Michael Porter is well known for his five forces framework, which remains one of the best ways to assess an industry's underlying structure.
An individual company can achieve superior profitability compared to the industry average by defending against competitive forces and shaping them to its advantage.
However one of the forces that is threat of new entrants or barriers to entry is the most important force within Michael Porter's framework of competitive analysis.
Focusing your attention on this particular force can help you make an actionable point for competitive advantage or strategies available to the company to remain superior.
Before we talk about Michael Porter's threat of new entrance or barrier to entry, let's look at the other four forces:
Supplier power is the degree of leverage a supplier has with its customers in areas such as price, quality, and service.
Suppliers may have power if:
- there are very few suppliers of a particular product.
- there are no substitutes.
- switching to a competitive product is very costly.
- the product is extremely important to buyers.
- the supplying industry has a higher profitability than the buying industry.
Buyer power is the bargaining strength of the buyers of a product or service.
Buyers may have power if:
- there are a small number of buyers.
- the company purchases large volumes.
- switching to a competitive product is simple.
- the product is not extremely important to buyers.
- customers are price-sensitive.
Substitution threat addresses the existence of substitute products or services, as well as the likelihood that a potential buyer will switch to a substitute product.
Competitive Rivalry describes the intensity of competition between existing firms in an industry.
Threat of new entrance or barriers to entry
This is one of the most important forces that a company has to deal with. An industry structure where barriers to entry are low will be crowded by many players. These industries may require less capital, have low scale and will often show a low return on investment.
The first area to look at is supply. These are usually cost advantages that allow a company to produce and deliver its products or services more cheaply than its competitor. These advantages could be related to proprietary technology or experience or maybe a combination of both.
The second area to look at is the demand. Some companies have access to market demand that their competitors cannot match. This is often linked with customer lock-in, out of habit, switching costs or simply not being able to find a substitute.
For example, if Nestle decides to increase Maggie’s price by ₹1, chances are that its demand will not be impacted. Similarly, we know that Tanishq charges a premium for its jewellery but still there is customer loyalty, may be driven by the brand power.
The third lever is the economies of scale. If the company has a high fixed cost in comparison with its total cost, as the demand increases it enjoys economies of scale because the cost per unit will decline.
There could be government protection. However, research indicates that any protection in the form of government licenses or patents is limited.
A sustainable competitive advantage would often be extremely simple but very difficult to replicate. At any point in time, any of the licenses can be a competitive advantage but licenses also come with their own expiry date.
One of the aspects of understanding competitive advantage is to figure out how sustainable are those advantages.
Look for local leaders either by geography or by sub-industry. The structure would often be only limited players (1-2), have high ROIC, limited debt and would often display pricing power.
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