Threat of Substitutes for Products or Services: Porter's Five Forces

Instructor: LeRon Haire
The lesson will introduce the threat of substitutes, which is one of Porter's Five Forces. The lesson will also analyze various elements of the threat of substitutes, including conditions that may increase the risk for substitutes.

Porter's Five Forces

Before we dive into the threat of substitutes, let's first explain exactly what Porter's Five Forces are. Named after Harvard Business School Professor Michael E. Porter, Porter's Five Forces were initially developed to categorize five primary market forces that will help to determine the amount of competition that exists in the market.

These five forces help businesses develop strategies in the area of competitive advantage. In addition to the threat of substitutes, the other four forces as designated by Mr Porter are:

  • Threat of new entrants
  • Bargaining power of suppliers
  • Bargaining power of customers
  • Competitive rivalry within an industry

As for the threat of substitutes, what are they and what effect do they have on the market? Let's examine some of these issues a bit further.

The Skinny on Substitutes

So what exactly is a substitute? A substitute can be defined as a good or service that has the ability to satisfy customer needs that are homogeneous, or similar in nature. These substitutes will often offer comparable prices to the originals as well. Here are a few common examples of substitutes that you may find familiar:

  • Home Depot and Lowe's
  • Pepsi and Coke
  • Burger King and McDonald's
  • Nike and Reebok

Although these household names may have a few differences, they are considered substitutes because of their overwhelming ability to generally satisfy the same customer needs. So let's say that you work for Pepsi, and your company is concerned about several substitute products, such as Coke and other generic cola beverages, and their ability to cut into your current customers. In order to understand what can be done to keep this from happening, you must first understand things from the customer's perspective.

Let's take a look at some of the conditions that increase the chance of substitutes.

Price

The cost of a product plays a vital role with customers in determining substitutes.
substitute

One of the common things that may cause customer switching to a substitute product is the price. For example, say you're still working for Pepsi and Coca-Cola has lowered its prices in an effort to gain more of the customer base for cola beverages. For those customers who just desire that similar taste, a lower price from your substitute competitor is a win-win situation for them.

This is also how price can act as a barrier for an organization. The organization must be careful when trying to raise its own costs because if their product is priced higher than the substitute competitors, they run the risk of migrating customers and that means a loss of revenue.

Quality

Quality is also an important factor with determining if a customer chooses a substitute.
quality

In business, it is the job of an organization to make quality products the public likes. When attempting to lower the risk of losing customers to substitutes, it's important that your customers perceive your quality to be better than that of substitutes. If customers feel that your substitute competitors have a higher quality of product, then there is a higher probability that you may lose those customers.

Availability

The price and quality of a product are each important factors when determining the conditions that increase the chance of substitutes. However, these factors are only relevant if substitutes are available in the market. When analyzing the threat of substitutes, organizations must first scan the market to determine if there are indeed any substitutes there. The fewer substitutes there are in the market, the better your chances to lower the risk of losing customers. Using our ongoing example of you working with Pepsi, let's assume that your only competitor is Coca-Cola. Although Coca-Cola is a more than worthy opponent, it would be a benefit if it were the ONLY substitute competitor in the cola beverage market.

Minimizing the Risks of Substitutes

To offset the conditions that increase the chance of substitute, it's important that organizations attempt to minimize those risks by enhancing their own strengths, while reducing the strength of their competitors. This can be done through differentiating and providing customer value.

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