Porter’s Five Forces…Explained

The trouble with value chains—which I unveiled Monday—is that they don’t stay the same forever. They are constantly changing. Disruption, right?

Take filmed entertainment. In 1980, it was just movies and TV, with movies in theaters and TV on broadcast. But home entertainment, cable, digital and the internet have all disrupted those two models. Plus toys and merchandise are sold for all of it now at unconsidered levels back then.

While the value chain shows how things currently flow, it is pretty silent on how the things relate. Who has the power in the relationship? Who creates the most value? And for people at the same part of the value chain, what is it like? So we need another tool.

And thus enters perhaps the most famous tool in strategy.

Porter’s Five Forces…Explained!

The second tool is similar to the first one, but focused on a single part of the value chain. The competitors at one layer. And to complicate it, after Porter unveiled it, he added a sixth force, so it’s the five forces, plus one. Here’s the shell of that model:

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That’s from Wikipedia, so I hope they don’t mind me borrowing. (And yeah pro sports tip: Wikipedia is pretty damn good at explaining a lot of economic, statistical, business and other scientific concepts. It doesn’t replace reading the underlying books, but is great for refreshers.) My change is to tilt the model from the Wikipedia version:

Screen Shot 2019-04-10 at 3.11.17 PMValue chain analysis and five forces analysis serve two different purposes. The value chain is really about analyzing who creates and captures value at each stage, with the specific costs, gross margins and profits at each potential stage. (Twitter follower Simon pointed me to the Exponent podcast from 2017 that digs in to this usage a bit deeper.)

Five forces analysis is about the power of each of the inputs or outputs of an industry on the potential to make a profit. But usually limited to one stage. It helps explain why profit margins are high or low given the biggest inputs on those margins. Here’s the picture from my text book. It combines how my model (listing the players) and the Wikipedia model (showing the forces). (Again, I love my Strategic Management text book, and they have it oriented my way):

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As I clarified, I could build a “Porter’s Five Forces” model/run a five forces analysis on potato chip manufacturers or stores or distributors or even potato farmers. Since we’ve been doing manufacturers this whole time, let’s keep with that:

Screen Shot 2019-04-10 at 3.11.38 PM

The key insight of a five forces analysis is explaining how strong or weak each of the interactions is. This is usually described as as high or low power. The power of each part is relative to your strength/situation. If someone has a lot of power, that means they can demand lower prices to buy, or higher prices to sell. The power of this model is it visualizes the strength of the various relationships. 

Still, let’s walk through the steps, to explain the value in the various components. And that pesky “plus one” that doesn’t fit neatly into the chart.

You start with suppliers to the west. Say your main supply is a commodity, like oil or corn or even energy. Well, the suppliers don’t have a lot of power to charge you higher prices since commodities tend to be priced at what the market can bear. If, on the other hand, you have a monopoly on the supplies—say a patent on a new drug—you can charge exceptionally high prices. 

For potato chips, you’ll notice there are many more supplies required to make the final product than just potatoes. However, for the most part those other supplies are still commodities, so my gut is the suppliers have low pricing power for the potato chip manufacturers.

On the east side of the model, you have buyers. Buyers are not “customers” necessarily and absolutely not necessarily “consumers”. If buyers have lots of power, they can demand lower prices. Take gas stations: I can always drive to the next one. If their power is low, it means they have to price low to get your business. Another currently relevant versions is tax returns. Only a few company offer the services, and they’re really hard to do, so consumers have less bargaining power. (The fewer options, the less bargaining power, in general.)

Let’s head to the middle of the model. The value chain is usually silent on this part: what is it like for you at your part of the value chain? If there are lots of players, then competition can be very fierce. Again, think commodities and all the potato farmers showing up to the farmer’s market at the same time. Or the ice cream truck wars of Portland. On the other hand, in heavily consolidated industries like cell phones or cable companies, isn’t it funny how they all sort of charge the same price, for usually bad products? That’s a lack of rivalry among firms. 

For potato chips, the main thing is that while it seems like there are a ton of potato chip options, uh, there aren’t. Frito-Lay owns them all. Doritos, Cheetos, Tostitos, Ruffles. All Frito-Lay. While there are smaller brands that have entered and expanded business in the last twenty years—Kettle Chips mainly—I’d say that rivalry is low among firms, because Frito-Lay buys most competitors, or uses its power to keep its shelf space with buyers. 

In general, the CPG companies have about 5-6 huge companies that own all the brands. I’m not sure if I’d call this rivalry fierce or not. I could argue either way. On the pro side, there is a lot of battles over price and the companies run small margins (see Kraft and Buffett right now). On the con side, with only 10 major players, there is a lot of unspoken agreements on behavior and sharing shelf space.

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The other thing that can really drive down margins is the ability for new firms to enter. (And this will probably be the key to discussing entertainment next week.) Look to the north of the model for this. If it is really easy to enter a market, then the barriers to entry are low. This can also force firms to keep prices low to ward off entrants. If the barriers to entry are high, then you can keep charging high prices or capturing value. Think cable companies for forty years in this way. Since it costs a fortune to lay fiber optic cable, the barriers to entry are very high. (Notably, Google’s adventures in fiber optic cable have been bad, but every tech company wants to launch a video service.)

