Some months ago I started a series of articles examining Michael Porter's Five Forces Model of Industry Analysis and today I return to look at the threat of substitutes.
Why The Threat Of Substitutes Is Important
The issue of the threat of substitutes is always a factor which limits the profit potential of a market but in times of economic change, the threat accelerates sharply but also the opportunity to help lure new customers into your market also exists.
Other Articles On Industry Analysis and the Five Forces Model
This article can be read in isolation but if you are not familiar with Michael Porter's Five Forces model, it may help to read the other articles first.
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.
For example if I want to travel from my home in Birmingham to Paris, I can drive (including the Channel Tunnel), I can travel by train and I can fly.
So the airlines 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 Threat of Substitutes Increases In A Recession
I was surprised to read last week that Sir Alan Sugar was predicting boom times for takeaway restaurants while I had been thinking that this represented a market that could be badly hurt in the tough times.
The difference came from how we were each seeing the movement from or to substitute solutions to a "nice meal that is little trouble and a bit of a treat".
Sir Alan Sugar was seeing the movement down from restaurants to takeaways.
I was seeing the movement from takeaways to high quality ready meals and a return to home cooking.
So you can see that 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, a takeaway could emphasise the quality of the food and give tips on how you can turn your Chinese takeaway into a romantic event.
To protect against the ready meals, the takeaway 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. 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 fact is that substitutes place a ceiling on the price a market and companies with the market can sustain.
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 in particular situations.
The key issue is 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 time 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 means I'm paying for the flight and two nights in Paris for the pleasure of having effectively one 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 but these 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.
But 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 and give myself the most time.
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 works the other way as well but the relative customer value between different substitutes can change.
The UK has seen the value of sterling fall against the US dollar sharply, making the Christmas shopping trip to New York a lot less attractive than in the last couple of years. The thrill of the experience of visiting New York hasn't changed but the price has in sterling terms.
Other times, it is the value that changes between substitutes and some products can make fast incremental or breakthrough changes in performance which shift the relative appeal of and threat from each substitute.
Analysing The Threat Of Substitutes
Step 1 is very much seeing your business as competing within a market and also within a wider generic solution market.
What problems do your products or services solve? Make a list?
Then identify how else a customer can potentially solve the problem. What substitutes will the customer consider?
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 subsitute market.
How can you tilt the value for money comparison in your favour (increase the perceived value or reduce the perceived price)?
How can you:
- Identify potential switchers from a substitute market?
- Communicate and educate about your offerings?
- Tempting them into wanting to make a trial purchase?
- Provide reassurance against any fears of switching?
- 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 this is both an opportunity and a threat.
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.
Paul Simister is a differentiation coach who helps small business owners to profit from differentiation, be distinctive in the eyes of their customers and stand out in a crowded marketplace. He writes the DifferentiateYourBusiness.co.uk blog.
You are invited to take a 30 day trial in my business growth system at Profitable Growth Strategies for $1 or £1. You will discover many ways you can increase your profits by selling more, more often to more customers.