CFA Level 2- Reading 31-The Five Competitive Forces that Shape Strategy

This is a part of my CFA Level 2 notes series. I will try and jot down the important points and ideas in each of the CFA readings, both for my reference as well as for my fellow aspirants who may benefit from it.

The five forces based on Porter’s 1979 HBR article which has since then become a standard in every strategy textbook.By understanding the scale and power of these five forces we can effectively chalk out strategies for the long-term profitability of the firm.

Let us now look at each force in depth.

1.New Entrants: New entrants to an industry bring new capacity and a desire to gain market share that puts pressure on prices, costs, and the rate of investment necessary to compete. The likelihood of new entrants would depend both on the barriers to entry [Supply side economies of scale(Lower cost per unit), Demand side economies of scale ( Network effects), Capital requirements, Customer switching costs, Proprietory technology, Brand identity, Distribution channels, government regulations!]
as well as the expected incumbent retaliation.

2.Suppliers: Powerful suppliers in an industry where passing the cost forward to customers is difficult can be a major hindrance to profitability.[ Eg: Microsoft and PC makers.] Suppliers can become a major force when they are more powerful than the company in question, or switching costs are high[Bloomberg terminals] or the supplier caters to a wide variety of clients.

3.Customers: Powerful customers can drive down profits either by pushing down prices or by increasing costs(by demanding better quality and service.) Large volume buyers or limited buyers are amongst the most powerful in the market.

4.Substitutes: A substitute performs the same or a similar function as an industry’s product by a different means. If an industry is unable to differentiate itself from the substitute effectively margins will take a hit.

5.Existing competitorsRivalry among existing competitors takes many familiar forms, including price discounting, new product introductions, advertising campaigns, and service improvements. The two factors that come into play while measuring competition is Intensity [Driven by number of competitors,high exit barriers,slow industry growth, unable to read competitors signals] as well as the Basis [Eg price driven(which is generally harmful for all parties involved) or differentiation focussed.-Blue ocean strategy principle in use]

Factors like industry growth rate, technology and innovation, complements and governments are also important in analyzing a sector, but all these are factors not forces since they don’t have a unidirectional impact on the profitability.

The competitive forces reveal the drivers of industry competition. A company strategist who understands that competition extends well beyond existing rivals will detect wider competitive threats and be better equipped to address them.

More CFA notes here:






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