The barriers to entry are high in consumer packaged goods, even though they shouldn’t be. This come from the massive consolidation at the center of the industry, which means the current players can try to box out upstarts. This is complicated to explain—and I don’t have enough numbers to prove my point right now—but it is easy to start a hot sauce, barbecue, or even chip company. It can be impossible to get national distribution. (And I don’t credit some sort of clever business strategy for this, but industry consolidation.)

The only new entrant I can think of is Kettle Chips, at least nationally, in America. Twenty-five years ago, they weren’t a thing and now they are. (Why? To summarize, a family company sold their company to a British PE firm, who later sold it to one company, who was bought by another and that company was bought by…Campbell’s Soup. Who didn’t even make the above chart.)

(Oh, all of these business examples are from America, for my foreign readers. That’s the market I know best.)

But while it can be hard to break in, that doesn’t mean there aren’t alternatives for customers. This brings us to the “south” and a perfect example of how a Five Forces analysis can provide insights the value chain can’t on its own. Substitutes are things that can fill in for the core product. You can either think of these super broadly or narrowly. An Oscar worthy example of this was when Reed Hastings said Fortnite is a bigger competitor than traditional TV for Netflix, he really meant it is a substitute for leisure time.

Potato chips have many substitutes. Say consumers want something healthier, they could eat pop chips or Hippeas. Those are healthy items that fill the same need of something to snack on. Or nuts for protein. Or pretzels. Or Cheetos. Even tortilla chips substitute for potato chips. If you go natural, apple slices! Those are examples of other substitutes for snacking and you could even go into candy. (Though we risk starting up the “snack vs treat” debate.) Moreover, you could decide to just NOT eat chips, which is healthier anyways. So here’s our chart with my “back of the envelope” perception of power:

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So my take on potato chips that the biggest piece keeping prices down is that you can always choose not to eat them. You don’t need chips to survive, and actually will live longer if you eat less of them. But that’s my gut take without pulling specific pricing numbers. (And if someone knows CPG better than me, which is a lot of people, shoot me a note if I got something wrong.)

Oh, did you notice that new piece, in the upper right? After rolling out these forces, Porter later added the “plus one”, complements. These are things that add value to the core product. For potato chips, think ranch or onion dip. Dips take a plain potato chip and kick it up a notch. Or salsa on tortilla chips. They aren’t in your value chain (presumably), but they definitely impact your bottom line.

Connecting the Value Chain to Five Forces

You may have noticed my sellers, incumbents and buyers had the same shapes I used in my value chain. I used the same shapes, because frankly, you can see that the value chain is really just the middle line of the Five Forces model. A connection that literally no one (that I know of) made in business school. They were basically two pictures of smaller parts of a much larger image, which is roughly the interlocking pieces of any industry. So I combined them, and since I felt like I was creating something new, I gave it my own name:

The Value Web

I call this my “insight” because again I really haven’t seen it in other places. And most of the maps of entertainment ignore the value chain component, instead using company names. the value pieces, as opposed to just company names. The name is simple: Value, because I love it above all else, and web, because it explains not just one layer but all the interlocking pieces. 

(I haven’t seen this term in other places, but Clay Christensen uses the term “value network” in The Innovator’s Dilemma, so it may not be that clever of an idea. And Deloitte uses it here, but focused on the supply chain.)

So let’s look at a value web for potato chips. 

Screen Shot 2019-04-10 at 3.12.03 PM

Some insights. Well, the traditional buyers are under threat from web sales. Not everyone (liquor stores are fine), but eventually, lots of things will be sold online, so every brand needs a web presence. Notably, some data shows that this means smaller CPG companies can expand their presence to new markets, so maybe the incumbents have less power. So that’s why understanding substitutes and multiple parts of the chain can be useful.

This is why I like the larger view. A value web will help a company at one level understand the substitutes and new entrants across the range of the value chain. And how that may impact their business. So Popchips are a substitute for potato chips, but online shopping is a substitute for grocery stores. A potato chip company probably needs to understand both those potential substitutes. 

Digital video has new digital entrants across a range of the value chain from producers (shooting video on cell phones) to streamers and eventually even bundlers. Youtube is taking eyeballs in a different way than Netflix, which is both at the end of the value chain. Online shopping is changing toy sales. Going back in time, even reality television—with its cheaper production costs—was a substitute for scripted television at the production level. 

The challenge with building a strategy web is one of simplicity and scale. Honestly, I’ve just about maxed out what I can build on Powerpoint (a tool which works for 95% of my image creation on this website) and what 95% of business folks use. I’ll need to look up other drawing tools to build a true strategy web. And even then, it will probably get update too frequently to last long. 

But we do have the two tools needed to analyze this industry in slightly deeper depth. Which I’ll start to do with my next big series and next week as I try to define digital video.

  1. […] at that same company and imagine them as a beautiful strategic butterfly ready to emerge from the Porter’s Five Forces cocoon and fly into the world with a new competitive strategy that will help them acquire […]

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  2. […] have another tool for that, fortunately. In the past, I’ve also explained “Porter’s Five Forces”. (It’s one of my most popular articles, actually.) Read that article here. Here’s a visual of […]

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