Industries & Forces

Re-introducing Michael Porter

Friends,

I hope that you are all feeling splendidly well on this, in my neck of the woods anyway, cold but sunny Friday.

Before we get to the topic du jour, I thought that I would very briefly tell you about the Strategy in Praxis book club. Given the positive feedback that I have received since I first brought it up, we are going ahead and starting on March 1. The date is set so as to allow everyone interested ample time to pick up the book that we are going to feature.

Joining the club will be free but limited to subscribers only.

I initially toyed with the idea of having multiple books to vote on, but while that may (likely will) become a thing down the line once we are all comfortable with the practicalities, it would likely cause more vexation than value early on. Thus, we will begin with The Management Myth; Debunking Modern Business Philosophy by Matthew Stewart. It comes via strong recommendation from Gary Forss.

In short, the book is a scathing critique of strategic discourse, MBA programs and management training written by a former McKinsey consultant. Stewart takes on giants from Taylor and May to Drucker, Porter and Peters, highlighting (in a theme befitting of this newsletter) the weaknesses, obfuscations and plain old bullshit. Its poignant yet entertaining nature should make, I hope, for a nice start to the book club.

In order to provide a wider perspective and promote much needed gender balance, the second book we read will be one written by a woman (or women).

If you want to join the book club, please reach out to me on Twitter or send me an email.

The business at hand

Now onto the discussion of the day.

As covered in previous analyses – not least our deep dive into his generic strategies – Michael Porter’s prominence in strategic management discourse is indisputable. Most strategists will be familiar with his work, or at least the status of it, to the point where listing his achievements would have little use beyond establishing that there is a hell of a lot of them. If there were such a thing as a Mount Rushmore of strategy, Porter’s face would doubtlessly be on it.

Today, we get to the second of his two most famous contributions. First introduced in his 1979 Harvard Business Review article How Competitive Forces Shape Strategy, Porter’s five forces model details the basis for competition. The collective strength of the forces determines, he argues, ‘the ultimate profit potential of an industry’. By extension, a strategist’s primary task is to position the company in such a way that it can influence them to work in its favor.

Before we get to what the forces actually entail, it is worth noting from a historical perspective that the task befalling strategy professionals (‘strategists’) instead of senior executives is indicative of a shift that happened in the 1980’s and 1990’s. Although many of us working today find it a natural state of affairs, there is a conversation to be had about whether it has been an improvement; with the change came a clear distinction between strategy formulation and strategy implementation – and, as a result, a number of handover issues. By objective measures, these have only gotten worse over time due to ever-increasing complexity.

Anyway.

In summary, the five forces are (1) the threat of new entrants, (2) the bargaining power of suppliers, (3) the threat of substitute products and services, (4) the bargaining power of buyers, and (5) competitive rivalries.

The threat of new entrants is relatively self-explanatory. Any new player in the vertical, whether a startup or an established company diversifying into it (be it through a new business endeavor or M&A activities), bring with them a desire to steal market share from incumbents. The seriousness of the threat depends on a myriad of factors, for example, whether the market is predominantly what I call entrenched (the barriers to entry are high and speed of change is low) or exposed (the barriers to entry are low and the speed of change is high). Porter argues that the higher the barriers to entry, the less dangerous newcomers are likely to be. However, I would add a caveat; high barriers can also mean that the companies that do enter are significantly better prepared both in strategic and financial terms, and so stronger competitors from day one.

The bargaining power of suppliers refers to the fact that their decisions can have dramatic effects on client businesses. To illustrate, a supplier could raise prices or reduce the quality of their products and services, and thereby squeeze profitability out of an industry unable to recover the cost by increasing its own prices. A supplier group is considered especially powerful if it is dominated by only a few companies, has a unique product, built up switching costs, or the client industry is not strategically important to it.

The threat of substitute products or services is precisely what you think it is. Often, they can lead to ceilings to what an industry can charge without losing sales (unless its firms can improve product quality either in actual or perceived terms). Substitutes can limit profits in both normal times and during booms; an increase in demand often leads to companies attempting to fulfill it in different ways, for example by covering alternative category entry points.

