Your actual competition

Your business has more competition than you may realize.

When most people list their competitors, they usually just name companies that make similar products. But in reality, they should also think of their suppliers, customers, substitute products—even potential new entrants that don’t exist yet!—as competitors.

Of course, these relationships are collaborative and beneficial to everyone involved. But it’s important to realize that they are competitors, in the sense that they compete with you for profit.

It’s like a 360° tug of war:

1. Industry rivals compete to offer higher value and/or lower prices (e.g. Ford vs Chevy).
2. Buyers want the most value at the lowest price. If they can find a better deal elsewhere, they’re happily switch (e.g. some random widget manufacturer vs Wal-Mart).
3. Suppliers want to charge you as high a price possible, and make it as hard as possible for you to switch (e.g. Dell vs Intel).
4. Substitutes are ready to cannibalize your industry by picking off segments of buyers and serving them in totally unique ways that make your product irrelevant (e.g. The New York Times vs Twitter).
5. Potential entrants are waiting in the wings, ready to swoop in if they sense they could succeed by offering buyers a better deal (e.g. Divinations vs other smart business thinkers who don’t currently have a newsletter but just know they could make something so much more compelling than this).

This idea—that there are five forces that influence your profitability—is what launched Michael Porter’s career. In 1979, he published “How Competitive Forces Shape Strategy” in the Harvard Business Review. It was an instant classic.

It may seem like a simple idea, but the implications are wide-ranging. 

For example, it might seem like a business’s profitability depends mainly on competitive pressure from rivals—but the other four forces have a huge collective impact. And since all companies within the industry are subject to those same pressures, there is a baseline level of profitability that varies from industry to industry.

In other words: some industries are consistently more profitable than others. This explains the economic logic behind the famous Warren Buffet quote:

“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

Using the Five Forces

Whether you’re an entrepreneur, executive, or investor, if you want to understand a business, it’s incredibly helpful to run a “five forces analysis.”

To start, research and answer the following questions:

1. What are the barriers to entry?

   • Are there economies of scale? Network effects? Patents? Etc.
   • How hard is it for buyers to switch?
   • How much capital would it take to start a competitor?
   • Are there any scarce resources you have access to that competitors don’t?
   • How likely are existing players to try to drive new entrants out of the market?

2. What’s the bargaining power of suppliers?

   • What are your costs of goods sold?
   • How might that change as the business scales?
   • If any of your suppliers doubled or tripled their price, how easy would it be to replace them? How badly would it impact your profitability if you stayed with them?
   • How much do your suppliers depend on you to stay in business?

3. What’s the bargaining power of buyers?

   • What percent of your total revenue do your top 10 customers account for?
   • How easily can your buyers switch to your competitors’ products?
   • Do your buyers demand high quality and are willing to pay a premium? Or are they price sensitive?
   • How much of your buyers’ cost structure do you make up? (The higher % of their costs are attributed to you, the more it’s worth it to them to bargain.)

4. What’s the threat of substitutes?

   • Before people started using your product, what did people do?
   • When people stop using your product, what do they do instead?
   • What other categories of products serve the same “job to be done” your product serves?
   • Are any of your substitutes steadily getting better? Cheaper? Both?
   • How hard would it be for your customers to switch to the substitute product?

5. How competitive are existing players?

   • Are there a lot of competitors?
   • Are most businesses roughly of the same size / market power?
   • Do you compete on price? Or on differentiated value propositions?
   • Do players in your industry have high fixed costs and low marginal costs? (If so, price cutting is more likely.)
   • Can you scale smoothly, or only in large increments? (If in large increments, expect fierce competition to make big investments in extra capacity pay off.)
   • Is the industry growing? How quickly? (If not, expect tougher competition to claim an increased share of a fixed pie.)

Then, once you start to get a rough sketch of how each force affects your business, you can generate a list of experiments to run, or questions to dive deeper on.

The list of questions above isn’t exhaustive. As you spend time answering them, you’ll think of others. The main idea is to figure out how things work.

Going through the process helps you build a much better model of your industry in your head. You’ll notice hidden opportunities and threats. Your current strategy will become more clear, and you’ll come up with lots of ideas for experiments and tweaks to your model.

Some of these ideas could turn into actions that transform your business.

An example: Spotify

The story of Spotify makes a powerful “five forces” case study, because it illustrates how entire corporate strategies are often designed to combat one powerful force.

(It’s also fascinating to me, personally! I used to work at Gimlet Media, which was acquired by Spotify for reasons that will become apparent below.)

Let’s quickly go through each of the forces:

Potential entrants: weak

It’s pretty hard to launch a new streaming music service. (Just ask Tidal.) First, you have to get the attention of record labels and negotiate a deal with them. That’s going to take years.

Then, you have to build a good product experience. Even to hit a baseline level of quality, it’s going to require a pretty huge amount of solid engineering and design time and talent. (Many would argue even Apple Music isn’t as good of an experience as Spotify!) You’re also going to have to integrate with a lot of devices—phone operating systems, cars, smart speakers, smart TVs, gaming consoles, and maybe a refrigerator or two.