Why do some businesses fail even though they have competent people and a great business plan? Porter suggests that the key to success in business is to be in the right industry. There are 5 forces that determine whether or not a certain industry is favorable:
Threat of New Entrants: Some industries are harder to enter than others. The Pharmaceutical industry, with all of its risks and high-price patents, is almost impossible for new firms to get in on the huge profit margins. A pizza shop has a very low barrier to entry - almost anyone with an oven and some pepperoni can start one.
Some industries can create barriers to entry by having customers dedicated to their brand... example: Fizzy, syrupy water. Despite the fact that it takes a small capital investment, the big soft drink manufacturers have squeezed out potential competitors with huge marketing campaigns.
Bargaining Power of Suppliers: Suppliers with low bargaining power are good for business. For example, in the coffee industry, the growers have very low bargaining power. They are poor, fiercly competitive and usually rely heavily on their buyers. A lb. of Green coffee costs the same today as it did in the late 60's (although the fair trade coffee movement is changing that).
A strong supplier would be Intel. What would happen if Dell stopped selling "Intel Inside"? Computer buyers would take their money somewhere else. Dell is in a very weak position and this is one reason why the computer assembly business has its pitfalls.
Bargaining Power of Buyers: Buyers with weak bargaining power are favorable. If you sell super-computers and you have very few customers, those customers wield a lot of power. Sometimes losing one sale can make or break the business. Another factor that affects buyer power is differentiation. Commodities like oats or pulp for paper have strong buyers because it makes no difference which supplier they choose.
Threat of Substitute Products: A substitute product for butter is margarine. A substitute for sugar is aspartame. This is a product that is not quite the same, but the customer can get the same value from it. When butter prices soar, people can simply choose margarine, so the butter producers are not free to set their prices wherever they want. If there was a good alternative to gasoline, would the prices would fluctuate so much? When electric or solar cars become popular, gas prices will stabilize.
Intensity of Rivalry among Competitors:It is pretty obvious that it is unwise to enter an industry that is already hugely competitive. As a North American firm, is it smart to enter the running shoe manufacturing industry when you know that there are already many developing countries who can drive down their costs by paying their workers 26c an hour? Of course not.
This analysis explains why so many companies fail, even though the people that run them are smart and competent. A firm in the right industry, with the right core competencies is poised for success.
NB: Michael Porter has his Ph.D. in Industrial Economics. This analysis is based on a report he published in the Harvard Business Review called "How Competitive Forces Shape Strategy" circa 1979. Itshaped the way many people see business today. Today Porter owns a very successful consulting business and occasionally teaches at Harvard.