Michael Porter, a well-known strategy professor at Harvard identified five forces that shape the profit-making potential of the average firm in the industry. The five forces are: rivalry, buyer power, supplier power, threat of new entrants, and the threat of substitute products. The strength of these forces varies widely by industry. Highly technical industries, such as advanced medical products and semiconductors, for example, have a low threat of new entrants, while in the restaurant business, the threat is very high. Porter’s Five Forces can be complex and require a bit of time to fully explain, so the content of this article will focus on rivalry only.
It can be helpful to think about competition like war. Although no physical violence is involved, each company has many weapons in it’s arsenal that it deploys to gain greater profits. Because there are usually a finite number of consumers in any one market, gaining market share for yourself usually means that someone else looses some. The following seven factors are critical to understanding the intensity of rivalry in an industry:
The Number and Size of Competitors
The more competitors in an industry, the more likely that one or more of them will take action to gain profits at the expense of others. In highly concentrated industries, it is difficult to keep track of the pricing and competitive moves of numerous players. When there are only a few competitors, however, rivalry tends to be less intense and firms might be more hesitant to anger one another, resulting in pricing wars.
Standardization of Products
Differentiated products, ones that boast different features or better quality, tend to produce loyalty in customers because they meet customer needs in unique ways. When products are standardized, or commodity-like, buyers are less loyal to a particular brand and it is easier to convince them to switch brands. Competition among commodities usually comes down to who can offer the lowest price.
Switching costs include any cost to the customer for changing brands. Switching costs for buyers are related to the degree of product standardization. For example, punch cards that enable the buyer to a free sandwich after 10 are purchased is a switching cost. Also, changing operating systems for computer users can be a significant switching cost due to brand loyalty and technological expertise.
Growth in Demand for Products
When demand is increasing rapidly, most firms can grow without taking existing customers from competitors. When growth slows, however, firms can become desperate. They may try to increase their sales volume by attracting customers from their competitors through sales promotions, price discounts, or other tactics. Of course, competitors then respond with their own sales promotions and price cuts, thereby increasing industry rivalry. A recent example of this is oil. Not only has there been a global glut, but demand slowed down, resulting in the price of oil dropping from $115 a barrel to $30 a barrel in a year and a half.
Levels of Unused Production Capacity
Unused production capacity is expensive. Firms typically try to produce at or near their full production capacity so that they can spread the fixed cost of factories, machinery, and other means of production across more units. They may even try to produce more product than the market demands, in order to use their capacity completely. However, when more is produced than is demanded in the market, firms often have to drop their price or risk having unsold product.
High Fixed Costs
Industries that produce products with high fixed costs can end up with a supply of products that they have to sell quickly or take large losses on. Additionally, firms that sell highly perishable products, like fruits and vegetables, encounter similar problems. As food nears the date when produce will spoil, grocery chains often steeply discount it rather than lose the sale completely. Products with high storage costs exhibit the same characteristics.
In some industries, companies don’t exit even when they aren’t making a lot of money. They stay because they have made investments in specialized equipment that can’t be used in any other industry. Another barrier to exit is labor or government agreements that make it difficult to close a plant. Emotional ties to employees or a business can also lead to less than rational decisions by top management to stay in business.
If you analyze your industry and where your company stands according to these seven factors, it can give you a better sense of where you stand and what you need to do to compete. If you own a restaurant and recognize the high level of competition, you can find creative ways to differentiate your product through special features or how you deliver the product to the consumer. Consider how an outside CFO can assist you in your analysis of rivalry and what you can do to create and maintain a competitive edge.