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The five forces of running a successful business Strategic planning is a very logical approach to running a business. It is a methodology that translates a companysvision into its mission, goals and operational tactics. The planning process culminates in a financial plan to determineif profit expectations will be met.

A fundamental step in the process is a review of external and internal factors impacting the business. This iscalled a situational analysis.

When done properly, this step helps companies uncover those few but absolutely fundamental things a companymust do correctly in order to be successful in its market segment. (In strategic planning, these are called the CriticalSuccess Factors, or CSFs.)

Many companies shortcut the situational analysis by using a process called SWOT (short for defining acompany's Strengths, Weaknesses, Opportunities and Threats). This is a less time-consuming but also less analyticalprocess, often performed as part of a management retreat. As you can see, Strengths and Weaknesses are internallyfocused, and Opportunities and Threats are externally focused.

But external factors are continually changing. As competitors react to changes in the marketplace, yourcompanys tactics may suddenly be invalid. Thats why analyzing external factors, on an ongoing basis, is imperative.

Defining external factors

External factors relate to industry and competition .

The industry is the arena where the competitive battle takes place. Analyzing this arena means looking at thethreat of new entrants and at barriers (usually cost-related) to entering and exiting the market. It also encompasseseconomic and governmental factors that could significant impact the industry

Analyzing the competition means looking at who the competitors are, their relative positions in the market, andtheir operating characteristics. Analyzing competition is not as easy as just identifying companies that make productssimilar to yours.

In any market, the type of competition can vary and includes brand competitors, form competitors, genericcompetitors and desire competitors. For example, if you manufacture boats, your brand competitors wouldbe Bayliner and Boston Whaler; form competitors to your boating product would be sailing andcanoeing; generic competitors to your recreation product would be tennis and baseball; and desire competitors foryour total spending would be housing, clothing and education.

External factors as forces of business

Michael Porter of the Harvard Business School, in his keystone work Competitive Strategy (New York: Free Press,1980), organized these external influences into the "Five Forces of Competition." Recently, Intel CEO Andrew Groverevisited Porter's ideas in his book, Only the Paranoid Survive (New York: Doubleday, 1996). He also added a sixthforce involving complementary products that function together (cars and gasoline, computers and software).

Porter's original five forces which we call the "Five Forces of Business" can provide a solid basis for yourExternal Analysis. Ive used Porter's concept in my strategic planning work with companies because it so clearlyfocuses on the issues that should be examined. The competitive forces determine the profitability of an industry.

The five forces of businessPorter's Five Forces, with brief examples, are as follows:

1) Barriers to entry and exit Typical barriers are high capital costs, government and legal barriers,economies of scale already in the industry, and fears of retaliation.

2) Bargaining power of the buyer This is composed of two major areas:

The buyers sensitivity to prices impacted by: the importance of the item they are buying from you inproportion to their total cost; the intensity of competition in the industry; and the importance of yourproduct to their overall quality.

The buyers relative bargaining power impacted by: the size and concentration of buyers relative tosuppliers; how much the buyer knows about suppliers products, prices and costs; buyers costsassociated with switching suppliers; and the buyers ability to vertically integrate.

3) Bargaining power of the suppliers Exactly the same determinants as listed in Bargaining power of thebuyer, but the roles are reversed.

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4) Competition from substitutes If there are few substitutes for the product, then consumers are insensitiveto price. For example, with products like gasoline or cigarettes, consumers will buy among competitive brands. But inthe short term, they will not substitute different forms of products, e.g. diesel fuel for gasoline, cigars for cigarettes.

If substitutes are available, then two major factors will determine whether the buyer will make substitutionswhen price becomes an issue:

Buyer's inclinations to make substitutions among products or services that satisfy a buyers need(frozen food instead of fresh foods). The key issue is to understand the willingness of buyers to shift

their purchases among similar products based purely on changes in relative prices. For example,motorists continue to prefer their cars even though mass transit systems provide significant reductions incommuting costs.

Performance characteristics of substitutes relative to price. For example, if buyers can travel by trainor plane from New York toChicago, their choice will depend on the value they place on their time. If thetravel time differential is two hours and the average traveler values his or her time at $50 per hour,train travel will be competitive whenever it is priced $100 below air travel.

5) Industry rivalry and competition In most industries, the major factor determining profitability iscompetition among firms within the industry. Of the Five Forces, most companies pay the most attention to this one.

Four major areas help define the level of competition:

Level of concentration If there is a small group of leading companies in the industry, pricecompetition is generally restrained by pricing parallelism or collusion (Duracel and Eveready in thebattery industry, Coke and Pepsi in the soda industry). The more competitors, the more difficult itbecomes to coordinate prices.

Diversity of competitors The more similar the competitors are in background, origin, commonstrategies and cost structures, the more stable the market will be. The more diverse the competitorsare (for example, oil producing companies within OPEC), the more difficult it will be to maintain pricingin the industry.

Product differentiation The more similar the products are within an industry the more likelycompetitors will use price cuts to expand business take commodities such as crude oil, telephone andwheat for example. Highly differentiated products are generally inelastic to price take perfume,restaurants, and management consulting services for example.

Excess capacity and costs Competitors will be more aggressive in pricing when they have a high ratioof fixed cost to variable costs. When there is a combination of high fixed costs and unused capacity,

firms tend to offer price cuts to spread their fixed costs over a greater sales volume. This practice ismore prevalent in companies who have a Production Driving Force companies such as airlines, papermills and hotels. (See article for a more complete definition of Driving Forces)

The five forces in strategic planningNone of the Five Forces is particularly complicated or difficult to understand. Focusing on each of them

individually and collecting the appropriate information will take time, but it will allow you to more clearlyunderstand the strategies needed to be successful.

An external analysis is not just a one-time occurrence; I cant stress that enough. Gathering information on theFive Forces should be a never-ending process. It is important that you know not only what your competitivemarketplace looks like today, but also what it is going to look like tomorrow.

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