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The Impact of Competitive Position on Prices and Costs

The Impact of Competitive Position on Prices and Costs

Items forecasted by analysts, like revenues and profit margins, are affected by the competitive environment that the company operates in. 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 the competition will affect a company’s financial results. The framework identifies five forces that affect the competitive environment and, consequently, costs and price projections. These are:

Threat of Substitute Products

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

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/or limit the quantity of inputs face downward pressure on profitability.

Bargaining Power of Customers

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

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 affect a company’s profitability, such as government regulation and taxes. 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. Threat of substitutes products.
  2. Bargaining power of suppliers.
  3. Government regulations.

Solution

The correct answer is C. 

Government regulations are one factor that affects a company’s profitability, but it is not one of Michael Porter’s five factors. Government regulations should be evaluated at how it affects the five competitive forces.

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

Reading 22: Industry and Company Analysis

LOS 22 (g) Explain how competitive factors affect prices and costs.

LOS 22 (h) Judge the competitive position of a company based on Porter’s five forces analysis.

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