Using the 5 forces for industry analysis
In this blog post, I aim to discuss how we, as economists understand the relative performance of companies that operate within different industries.
This is a hugely important skill as looking at the bottom line of two companies across two different industries doesn’t actually tell you a whole lot about how well / badly those companies are managed. Why? Because different industries have inherently different profitability. That is to say, some industries are just more profitable than others.
So, just because pharmaceutical giant, Pfizer yields a greater profit margin & better returns for their investors than Easy Jet, doesn’t necessarily mean one has been managed better / worse than the other.
To understand the relative performance, you first have to understand the industry in which they operate, to do that, we use the 5 forces model.
The 5 forces that we’re interested in are:
- Threat of new entrants: How high are the barriers of entry into the industry? Among others, barriers can surround extreme regulatory demands; the existence of patent-able products or the cost to get started in the industry.
- Bargaining power of the buyers: i.e. how much leverage the customers have over your price. We’ll discuss this in our examples.
- Bargaining power of suppliers: i.e. how much leverage you have over your suppliers. Let’s say you’re going to start building desktop computers, you’re at the mercy of the Windows Operating System pricing model and won’t have much influence over those costs, simply because, there is nowhere else for you to go.
- Threat of substitute products: This isn’t supposed to be about other companies that sell exactly the same product as you. It’s supposed to be an analysis of other options customers have. For example, why do people go to the gym? To get fitter or to make new friends, right? So the viable alternatives to getting fitter are: home fitness equipment, outdoor exercise or a diet plan. The alternative to making friends is joining a club or going to a bar.
- Rivalry among existing competitors: Are there frequent price wars in this industry? How ‘hot’ is the rivalry?
So, let’s put this into a real life example by looking at both the airline and the pharmaceutical industries.
- Threat of new entrants: The barriers to entry in the airline industry are not as high as you may think. Yes, you’ll need a big wad of cash to purchase planes; pay pilots and to rent a spot on a runway, but other than that, there are no patented products in the airline industry, at least, none that would stop new competitors with a lot of financial clout taking you on.
- Bargaining power of buyers: The power of the consumer (i.e. me and you) is massive in the airline industry. All airlines are homogeneous, there is no discernible difference in the service they offer and we buy, mostly based on price. With websites that aggregate prices from all airlines in a transparent manner, we don’t even need to shop around to find the best deal.
- Bargaining power of suppliers: There are only a couple of major players in the airline market. Boeing and Airbus for the planes themselves and Rolls Royce and GE for the engines. As such, you don’t have a whole lot of choice when it comes to getting new planes / engines, you’re stuck with only a couple of suppliers, resulting in very little room for negotiation.
- Threat of a substitute: As an airline, your service could be substituted by cars, trains or passenger boats.
- Existing competition: Airline competition is fierce. The reason being that airlines have very high fixed costs and very low variable costs. The cost of getting a plane into the air and to its destination is not hugely different, whether you have 1 or 100 passengers. As such, the companies will sell as cheaply as they have to in order to get all the seats filled.
The airline industry example shows that the industry has relatively low costs to entry, high bargaining power by customers, little negotiation power with suppliers; that your service can quite easily be substituted and that the competition is extremely intense. All these factors work against the airline, which explains why airlines are one of the least profitable industries out there.
- Threat of new entrants: The barriers to entry in the pharma industry are huge. The cost to develop a new drug is out of reach of most companies, the regulations surrounding the release of a new drug are very rigorous and it can take years to get a new drug to market. Couple that with the fact that major players patent their products, it makes threat of new entrants very minimal.
- Bargaining power of buyers: The power of the consumer (i.e. me and you) is extremely low in this industry. If we are prescribed something by the doctor, we either take it or suffer the consequences, so the customer cannot negotiate a better price.
- Bargaining power of suppliers: The raw components that go into creating drugs are commodities. The value is delivered through the process in which the pharmaceutical company put all those commodity parts together. So, the suppliers have very little bargaining power.
- Threat of a substitute: Herbal remedies and potential operations are the only real substitute to taking the drugs you’re prescribed. Neither are particularly appealing, so you’d say that the threat of substitution is very low.
- Existing competition: The Pharma industry has low competition, primarily due to the patented products in the industry.
The pharma industry example shows that the industry has extremely high barriers to entry, low bargaining power by customers, low negotiation power of suppliers and that your service can not easily be substituted. All of the forces are working in favour of the pharma company.
So what does this all mean?
Clearly the pharmaceutical industry has a much easier time of it. The risk of competition is very low, their customers don’t have a huge amount of choice other than to use their product and their suppliers don’t hold the key to their success as the component parts are commodities.
Conversely, customers can choose from many airlines to find the lowest price. There are only a couple of suppliers, leading to little-to-no negotiation and the service can be quite easily substituted.
So back to the original point, you can’t look at the bottom line of a pharma company and directly compare it to an airline. They’re in very different industries, with different forces working for and against them. A 10% profit margin in air travel may be excellent for the industry, it may even be market leading; while the same profit margin in a pharmaceutical company may be considered to be poor & lagging behind others in the market. You need to look at the wider industry to understand how well / poorly a company is performing against its peers.