The Impact of Competitive Position on Prices and Costs

Analysts forecast items such as revenues and profit margins. The competitive environment in which a company operates affects these items. Further, analysts’ projections for these items are based on an estimate of a company’s future competitive strength.

Analysts use Michael Porter’s five forces framework to evaluate how competition will affect a company’s financial results. The framework identifies five forces that affect the competitive environment, costs, and price projections. These are:

The threat of Substitute Products

Companies have limited pricing power if there are many substitutes in the markets and the switching cost is low. On the other hand, if there are few substitutes and high switching costs, companies have greater pricing power.

The Intensity of Rivalry among Incumbent Companies

Pricing power is limited in fragmented industries with limited growth, high exit barriers, high fixed costs, and identical products.

Bargaining Power of Suppliers

Companies whose suppliers have a greater ability to increase prices and limit the quantity of inputs face downward pressure on profitability.

Bargaining Power of Customers

Companies whose customers have a greater ability to demand lower prices or control the quantity of end products face downward pressure on profitability.

The Threat of New Entrants

Companies in industries with low entry barriers face downward pressure on profitability. If there are high entry barriers, it is easier for incumbents to raise prices.

Besides Michael Porter’s five factors, other factors, such as government regulation and taxes, affect a company’s profitability. The best way to evaluate this is to analyze how government policies affect the five competitive forces.

Question

Which is the following is least likely one of Michael Porter’s five forces?

1. The threat of substitute products.
2. Bargaining power of suppliers.
3. Government regulations.

Solution

The correct answer is C. 

Government regulations affect a company’s profitability. However, they are not among Michael Porter’s five factors. Government regulations should be evaluated based on how they affect the five competitive forces.

A is incorrect. The threat of substitute products is one of Michael Porter’s five forces. If there are many substitutes, a company has limited pricing power.

B is incorrect. The bargaining power of suppliers is one of Michael Porter’s five factors. Companies whose suppliers have a greater ability to increase prices and limit the quantity of inputs face downward pressure on profitability.

Reading 17: Financial Statement Modeling

LOS 17 (j) Judge the competitive position of a company based on Porter’s five forces analysis.