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