This article is called what is the threat of substitutes within Porter’s five forces model? It explains the substitute threat, how to detect and analyse it within your industry.
Do you have a sustainable competitive advantage? An advantage which 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 is 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 word examples
The threat of substitute examples including one of which may be debatable. Which one?
- Mobile phone is a substitute for a 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
The lower the threat of substitutes within your industry, the higher the potential price ceiling. As an investor in a business, it is preferable to invest in companies where there’s a low threat from substitutes.
The most dangerous substitutes that you should always be looking out for are those who are becoming cheaper compared to their performance and those that earn 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 need to 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, increases profit potential for the firms in the industry but potentially could find it hard to change direction or innovate.
The threat of substitutes — Determining factors
To determine and detect whether your industry has a significant threat of substitutes, you need to analyse the following aspects of your industry.
- Are switching costs low, meaning there is little if anything is preventing your customer from purchasing the substitute product/service to the determent of your own offering.
- Is the alternative offering cheaper than your industry’s product or service? Does this place price ceiling to prevent you charging what you want to 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 attributes, functions, or performance of the substitute product are equal or superior to the industry’s product? You may have a high threat of substitutes to cope with, and your current profit potential is under danger.
More expensive alternative
But suppose the substitute product is more expensive, of lower quality, it’s functionality does not compare with what you do, and switching costs are high? Then these competitors offer significantly reduced threat. 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 is going to threaten in the future.
Not all of these factors will apply to your business, but some certainly will. The analysis will not always be straightforward, and you may have indications of a high threat of substitutes and 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 the 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. A low threat of substitute increases your potential profit capability. This profit potential is of course the same for your Direct and Indirect competitors too. A high threat of substitute products makes your industry less attractive and decreases the level of potential profit that can be achieved.
When using Porter’s five forces model, the threat of substitute products and service is just one of the factors to be considered when analysing your industry sectors structural environment. The best way to start is by getting a clean whiteboard and create a list of all your potential substitutes you as a threat. Analyse the danger and 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 able to identify and react to any threat of substitutes. It explained the substitute threat, how to detect and analyse it within your industry.
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