The Five Forces of Small Business Strategy
Small business success requires discipline and guidelines around these five sectors.
Return on Investment (or “ROI”) measures the gain or loss generated on an investment relative to the amount of money invested.[1] Another way of looking at ROI is that it shows how profitable a business is.
Experts on corporate strategy have long discussed how businesses should look at themselves strategically; to understand the levers that drive ROI and implement policies that can maximize it. One of the most influential strategic analyses is called the Five Forces Analysis that was pioneered by Professor Michael Porter of the Harvard Business School in the late 1970’s.
According to Professor Porter and his disciples, there are five market-related forces that drive ROI, but, for the analysis to make sense, it is important in the first instance for a business to understand what it does, the product or service lines it has, and its target market.
1. What Does Your Business Do?
At one level this should be an easy question to answer, i.e. my business is an oil company, a radio station, a clothing manufacturer, an online magazine, etc. But, on another level, defining one’s business for purposes of identifying the specific market being targeted, is, sometimes, not so simple.
One commentator pointed out, for example, that one of the biggest mistakes made by Oil industry executives in the 1960s was thinking of their industry merely as an extraction industry (i.e. taking oil or coal out of the ground) rather than as an energy industry, a much broader vision of their businesses that might have motivated them into considering developing alternative forms of energy like solar, wind, etc.[2]
More recently, some apparel manufacturers are thinking of themselves more as technology companies as they pioneer ways of integrating smart technology into clothing and accessories.
Understanding what one’s business actually does and the markets it really serves, will, in turn, help define the business’s product lines and target markets and make it more possible to identify the levers that can drive ROI.
2. Leverage Over New Entrants and Barriers to Entry
The more difficult it is to enter a market, the more leverage the players already in the market have over determining the price of their goods and services, which can drive up their ROI.
For example, an enterprise that makes clothing that is relatively easy to make is likely going to have less control over pricing as competitors enter its market. To maximize ROI in such a market environment, a party would, among other things, need to better differentiate its product by making it superior to others and/or more difficult to duplicate and/or channeling more resources into marketing to build greater brand loyalty.
In a word, a business will need to be knowledgeable about the barriers to entry that exist, or that could be erected, to discourage competitors from entering the target market.
3. Availability of Substitutes
Another force that can drive or depress ROI is the availability of substitutes for an enterprise’s products or services.
For example, Burger King is not so free substantially to raise the price of its hamburgers because, if it does, customers may readily switch to MacDonald’s or Wendy’s.
On the other hand, a drug manufacturer, which may be the only source of a given medication, is more likely to have leverage over its customers in terms of being able to raise prices because of the unavailability of reasonable substitutes.
4. Bargaining
- Bargaining Power of Customers
Where a supplier is selling to only a few customers, customers are in the better position to extract pricing concessions, thereby potentially maximizing their ROI at the expense of the supplier.
An example of the leverage a customer can have over suppliers is Walmart, which has such a large market share in so many product lines that it has been able to dictate prices to many of its suppliers, enabling Walmart to maximize profit margins while giving substantial discounts to ultimate consumers.
- Bargaining Power of Suppliers
Conversely, a supplier can also achieve leverage over its customers if the supplier’s goods are critical to the success of its customers’ own products and services.
Where a wholesaler of tractors is compelled to rely on a limited number of suppliers to provide components or replacement parts, the suppliers can extract higher prices because the customer has little alternative.
As such, just as it is important for suppliers to diversify their portfolio of customers to reduce customers’ bargaining leverage, so it is also important for customers to diversify their portfolio of suppliers.
5. Rivalry in the Marketplace
Where an industry sector has many participants and is very competitive, ROI tends to be more equal among competitors.
To maximize ROI in a competitive market, a business needs to forge some competitive advantage through technological innovation, marketing, achieving supply sourcing and distribution efficiencies, etc.
On the other hand, the more concentrated a market is, often the less competitive it is so that its participants have more leverage over customers in terms of being able to extract higher prices for goods and services, owing to the limited supply of the product and available substitutes.
The Takeaway
The five forces analysis presents a framework that can lead to a fuller understanding of a business’s market environment and the levers that it can use to enhance its leverage in the marketplace to drive ROI.
[1] See https://www.merriam-webster.com/dictionary/ROI.
[2] See “Marketing Myopia,” by Theodore Levitt, p. 45 (Harvard Business Review, Vol. 38, No. 4, July/August 1960). This is a truly excellent article on how CEOs often fail to understand the nature of the companies they are managing; as current a piece now as it was back in 1960 when it was published.
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