Michael Porter revolutionized the world of business strategy when he developed his Five Forces framework, which evaluates the competitiveness — and resulting attractiveness — of an industry based on five competitive forces. We’ve discussed the framework previously, but now we’re taking a more in-depth look at each individual force. Today, we’re looking at the threat of substitutes.
Along with the threat of new entrants and competitive rivalry, the threat of substitutes is one of the three forces typically portrayed along a horizontal axis when Porter’s Five Forces are shown graphically. This is in contrast to supplier power and buyer power, which are portrayed vertically. This is to reflect the fact that new entrants, competitive rivalry and substitutes are forces that share the same market. The supplier of a substitute product is more likely to compete with you directly than one of your own suppliers or buyers.
Substitutes differ in an important way from existing competitors and new entrants. Existing competitors and new entrants tend to compete more or less head-to-head. They may have a market position in a different niche, but they’re generally selling the same thing. A simple example is the pizza industry. A pizza parlor might position itself as a high-quality, upscale offering that is able to charge a premium because of its high quality. Its direct competitors — whether new or existing — could include a low-price pizza buffet. These businesses represent the dine-in pizza market. A substitute product would be carry-out pizza parlors or street vendors selling pizza by the slice. They sell a similar experience, but not the exact same thing. The important thing about substitutes is that they are similar enough to the primary offering that consumers are more or less indifferent between the primary offering and the substitute in terms of utility. Even though I might typically go for a dine-in experience, I’m still just as happy with a carry-out experience.
When it comes to substitutes, it’s important to not think too narrowly. In our simple example, substitutes could also include other forms of junk food (no offense intended to the pizza industry). A fast-food hamburger chain could be a substitute for pizza. Similarly, a substitute could still focus on pizza but could be take-and-bake or frozen pizzas instead of ready-to-eat pizzas. A substitute could also be health food from a grocery store.
Obviously each of the examples above may be more or less attractive to potential consumers than the primary industry for different reasons. Strategic CFO discusses four determining factors of the threat of substitutes.
Switching Costs
“If the consumer’s switching costs are low, meaning there is little if anything stopping the consumer from purchasing the substitute instead of the industry’s product, then the threat of substitute products is high.” This is not the same thing as price. Think of a contract with a cable company. You might be locked into a year-long term with a penalty if you decide to drop your service and switch to satellite. That’s a switching cost.
Price
“If the substitute product is cheaper than the industry’s product — thereby placing a ceiling on the price of the industry’s product — then a threat of substitutes high risk is the case.” In our hypothetical example above, if a cheap fast-food option like $1 burgers enters the market, some consumers will be less willing to pay $30 for a sit-down pizza dinner for two. It doesn’t mean nobody will, but some market share will almost certainly be lost.
Quality
“If the substitute product is of equal or superior quality compared to the industry’s product, the threat of substitutes is high.” Think of your own consumer behavior patterns. You may be quite happy with a particular product at a particular price point, but if a new product emerges that is of the same or higher quality, at the same or lower price, you’re likely to consider at least trying that new product.
Similarity
“If the functions, attributes, or performance of the substitute product are equal or superior to the industry’s product,” the threat of substitutes is high. This will depend on consumer tastes. Are hamburgers equal to or superior to pizza? What about health food from a grocery store that you have to cook yourself?
It’s important to remember that substitutes can be close substitutes or distant substitutes. But a substitute doesn’t have to be close to draw business away from an industry, and there are almost always multiple substitutes. One of the reasons we used the example of the dine-in pizza industry in this case is that it has a high threat of substitutes, meaning it lends itself easily to examples.
Porter’s isn’t just a theoretical model. It has practical applicability for business people in any industry or field. As you think about the impact of substitutes, consider the types of substitutes that might exist—or might emerge—to compete with your products and services. These considerations should be part of an ongoing process of environmental scanning to help forecast and identify potential risks that must be addressed to ensure your business remains viable and competitive.
How might these considerations help you position your products and services more competitively?
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Tags: competition, Porter's Five Forces, Strategic Planning, Strategy, switching costs, threat of substitutes