Thursday, November 10, 2011

Porter's 5 Forces in the Automobile Industry

Porter's Five Forces, also known as P5F, is a way of examining the attractiveness of an industry. It does so by looking at five forces which act on that industry. These forces are determinants of that industry's profitability.

The five forces are:

1. The threat of new entrants
In the auto manufacturing industry, this is generally a very low threat. Factors to examine for this threat include all barriers to entry such as upfront capital requirements (it costs a lot to set up a car manufacturing facility!), brand equity (a new firm may have none), legislation and government policy (think safety, EPA and emissions), ability to distribute the product (Alfa Romeo has been out of the US since the early 90s largely due to the inability to re-establish a dealer network. But if you are looking at Singapore, for example, only one Alfa Romeo dealer is needed!).

2. The bargaining power of buyers/customers
Who in the US has ever bought a car without bargaining? Anybody? In 2009 especially, US dealers were giving great deals to buyers to get the industry moving. While quantity a buyer purchases is usually a good factor in determining this force, even in the automotive industry when buyers only usually purchase one car at a time, they still wield considerable power.

However, this may be different in other markets. In Singapore it sure is lower than in the US, creating a more favorable situation for the industry but not the buyers.

Generally, however, it's safe to say the customers have some buying power, but it depends on the market.

3. The threat of substitute products
If buyers can look to the competition or other comparable products, and switch easily (they have low switching costs) there may be a high threat of this force. With new cars, the switching cost is high because you can't sell a brand new car for the same price you paid for it. A P5F analysis of the car industry covers the new market, not used or second-hand.

But what about the threat of substitute products before the buyer makes the purchase? You need to know whether the market you are analyzing has many good alternatives to new cars. A vibrant used car market perhaps? Used cars threaten the new market. How about a very good mass-transportation system?
Product differentiation is important too. In the car industry, typically there are many cars that are similar - just look at any mid-range Toyota and you can easily find a very similar Nissan, Honda, or Mazda. However, if you are looking at amphibious cars, there may be little threat of substitute products (this is an extreme example!).

4. The amount of bargaining power suppliers have
In the car industry this refers to all the suppliers of parts, tires, components, electronics, and even the assembly line workers (auto unions!). We know in the US the auto unions are tremendously powerful. But we also know that some suppliers are small firms who rely on the carmakers, and may only have one carmaker as a client. So this force can be tricky to evaluate.

5. The intensity of the competitive rivalry (which is in part determined by 1-4)
We know that in most countries all carmakers are engaged in fierce competition. Tit-for-tat price slashes, ad campaigns, and product developments keep them on the edge of innovation and profitability. Margins are low and pressure between rivals is high.

All major car-producing nations experience this intense rivalry. This obviously includes the US, Japan, Italy, France, the UK, Germany, China, India, and more.

State-owned car manufacturers like Proton in Malaysia experience less rivalry but are still under pressure from imports.

While a P5F analysis applies to all companies competing in one industry (and market) the same, what differs is that those firms' profitability will vary between them. This is because of their own competitive advantages and varying business models. So just because all firms in one industry and market are subject to the same forces doesn't mean they perform equally.

A P5F analysis should always be done in conjunction with other assessments, and should not be regarded as being absolute. It should only serve as an indicator, not absolute fact or even necessarily accurate.
There are many critical assumptions that should be made and explained in one's P5F analysis. The market must be described, the competition must be explained, and the products must be defined.

For example, a P5F analysis of the car industry in the US would not necessarily apply in China. The markets are totally different, and the product life cycle is not even close to being the same.

Another example is the type of automotive industry. A P5F analysis of the electric car industry would be entirely different than one of the conventional car industry.

Porter's Five Forces in the Auto Industry Around the World

For a P5F analysis of the auto industry in the US, click here.
To see a P5F analysis of the auto industry in China, click here.
A P4F analysis of the Indian auto industry is here.

The Porter’s Five Forces analysis is designed to evaluate the competitive forces in the industry the firm operates. If it determines that the combination of forces in the industry act to reduce profitability, it is saying the industry is unattractive. Even worse is an industry close to total competition.

Keep in mind that this exercise evaluates the industry, not the firm (General Motors). As such, this assessment would apply to Ford, Chrysler, Toyota, Honda, or any other automotive firm manufacturing and selling cars and trucks in the US.

"...manufacturing and selling cars and trucks in the US" is key. You must think about and clearly define your business unit before starting a P5F analysis. Is it in the US? China? India? Japan? Obviously the threats and forces in these countries will be far different than in the US.

The Porter analysis examines three horizontal forces, or competition in the same industry: Threat of new entrants, threat of substitute products and threat of established rivals. Two forces are from vertical competition, or those from the supply-chain: Bargaining power of customers and bargaining power of suppliers.

This exercise would be relatively easy to perform if the industry were stable and uniform. None of the answers to the degree of threat Porter’s Five Forces pose are black and white or clear-cut. In one case, the bargaining power of suppliers, either extreme could be argued.

Moreover, the table in the appendix which tallies up the criteria for each of the five forces fails to identify many of the current economic conditions and dynamics in the automotive industry today. As a result, the findings may not be completely congruent with reality.

Keep in mind this analysis was written in the Spring of 2009, in the worst of both the automotive shake-up and the global economic crisis. Things have since changed.

A summary of the findings is below:

<6x4 blue table goes here>

1. There is low threat of new entrants
2. The bargaining power of buyers/customers is low
3. There is a huge threat of substitute products
4. Suppliers do not have much bargaining power
5. There is a significant amount of rivalry among competitors

<green table 1 goes here>

The analysis above indicates that the industry is moderately favorable to profitability.

However, in another analysis of the industry, based upon industry-specific news and facts surrounding the suppliers, buyers, competitors, and more, the results are very different. This is not based on the tallied results in the appendix:

<green table 2 goes here>

Footnote 10: Source, AFP:
According to this second analysis, the threats of substitute products, bargaining power of customers, and rivalry among competing firms are high, and are unfavorable to industry profitability.

The bargaining power of suppliers and threat of new entrants are moderate, which is not very favorable to industry profitability. It should be noted, however, that the bargaining power of suppliers may be induced upon them by force, as if they stop supplying it is not because they have money and are threatening the automakers, but because they cannot afford to keep assembly lines open. This creates a negative-sum game, hurting both parties. It could force the automakers to rescue the suppliers.

In summary, the industry is unfavorable to profitability.


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