Understanding and Quantifying Porter

“Michael Porter, very early in his career, he went after the single biggest and most consequential question in business. Why are some companies more profitable than others, why are some industries more profitable than others, why are some countries or regions more successful than others and what does this mean for companies in a global era?”

“Porter took a different path, creating what he calls ’frameworks.’ In his own words, ‘My frameworks provide a set of logical relationships that are fundamental. They’re like physics – if you’re going to have higher profitability, you’ve got to have a higher price or a lower cost. That industry competition is driven by the five forces. That firm is a collection of activities these frameworks provide basic, fundamental and I believe unchangeable relationships about the ‘matter’ of competition’. “

  • Joan Magretta.

Porter’s forces describe how competition and strategy plays an important role in the success of a business organization. A great business must have some competitive strength whether be it pricing power or cost-effectiveness, high barriers to entry or less availability of substitutes. One way or the other sum of these business forces decide the future of a great business.

Wouldn’t it be great if we could compare two different types of businesses?

Let’s say we take two completely unrelated business Airline and Banking. We cannot use the same financial matrices to compare these businesses, neither do they share the same governing model, nor are these businesses driven by the same growth drivers. But if we were to choose between one of them, how would one rank which one is better? On what parameters could they become comparable?

One of the answers that come to my mind is Porter’s Five Forces:

In my understanding, I would like to rank these forces based on the effects and the strength they hold in the business. In general, they are ranked as Low, Medium and High. But that still doesn’t make these businesses any more comparable, because one might have a high supplier power, whereas the other might have low barriers to entry. This does not make them comparable.

So, to cater to this issue, I would like to quantify them. By giving scores to each of the ranks mentioned above. Low gets a score of 3, Medium gets a score of 2 and High gets a score of 1. And to scale them to a score out of 5, I would sum the scores of all the forces and divide them by 3 to get the scale. The reason for a score of 3 is, if a business has low competition or low buyer power, that should be rewarded as strength of the business, whereas for a score of 1, a business with high supplier power or high threat of new entrant must be punished as a weakness in the business.

E.g.- In the airline business, the supplier power is high (score of 1), as there are only a few manufacturers, the buyer power is low (score of 3), the industry rivalry is high (score of 1), the threat of new entrant is low (score of 3) and the threat of substitute is nearly low as it is the fastest mode of transportation (score of 3). So now, to scale it out of 5, we add them and divide by 3, we get 11/3= 3.66 out of 5.

And in the case of the banking business, the supplier power is low (score of 3), the buyer power is low (score of 3), the threat of new entrant is low (score of 3), the threat of substitute is low (score of 3) and the industry rivalry is high (score of 1). So, we end up with 13/3= 4.33 out of 5.

Does this mean that banking is a better business than airlines? No, this is only a way to scale how many of the industry forces are in favour of the business.

Let’s take a comparison between a cigarette manufacturer versus a coffee manufacturer (In Indian scenario). Both of them being a consumer driven product.

In cigarette industry, the buyer power is low (score of 3), supplier power is moderate (score of 2), industry rivalry is high (score of 1), threat of substitute is high (score of 1) and the threat of new entrant is low (score of 3). We end up with 3.33 out of 5.

Whereas in the coffee industry, the buyer power is low (score of 3), supplier power is moderate (score of 2), Industry rivalry is high (score of 1), threat of substitute is moderate (score of 2) and the threat of new entrant is moderate (score of 2). We end up with 3.33 out of 5.

So, despite being two completely different products, they have a lot of similarity as a business. Both of them score equally, while having variation in the score for threat of substitute and the threat of new entrant, they are being punished and rewarded equally for the same. This brings in some comparison grounds for different businesses to compared against each other, even with huge differences in operations.

To have a great business for over a long period, in my opinion, at least 70% of the forces should be in the favour of the business, which brings the threshold to 3.5 out of 5.

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