Threat of Substitutes in Porter’s 5 Forces
Porter’s Five Forces is a market competition analysis model developed by Michael E. Porter. The model puts forward five categories of forces that determine the level of market competition a business faces. Organizations employ Porter’s Five Forces to analyze the market structure, including its attractiveness and anticipated profitability. It is also used as a corporate strategy for sustainability. The Five Forces are:
- The possibility of new players
- The power that suppliers hold
- The power that customers hold
- Intense competition
- The existence of substitute services and products
The existence of substitute products is a critical part of Porter’s Five Forces. Porter defines a substitute as a good or service that a customer can opt to purchase instead of the company’s product to fulfill the exact needs. Substitute products are characteristically homogenous, with few differences from the industry’s products. From a customer’s perspective, the substitute usually has comparable prices with the same benefits as those offered by the company or industry. When customers have numerous options, the organization’s profitability is negatively affected. Porter’s Five Forces describe substitutes as critical in determining the market’s competitive structure.
Examples of substitute products are tea and coffee. If a market has a definite number of customers, the number will choose between tea and coffee. Both are beverages, and the customers can get similar benefits from each. Another example is the case of a restaurant that faces the threat of substitutes from other high-end restaurants, supermarkets, dinners, local bakeries, or ready-to-eat food packets. Customers have a variety of options to choose from when getting their meals.
Factors that Affect the Threat of Substitute Products
Threats of substitute products are a key concern for an organization since they determine the level of profitability that can be obtained. A market with more substitutes means an organization must constantly invest in promotional activities while struggling to have a fraction of the market share. If there are few or no substitutes, the organization experiences low competition and is likely to enjoy a significant market share. The level of the threat of substitutes varies from industry to industry. The following conditions determine these variations.
Price of the Substitute Product
The general assumption is that most customers are price-conscious. Price consciousness implies that customers would always opt for the most cost-friendly product in the market. According to Porter’s Five Forces, consumers would always go for a product with the lowest price or that cost the least to get, as long as they can get similar benefits. The threat of substitutes is always high for an organization operating where the substitute products cost the same or less than what it offers. If an organization has substitute products costing higher than its offering, the threat of substitutes is considered low. Concerning profitability, a high level of threats of substitute products means that organizations are faced with a price ceiling. A price ceiling occurs when organizations cannot raise the prices of their products or services beyond a certain level, or they will risk losing their customers to substitutes. This way, they have to bear low profitability or lose revenue altogether. Prices influence fast-moving consumer goods such as foodstuff.
Quality of the Substitute Product
The quality of products is also an important factor when customers make purchasing decisions. The general assumption is that customers want value for their money with the price factor aside. Customers will always go for a product or service they perceive to fulfill their needs most effectively. Products like electronics exist in varying brands. The buying decision is based on which product the consumers value more or exhibit higher performance. An organization that has substitute products with equal or superior quality can be described as experiencing a high threat of substitute products. If the substitutes exhibit inferior quality, the organization can be described as experiencing a low threat of substitute products.
Availability of the Substitute Product
The price and quality of products and services are important factors for determining the level of substitute products in any industry. However, the substitutes must be present before the two can be analyzed. In other words, the threat of substitute products begins by determining if they exist. For most organizations, the availability of substitute products is the first consideration when entering a new market. An organization has to scan for substitute product availability to determine the market’s attractiveness. The organization will likely lose customers or be at constant war with other companies if there are already many substitutes.
In contrast, the market can be seen as attractive if there are few or no substitute products. For example, the phone manufacturing industry is already filled with numerous substitutes. Therefore, to beat such a market, the organization must design phones with unique and/or superior qualities but at the least possible price. In other industries, such as aeronautical engineering, only a few existing aircraft parts manufacturers exist. If an organization manages to enter such an industry, there is a high likelihood of profitability. However, other factors, such as the cost of entry into such markets and the monopolistic power existing players hold, will come into play when making market entry decisions.
How to Minimize the Threat of Substitute Products?
Even if a business entered a market with very little or no threat of substitute products, eventually, other players would discover the market and enter. Therefore, sooner or later, the organization would be tasked with ensuring they stay at the top of the game and beat other competitors. Below are some of the major ways of minimizing threats of substitute products:
Product Differentiation
Product differentiation is critical in addressing the homogeneous aspect of substitute products. The rule of thumb is that as long as products or services offer the exact level of satisfaction with no extra feature to differentiate them from each other, customers would always see them as perfect alternatives. There are many ways that businesses can distinguish their products from other substitutes. The goal of product differentiation is constantly introducing an extra unique feature that would stand out against other products.