Previous posts on this blog have made the argument that the key to an Architecture/Engineering (A/E) firm’s success is good strategy. A simple way to view strategy is to view it as the link between the internal elements of a company (its capabilities, resources, and activities) and the external environment (clients, competitors, etc.). In order to be successful over the long haul, this strategy must be unique and must provide a valuable fit between the company and the external environment it competes in. This unique fit can be established through the unique value the company delivers through its systems and choices.
In order to understand how to best craft successful strategy, we need to have a good understanding of both the internal world our firms and the external world of the markets in which we compete. Luckily, the strategy guru from Harvard Business School, Michael Porter, developed a great tool to help us understand the external half of this equation, Porter’s Five Forces of Competition. This is outlined in his paper “The Five Forces that Shape Competition” – reference provided at the end of this post.
Five Forces of Competition
Porter’s Five Forces of Competition provides a framework to understand the industry and markets in which we compete. The framework presents five forces, or drivers, of profitability that define competition within any industry. If you understand the nature and power of these forces, then you will understand who gains the value (or profitability) in the industry and how you may be able to influence that in the future. The definition of industry for this purpose can be an area in which you compete where your actions and those of your competitors could affect one another or where these forces of competition differ. An easy way of looking at this for most A/E firms, is that a distinct market segment can be treated as an “industry”.
These five forces are the forces that push profitability around an industry. They determine who will capture the largest portion of value in an industry – the customers and clients, suppliers, competitors, etc. The forces that are the strongest are the forces that will have the largest effect on profitability and success, so they are the ones that are most important to address your firm’s strategy. These five forces that shape competition are as follows.
- Threat of new entrant competitors into the industry
- The power of your suppliers in the industry
- The power of buyers of products and services in the industry
- The threat of substitutes to these products and services
- Rivalry among existing competitors within the industry
Industry analysis through the five forces can help you can gain a better understanding of existing or potential market segments. You can do this by looking at each of these five forces and asking the following questions.
- Are the drivers of each of these forces stronger or weaker than the broader industry in which we compete, on average? This should define profitability within the market segment to the average of the industry as a whole.
- Why are these drivers stronger or weaker? This will provide you with insight that may lead to strategic opportunities and choices.
- Has there been any change in these forces recently? What changes do you anticipate in the future? This too can provide you with insight that may lead to opportunities in strategy.
Understanding the market segments in which you compete is key to the development of successful strategy. Effectively understanding market segments is more than understanding clients, their needs, and your competitors. Those things are important, but to truly understand market segments, you must understand the underlying structure of competition for value within that market segment. The Porter’s Five Forces framework is key to understanding that structure.
Let’s dive deeper into each of these forces and see how this framework can be applied to the A/E industry specifically. We will do this by looking at each of the five forces and what the potential drivers of each of these forces could be. You can utilize these drivers to help you conduct an industry analysis of your existing or potential market segments. The terms industry and market segment will be used interchangeably here for reasons outlined above. A helpful way to use the list of drivers below to analyze a market segment is to ask yourself whether the driver pushes profit towards your firm or away from it to somewhere else, how powerful the driver is, and if something about that driver is changing.
