers things, only show them what he wanted to show them about the car, the good features about the car, because he had all the knowledge. There was no internet. You needed the blue book, and many people did not have the blue book. And he was able to charge higher profit. Once the customer is informed, then they know the pros and the cons, the quality of the car and not the best quality so they can negotiate with you. Also, when you want to buy something, you could always go on the internet and see how much it's selling for. Therefore, you have more power as a buyer. Generally speaking, with more knowledge, with the internet, buyers, customers should have more power. Threat of substitutes. Well, as it suggests, do customers have substitutes? What's the availability of alternative product or service that they can fulfill their similar need? If substitutes are readily available and a four comparable benefit at a lower price, well, then they can pose a threat to your industry. As a result, you have less profit. However, if the opposite is true, then you could have more profit. As I mentioned earlier, for example, cost to switch between Netflix, Amazon, and Disney Plus is real easy. The substitute is there and you could easily switch. How about a company like Tesla? Tesla is an electric car. And you might think, well, this is a specialized item. If you want to buy it, you have to pay premium. Indeed, you have to pay premium. But do customers have substitutes? And the answer is yes. They don't have to buy an electric car. If they want to buy an electric car, there is other alternative. Ford is building one. GM is building electric cars. So there are substitutes. There's always substitutes. Well, you don't even have to buy a car. You could use public transportation. That's a substitute. It all depends on the perception of the customer. Believe it or not, although Tesla is a specialized or it's the leader in its industry, recently they reduced their prices. And when company reduced their prices, as I mentioned at the beginning, it means they are feeling the intensity of competition. Believe it or not, since we don't have a monopoly, the competition, generally speaking, between companies is intense. As a result, company will need to understand Porter's five forces. So they understand their business. They understand what industry they are dealing with. So they can do what? They can better strategize and increase their profit. You want to know everything you need to know about your competitors, the threat to new entrants, the power of your suppliers, the power of your buyers, as well as the threat of substitutes. You want to deal with those? Try to manage to differentiate yourself, make yourself look special, so you can keep your prices up. What should you do now? Go to Farhat Lectures and work MCQs about Porter's five forces, about preparation for your next exam. Good luck, study hard and of course, invest in yourself and stay safe.