Threat Of Substitutes

Threat of substitutes refers to the ease with which consumers may shift to competing products and services that are provided at comparatively comparable costs and features. The purpose of this strategy is to help businesses comprehend the market position and competitive dynamic in the industry.

It highlights the risk posed by alternative products/services, urging businesses to innovate and differentiate to retain customers. Understanding this threat enables firms to anticipate market shifts, enhance their offerings, and sustain competitive advantages in evolving industries, safeguarding profitability.

• The threat of substitutes refers to the risk posed by alternative products or services. These could satisfy a customer need or function similar to the offerings within a specific industry.
• It assesses the potential impact of alternative options on an industry's market share, profitability, and competitive position. Thus luring customers away from existing products or services.
• The threat of new entrants stems from potential competitors entering the market and introducing new products or services that challenge existing companies. In contrast, the threat of substitutes arises from alternative products or services already existing outside the industry.

Threats of substitutes are the possibility that goods and services from other sectors could replace those provided by businesses operating in a specific industry. It is a critical aspect within Porter's Five Forces framework, hence indicating the vulnerability of an industry's profitability due to alternative products. Hence, this strategy specifies that the market competition level would be high if the customers had a variety of options to select from.

The degree of threat depends on factors such as price, performance, availability, and customer preferences. Moreover, there are a combination of several factors involved in the threat of substitutes as follows -

1. Impact on Profitability: Substitutes with better pricing, quality, or easier accessibility can erode an industry's market share and reduce its profitability. This necessitates constant vigilance and adaptability from businesses.
2. Customer Behavior: Analyzing consumer tendencies, such as brand loyalty or willingness to experiment, helps predict potential shifts toward substitutes. Companies must tailor strategies to retain customers amid changing preferences.
3. Product Differentiation: The perceived uniqueness or specialization of a product affects its susceptibility to substitutes. Therefore, strong differentiation can mitigate the threat by establishing a unique value proposition.
4. Switching Costs: Higher costs associated with shifting to substitutes act as a deterrent for customers. Conversely, low switching costs make it easier for consumers to opt for alternatives, increasing the threat level.
5. Availability and Accessibility: If substitutes are easily accessible and widely available, they become a more immediate threat. Industries must focus on enhancing their products or services to maintain a competitive edge.

Hence, the purchasing power of businesses within an industry may be restricted by a high threat of substitutes, which could result in reduced profit margins. In addition, industry participants often relax their cost constraints when the threat of replacements is lower, which drives up costs for consumers. Thus, the threat of substitute products emerges when a particular product or service satisfies customer requirements, where these products have similar features and benefits.

Let us look at the threat of substitutes  analysis examples to understand the concept better -

Example #1

An example of the threat of substitutes in the retail industry is the competition between traditional supermarkets and meal kits delivery services like Blue Apron, HelloFresh, or Sun Basket.

These meal kit services offer an alternative to traditional grocery shopping by providing pre-portioned ingredients and recipes delivered directly to customers' doors. This convenience and the promise of easy-to-cook, high-quality meals act as substitutes for the traditional grocery shopping experience.

For supermarkets, these meal kit services represent a threat as they cater to customers seeking convenience, time-saving options, and a different approach to meal preparation. As a result, supermarkets have had to adapt by offering their meal kit solutions or enhancing their ready-to-cook and ready-to-eat meal options to compete with the convenience and novelty offered by these substitutes.

Example #2

Imagine a hypothetical scenario of the threat of substitutes in the smartphone industry where a new technology emerges offering holographic communication devices that provide an immersive experience far beyond traditional smartphones. These holographic devices offer similar functionalities but with enhanced features like 3D projection and interactive interfaces.

Customers, drawn by the novelty and enhanced capabilities, start considering these holographic devices as a substitute for traditional smartphones. As a result, smartphone manufacturers face a heightened threat of substitutes, potentially leading to a decline in their market share and profitability.

To mitigate this threat, smartphone companies might invest in research and development to enhance their products with innovative features or form strategic partnerships to incorporate holographic technology into their devices. Hence, this proactive approach aims to differentiate their offerings and maintain customer loyalty, minimizing the impact of the emerging substitute on their market position and profitability.

Businesses can overcome the threat of substitutes in various ways-

1. Product Differentiation: Innovate and create unique features or functionalities that set your product apart from substitutes, making it harder for customers to switch.
2. Customer Education: Educate consumers about the distinct advantages or benefits of the product compared to substitutes, highlighting its value proposition.
3. Cost Leadership: Lowering prices or offering competitive pricing can encourage customers to opt for substitutes purely based on cost.
4. Partnerships or Acquisitions: Form alliances or acquire companies in the substitute market to diversify offerings and capture a broader consumer base.
5. Enhanced Marketing and Branding: Strengthen the brand identity and marketing efforts to build customer loyalty, emphasizing the emotional or practical advantages of your product over substitutes.
6. Continuous Innovation: Invest in research and development to stay ahead of emerging substitutes, adapting your product to changing market preferences.

The differences between the threat of substitutes and the threat of new entrants are as follows -

This has been a guide to Threat Of Substitutes and its definition. Here, we explain its examples, how to overcome it, and compare it with threat of entrants. You can learn more about financing from the following articles –

• Porter’s Five Forces
• Substitute Products
• Barriers To Exit