Threat of New Entrants
The threat of new competitors entering an industry is the first of the five forces. High barriers to entry decrease the threat of new entrants which will increase profitability of the segment. If incumbent competitors in the industry have a lot of power, they will be able to decrease the attractiveness of the market segment to new entrants which will increase profitability. Drivers of the threat of new entrants include:
- Large capital requirements that raise the barrier to entry
- Specialized experience and expertise that raise the barrier to entry
- A large degree of expected retaliation from competitors within an industry that make the segment less attractive to new entrants
- Difficult to access clients and channels decreases the threat of new entrants
- Incumbents having large advantages such as ability to win work or control pricing that make the segment less attractive to new entrants
- Supply-side economies of scale incumbents enjoy due to the amount of work they provide (tough thing for an A/E firm to pull off) that make the segment less attractive to new entrants
- Demand-side economies of scale incumbents enjoy due to buyer’s being attracted to incumbents due to the amount of work they provide in the market segment that make the segment less attractive to new entrants
- Large client switching costs for clients to switch from one provider to another that make the segment less attractive to new entrants
Power of Suppliers
The bargaining power of suppliers can affect the distribution of value and profit within a market segment. If suppliers have high bargaining power, they can capture a larger portion of the available profit in an industry through their pricing power. Greater power for suppliers translates into lower profitability for firms. As A/Es, another powerful “supplier” force can be driven by current and future staff as they are suppliers of the knowledge necessary to deliver our services. Drivers of the power of suppliers include:
- Large switching costs for firms to switch from one subconsultant or hire new employees that increase the power of suppliers
- A limited labor pool to pull from for the type of skills necessary to deliver services in a segment that increases required wages due to supply and demand
- A limited group of subconsultants to pull from that increases the pricing power of those suppliers
- Specialized skills that are required from staff or subconsultants that increase the pricing power of these suppliers
- Availability of substitutes to staff (such as contract workers) or subconsultants that will limit the pricing power of these suppliers
- The threat of suppliers to integrate forward into the A/E field (such as employees potentially starting their own firms) that will limit the profit potential of the firm
- Employee and subcontractor dependency on the industry that will tend to limit the power of these groups if their skills are not transferable
Power of Buyers
The power of buyers can affect the profitability of a market segment in a number of ways but they mostly boil down to how much bargaining power buyers have and how much sensitivity to price they have. If buyers have more bargaining power, they can demand better prices from you and your competitors driving down profitability. The more sensitive they are to price, the lower the profitability of the segment. Drivers of the power of buyers include:
- All small concentration of buyers that have a large share of the target market that increases their leverage and power
- A high level of differentiated service offerings from firms and their competitors that increase their pricing power in the market segment and decrease the leverage of the buyers
- Large switching costs for buyers to switch from one firm to another that increase the pricing power of those firms
- If the cost of a firm’s services is large compared to the to the buyers’ product or service overall cost, the buyer will have greater levels of cost sensitivity
- If quality is important to a buyer and your services affect that quality, buyers will be less price sensitive
- If profit margins of the buyer’s industry are very low, they will be more price sensitive
- The threat of buyers integrating backward into the A/E field (such as contractors or owners providing A/E design in-house) will limit the pricing power of firms
Threat of Substitutes
Substitutes are not competitors that provide a similar service than you. Substitutes fulfill the needs of your clients through a different means than you do. Examples of substitutes in the A/E world could be hiring full-service design/build contractors as opposed to directly hiring you as an A/E, prefabrication and utilization of standard designs, etc. Drivers of the power of substitutes include:
- A low potential price/performance trade-off of utilizing a substitute that increases the threat of substitutes and limits the pricing power of firms
- Large switching costs for buyers to switch to a substitute service that limits the threat of substitutes
Rivalry Between Competitors
The force of competitive rivalry within a market segment will affect the profitability of that market segment since competitors are typically vying for the same work. The power of this force is related to how intense the competition is and how much the competition revolves around price. The more intense and price-driven competition is, the more profitability will be decreased in the market segment. Drivers of the power of competitive rivalry include:
- High growth in the market segment that attracts competitors and increases the level of competition
- Relatively evenly distributed market share among many competitors in the market segment that increases the level of competition
- A large level of commitment of competitors that increases competition and increase the odds for competition on price
- A large level of differentiation between competitors that decreases the likelihood that price will be a basis of competition
- Specialized skills of competitors that may not be transferable elsewhere creating high barriers to exit that may drive your competitors to fight to the death by means of lower pricing to not lose this market segment
Note: The following is a great reference that describes this framework in more detail if you are interested in learning more.
Porter, Michael E. “The Five Forces that Shape Competition.” Harvard Business Review, January, 2008.