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Threat of Substitutes In Porter’s Five Forces Model

The threat of substitutes is an important element in the Five Forces Analysis model introduced by Michael Porter in his book Competitive Strategy.

The issue of the threat of substitutes is always a factor which limits the profit potential of a market.

In times of economic difficulties, the threat accelerates sharply but it also represents an opportunity to help lure new customers into your market as customers priorities, needs and wants change.

Other Articles On Industry Analysis and the Five Forces Model

This article on the threat of substitutes can be read in isolation but if you are not familiar with Michael Porter’s Five Forces model, it will help to read Porter’s Five Forces first and then later read about the other forces that influence industry profitability.

Threat of New Entrants

Bargaining Power Of Buyers

Bargaining Power Of Suppliers

Threat of Competitive Rivalry

What Is The Threat of Substitutes?

The threat of substitutes force recognises that every customer has a choice when they buy which is not limited to the same industry or market.

There are different ways to satisfy a particular need. See What Are You Doing On Saturday Night.

Substitutes Offer Customers the Choice Of How To Solve A Problem

If I want to travel from my home in Birmingham to Paris, I can:

  • Drive (including the Channel Tunnel);
  • Travel by train;
  • Fly.

The airlines that fly from Birmingham are not just competing between British Airways, Air France and BMI Baby. They must recognise that I have substitute solutions to meet my desire to travel to Paris.

This threat of substitutes (driving or train) places restrictions on what the airlines have to offer to convince me that flying is the best solution. The customer value attribute map or what Blue Ocean Strategy calls the strategy canvas is a useful way to look across the dimensions of customer value to show the advantages and disadvantages of substitutes from the customer’s perspective.

The Threat of Substitutes Increases In A Recession

Takeaway restaurants have seen a migration of customers in the recession and open up opportunities for businesses like Housebites.

The threat of substitutes can impact your business both ways and, if you owned a takeaway business, you need to have marketing strategies to tempt people away from restaurants and defend against the threat of the ready meals.

For example to tempt regular restaurant trade to the substitute takeaway service, a takeaway business could emphasise the quality of the food and give tips on how you can turn your Chinese takeaway into a romantic event at home or into a party night with a small group of friends.

To protect against the threat of substitution from ready meals, the takeaway business would again emphasise quality, introduce a delivery service (it is what stops me buying fish and chips compared to Indian, Chinese, pizza etc) and have a regular buyer reward scheme e.g. buy on four occasions and get the fifth free (with some kind of value limit).

Threat of Substitutes: The Theory

Let’s take a look at how Michael Porter explained the threat of substitutes in his Five Forces Model.

The main issue is that the existence of substitute products and services place a ceiling on the price a market and companies with the market can sustain.

Going back to the takeaway food example, the closer the price the cost of the takeaway gets to the price of a restaurant meal, the less threat it is as a substitute solution.

The key issues on the threat of substitutes are:

  • The willingness of customers to switch across different products (which is often a factor of how easy it is to compare and contrast the different offerings); and
  • The relative price/value offered by the different substitutes.

If we return to my example of getting to Paris for a weekend break, what I want is to travel easily, quickly and cheaply so that I have most opportunity to enjoy my time in Paris.

A cheap flight going out early Friday morning and returning late afternoon on Sunday is ideal but what if I can’t fly out until 4:00pm on the Friday?

That writes off Friday as a holiday and if combined with a forced early flight back on Sunday, it means I’m paying for the flight and two nights in Paris for the pleasure of having effectively one full day to relax and have a good time.

That could make other methods of transport attractive, especially if I lived near the south coast of England and if I have the belief that Airlines Suck (an interesting perspective on the difference between customer satisfaction and  customer value.)

Alternatively the flight times could tempt me to look at flying to Paris from a substitute airport or could get me thinking about substituting Paris for Rome, Florence, Prague or any of the other great cities in Europe. What I really want is a lovely weekend break.

The comparisons are difficult. I’m not comparing like with like and that’s why the desire to switch is so important. If I really want to go to Paris for a special reason, my potential substitutes narrow to how I can get there in ways that maximise my time in Paris and minimise the pain of the journey.

Differentiation And The Threat of Substitution

Effective differentiation will create buyer preference within a product category because it helps one product stand out as a bullseye match between what it offers and what the customer wants.

A product that has very strong differentiation will turn competitors’ products into possible substitutes rather than direct alternatives. The threat doesn’t go away entirely but it is reduced.

Substitutes and Customer Value

Customers want value for money and because this is a ratio, it can get better if:

  • The value or benefits you receive as a customer increase.
  • The price you pay reduces.

Value for money gets worse when the value reduces or the price increases.

The relative customer value between different substitutes can change because of changes in one alternative rather than the other which is why it’s important to watch what’s happening in the substitute markets.

Even with the Euro crisis, the UK has seen the value of sterling fall against the Euro, making the Christmas shopping trip to Paris a lot less attractive than in the last couple of years. The thrill of the experience of visiting Paris hasn’t changed but the price has in sterling terms.

Other times, it is the value that changes between substitutes. Some products can make fast incremental or breakthrough changes in performance which shift the relative appeal of the products and increase the threat of substitution.

Analysing The Threat Of Substitutes

Step 1  of assessing the threat from substitutes is very much seeing your business as competing within a market and also within a wider generic solution market.

Too often business managers are focused on their direct competitors and miss what’s happening in substitute markets until sales volumes are disappearing quickly.

What problems do your products or services solve? Make a list.

Then identify how else a customer can potentially solve these problems. What substitutes will the customer consider as viable alternatives?

Then start looking at each substitute so you understand the appeal.

  • What benefits does the substitute provide compared to you?
  • What price point is it at?
  • What is the weakness of the substitute? What constraints or limitations does it impose on a customer?
  • Why would a customer switch between substitutes?
  • What barriers are there to stop customers switching?
  • What trends are there is the substitute markets? Where is customer value being gained or lost? What can cause sudden changes in price?

When you have the basic information, you can then start to look at building strategies to either defend against the threat of substitutes or to attract customers from another substitute market.

How can you tilt the value for money comparison in your favour by increasing the perceived value or reducing the perceived price?

How can you:

  1. Identify potential switchers from a substitute market?
  2. Communicate and educate about your offerings?
  3. Tempting them into wanting to make a trial purchase?
  4. Provide reassurance against any fears of switching?
  5. Retain their customer loyalty?

A lot of this is good marketing but it is aimed at encouraging customers of substitutes to switch to a different product and when they do, to choose you.

Conclusion on the Threat of Substitutes

I have tried to show that substitution between products and services is both an opportunity and a threat and therefore can appear on both sides of your SWOT analysis.

If you don’t recognise the existence of substitutes, you won’t put in place the right defensive strategies to keep some of your current customers and you won’t follow offensive strategies to attract new customers to you.

If you want to know more about Michael Porter and his Five Forces model, his Competitive Strategy book is rightly considered a classic.

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