What is the threat of substitutes?
This article is called What is the Threat of Substitutes within Porter’s Five Forces Model? It explains the substitute threat and how to detect and analyse it within your industry. Do you have a sustainable competitive advantage? An advantage that offers many years of profitability? What about your Threat of Substitutes?
Porter’s Five Forces model
Michael Porter argues that five forces influence competition and long-term investments. The five forces are the:
- Threat of entry
- Bargaining power of suppliers
- Bargaining power of bias
- Intensity of rivalry
- Threat of substitution
It is important that you are strategically positioned within your industry to defend yourself from these forces and then go on the attack by manipulating them to your advantage. A key part of Porter’s five forces is what he calls the threat of substitutes. He defines a substitute as an alternative product/service a customer can buy instead of your offering. Not from a direct competitor but a product/service that can do the same things your offering does but is from another industry.
Real-world examples
The threat of substitute examples, including one that may be debatable, is also a concern. Which one?
- Mobile phone is a substitute for landline phone
- Social media substitute for newspapers.
- Zoom conferencing is a substitute for a train ride
- Bicycles and cars
- Supermarket food or restaurant
- Going out bowling or video games
- Kicking the ball around at the park or FIFA21
- Apple music or a live performance
- Bottled water versus tap water
- Hotels or Airbnb
- Airline flights to staycations
- DVD purchase or Netflix and other view-streaming
Lower threat
The lower the threat of substitutes within your industry, the higher the potential price ceiling. As an investor in a business, investing in companies with a low threat from substitutes is preferable. You should always look out for the most dangerous substitutes, which are becoming cheaper compared to their performance and earning higher returns on capital than your industry. These substitutes have the potential to drive prices down within your industry. They have other spillover effects that you must consider when investing or expanding further into the sector yourself.
A customer chooses to purchase the substitute instead of your product
Substitution threat affects the profitability of an industry because consumers can choose to purchase the substitute instead of your product. The availability of close substitute products will make your industry more competitive. A lack of comparable substitute alternatives makes an industry less competitive. It increases profit potential for the firms in the industry, but potentially could find it hard to change direction or innovate.
Take the company that produces customised brands as an example. With customisation as its main feature, it can satisfy customers’ needs in all aspects and adapt to changes in market preferences. Even a small badge can be made of various materials and designs, such as the well-known custom acrylic pins, enamel pins and metal pins. Through innovation, it will weaken the threat of substitutes and enhance competitiveness.
The threat of substitutes – Determining factors
To determine and detect whether your industry is significantly threatened by substitutes, you need to analyse the following aspects of your industry.
- Are switching costs low, meaning little if anything prevents your customer from purchasing the substitute product/service to the detriment of your own offering?
- Is the alternative offering cheaper than your industry’s product or service? Does this place price ceiling prevent you from charging what you want for your services?
- What about the quality of their offering? Is it as good or better than what you can offer? If so, the threat of substitutes is high.
- What if the substitute product’s attributes, functions, or performance are equal to or superior to those of the industry’s product? You may face a high threat of substitutes, and your current profit potential may be in danger.
More expensive alternative
But suppose the substitute product is more expensive and of lower quality, its functionality does not compare with what you do, and switching costs are high. Then, these competitors offer significantly reduced threats. However, it would be best if you kept an eye on things. A new kid on the block is likely building some technology in their Singaporian back bedroom—the one that will threaten them in the future.
Analysis
Not all of these factors will apply to your business, but some certainly will. The analysis will not always be straightforward; you may have indications of a high threat of substitutes and a low threat of substitute products. So consider the nuances of your analysis and your particular circumstances and that of your industry when evaluating competitive structure and potential market profit.
High and low threat
So Porter’s threat of substitutes shows us that a low threat of substitute products makes your industry more attractive and increases your potential profit capability. This profit potential is, of course, the same for your direct and indirect competitors. A high threat of substitute products makes your industry less attractive and decreases the level of potential profit that can be achieved.
The Five Forces Model
In summary, when using Porter’s five forces model, the threat of substitute products and services is just one factor to consider when analysing your industry sector’s structural environment. The best way to start is by getting a clean whiteboard and creating a list of all your potential substitutes have as a threat. Analyse the danger, give each business a threat rating, and plan to counter the risk. Many of these will be to take no action. No action until they do this or that. Watch them until they make this move or that move.
The aim of this article, called What is the Threat of Substitutes within Porter’s Five Forces Model, was to enable you to better identify and react to any threat of substitutes. It explained the substitute threat and how to detect and analyse it within your industry. Next, the article will ask what Porter’s five forces are threatening to new entrants.
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