Switching Costs

Porters Five Forces – content, application, and critique

  • Based on the insight that a corporate strategy should meet the opportunities and threats in the organizations external environment => understanding of industry structures and the way they change

1. Bargaining Power of Suppliers

  • All input sources that are needed in order to provide goods/services
  • High when:
    • Market is dominated by few large suppliers
    • No substituted for that particular input
    • Suppliers’ customers are fragmented, so their bargaining power is low
    • Switching costs from one supplier to another are high
    • Possibility that supplier integrate forward in order to obtain higher prices and margins
      • Buying industry has a higher profitability than the supplying industry
      • Forward integration provides economies of scale for the supplier
      • Buying industry hinders the supplying industry in their development (e.g. reluctance to accept new releases of products)
      • Buying industry has low barriers to entry
  • Buying industries face high pressure on margin from their suppliers in the situations
    • Dependence on powerful suppliers can reduce strategic options for the organization

2. Bargaining Power of Customers

  • Determines how much pressure customers can impose on margins and volumes
  • High when:
    • They buy large volumes/ There’s a concentration of buyers
    • Supplying industry comprises of a large number of small operators
    • Supply industry operates with high fixed costs
    • Product is undifferentiated and can be replaced by substitutes
    • Switching to an alternative product is relatively simple and is not related to high costs
    • Customers have low margins and are price-sensitive
    • Customers could produce the product themselves
    • Product is not of strategical importance for the customer
    • Customer knows about the production costs of the product
    • There is the possibility for customer to integrate backwards

3. Threat of New Entrants

  • Always a latent pressure for reaction and adjustment for existing players in the industry
  • Level of threat from new entrants depends on the extent to which there are barriers to entry:
    • Economies of scale (min. size requirements for profitable operations)
    • High initial investment and fixed costs
    • Cost advantages for existing players due to experience curve effects of operation with fully depreciated assets
    • Brand loyalty
    • Protected intellectual property like patents, licenses, etc.
    • Scarcity of important resources
    • Access to raw materials is controlled by existing players
    • Distribution channels are controlled by existing players
    • Existing players have close customer relations
    • High switching costs for customers
    • Legislation and government action

4. Threat of Substitutes

  • Potentially attract a significant portion of market volume => reduce potential sales volume for existing players
  • Also relates to complementary products
  • Treat of substitutes is determined by factors like:
    • Brand loyalty
    • Close customer relationships
    • Switching costs for customers
    • Relative price for performance of substitutes
    • Current trends in technology, customer preferences, etc.

5. Competitive Rivalry Between Existing Players

  • High competitive pressure leads to pressure on prices, margins, and profitability for every single company in the industry
  • Competition likely to be high when:
    • There are many players of the same size
    • Players have similar strategies
    • There is not much differentiation between players and their products, hence, there is much price competition
    • Low market growth rates (growth of a particular company is possibly only at the expense of a competitor)
    • Barriers for exit are high (e.g. expensive and highly specialized equipment)
    • Customers are price sensitive and/or have low switching costs

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