The bargaining power of buyers (whether B2B or B2C) is similar in logic to that of suppliers. Strength is related to concentration of market share (the more a buyer holds, the stronger they will be), volume of purchase, importance (or lack thereof) to the buyers’ own products and services, and so on. Buyer groups that earn low profits can pose additional threats by being more likely to look to lower its purchasing costs (by comparison, highly profitable buyers are typically a lot less price sensitive).

Although retailers would qualify as buyers, they deserve a special mention. As Porter also notes, their strength is determined by the same rules with one important addition. Retailers can gain significant bargaining advantages over manufacturers when they can influence consumers’ purchasing decisions. This is something that I have personally witnessed, and for full transparency also taken advantage of strategically, in my work in fintech and e-commerce. I would even go so far as to contend that the ability to drive a scale of acquisition that the ‘opposite party’ is unable to achieve on their own often is, so to speak, the bargaining chip to rule them all.

Lastly, competitive rivalries (‘jockeying for position’, as he originally labelled it) concerns any and all threats related to already existing direct competition. These can be of particular importance if the industry growth rate is limited (leading to battles over market share rather than efforts to drive further market expansion), switching costs are low, fixed costs are high or the provided products are perishable (causing a temptation to cut prices).

So far, so good

The five competitive forces represent an external-internal view of the organization and, by extension, its approach to strategy. By positioning itself where the forces are most advantageous, it can build a defense of sorts against them or even take advantage of them. Or so the story goes.

Implicit in this conclusion is an assumption of no, or at least knowable, change; all positions are relative by nature (they can only ever be defined in relation to something else). For a company to find a lasting position, the forces have to be foreseeable. Porter explicitly states that, in ‘long-range planning’ (which refers to a life span of at least a decade), the strategist’s task is to ‘examine each competitive force’ and ‘forecast the magnitude of each underlying cause’.

However, industry evolution is not only inevitable, but also in most verticals impossible to predict beyond the very narrowest of time horizons (remember the law of the adjacent possible). The next three months may resemble the previous three months, but the farther we look ahead, the less we will be able to see (and forecast). The challenge, then, turns out to be entirely different in reality than on paper.

Yet there is an even more fundamental flaw in the author’s reasoning.

As with many purveyors of models and frameworks, Porter’s work is very flattering to strategists – he assumes that they are all able to define their industries properly, weigh the various forces against each other accurately, and position their companies accordingly (conveniently, he does not himself discuss how). My experience tells me that may necessarily not be the case. But even if it were, the five forces are about the industry, not the company. Consequently, the flawless strategists would all logically reach the same conclusion, rendering the exercise pointless from a competitive advantage perspective!

Practice does not make perfect

Although I do not think that Porter deserves all of the crap flung in his general direction (e.g., for failing to foresee online commerce and its implications for distribution barriers), the five forces undoubtedly fail to hold up to a practitioner’s scrutiny. Despite their undeniable impact in academic circles, and maintained prominence in many business schools, Porter’s model is today therefore barely used by corporate managers.

This is partly down to the fact that the five forces are inherently reductionist. As we know, markets are complex adaptive systems, and as such impossible to reduce. There will, in other words, always be counter-arguments based on unaddressed practical nuance.

For example, a product manager will inevitably observe that Porter’s model fails to account for complement products. A procurement manager will point out that it over-simplifies the value chain and that there are lock-in effects in purchasing (requiring balance between a) the resilience created by not relying on a single source, and b) the potential financial benefits of buying only from the one even if more or less identical choices are available). The list of similar exceptions and additions would be endless.

Porter’s assumption of more or less static industries (a requirement for accurate forecasts) to make his argument work also undermines it to the point where it is difficult to take seriously in a modern setting. Contexts, such as competitive forces, will continuously and perpetually change, which means that the ‘best strategy’ (if we allow ourselves the theoretical existence of such a thing) is entirely fluid. An unfortunate truth for anyone peddling universal solutions, but true nonetheless.

If one is to use the five forces model at all (which I would argue can still be of value), it is thus best served as a metaphorical illustration or diagnostic snapshot in conjunction with other frameworks. In and of itself, the practical use (despite its prestigious creator’s claims to the contrary) is limited, both in breadth and depth of application as it pertains to strategy formulation. It tells us precious little of how to achieve a competitive advantage - however we define it - and nothing about how to maintain it.

Next week, we are going to take a look at a branch of strategic management that arose as a direct response to Porter’s work. Until then, I wish you a lovely weekend.

Onwards and upwards,
JP