The first step in substitution analysis is to identify the substitutes an industry faces. This seemingly straightforward task is often not easy in practice. Identifying substitutes requires searching for products or services that perform the same generic function or functions as an industry’s product, rather than products that have the same form. A truck differs greatly from a train, but they both perform the same generic function for the buyer—point-to-point freight transportation.1
The function a product performs depends on its role in the buyer’s value chain. A product is used by the buyer in performing some activity or activities—a truck or a train is used in inbound or outbound logistics, for example, while skis are used as part of a buyer’s recreation in winter. As discussed in Chapter 4, a product often affects not only the buyer value activity in which it is used but also many other activities. A component used in a product passes through inbound logistics, is held in inventory before it is used, and must be serviced in the field after sale, for example. Similarly, baby diapers are not only worn by the baby but also must be put on by the parent, laundered if they are reuseable, and purchased and stored. All the impacts of a product on the buyer are relevant in defining substitutes and their relative performance. Finally, the value activity in which a product is used may be connected to other activities through linkages. The precision of a part can influence the need for product adjustment and for aftersale servicing, for example. Linkages affecting a product can also influence substitution, because they often create possibilities for discovering new ways to combine activities.
In the simplest form of substitution, one product substitutes for another in performing the same function in the same buyer value activity. This is the case of a ceramic engine part substituting for a metal engine part. Though the substitution is direct, linkages can still exist. A ceramic part may require different handling, for example. Even in simple substitutions, it is also important to define the function of a product in the activity generically rather than literally—what the product does rather than how it does it. The generic function of a product is often very broad, particularly in consumer goods. A manufacturer of metal downhill skis faces substitution not only from epoxy or fiberglass skis but also from cross-country skis, other winter sports equipment, other leisure products that can be used in winter, and from the buyer taking more leisure time in the summer rather than winter. The generic function of metal skis, most broadly defined, is recreation. The more generically the function of an industry’s product is expressed, the greater the number of potential substitutes there usually are.
In the more complex forms of substitution, a substitute performs a different range of functions than an industry’s product and/or affects buyer activities in a different way. In the case of a truck substituting for a train, for example, loading, unloading, packaging, and shipment size may all be different though both perform the same transportation function. A substitute may also perform a wider or narrower range of functions than an industry’s product. For example, a word processor is not only a substitute for the functions of a typewriter but also for other functions such as calculating and small-quantity copying; a heat pump performs both heating and cooling, while a conventional boiler system can be used only for heating; a disposable diaper removes | the need for laundering. Conversely, a waffle maker performs fewer functions than a toaster oven, and a specialty retailer sells only one line of goods that are a subset of the product assortment of a depart-ment store. In identifying substitutes, then, it is necessary to include products that can perform functions in addition to those of an indus-try’s product, as well as products that can perform any significant function among those the industry’s product can perform.
Because a substitute can perform a wider or narrower range of functions, chains of substitution for a product can go in very different directions. For example, the functions of a racetrack include both gambling and entertainment. Substitutes for the gambling function include casinos, off-track betting, and bookies, while substitutes for the entertainment function are even more numerous and include movies, books, sporting events, and so on. The more functions a product performs in the buyer’s value chain, the greater the number of chains of substitutes.
While one usually thinks of substitutes only in terms of different products, in many industries there are at least four other options that must be considered as substitutes in a broad sense. One option is that the buyer does not purchase anything at all to perform the function, the most extreme form of a substitute with a narrower range of functions. In water meters, for example, the primary substitute is not to meter water usage at all. Similarly, the leading U.S. salt producer, Morton-Norwich, is being threatened by concern over the health effects of sodium that has reduced consumption.
A second potential substitute is to lower the usage rate of the product required to perform the function. In aluminum, for example, new beverage cans require thinner walls and hence less aluminum. Similarly, in offshore drilling rigs, new directional drilling techniques and down-hole measurement of the drilling process promise to reduce the amount of rig time required to drill.
A third substitute that is often overlooked is used, recycled, or reconditioned products. In aluminum, for example, perhaps the most threatening substitute facing primary aluminum producers is secondary (recycled) aluminum. Secondary consumption has grown rapidly in both the United States and Japan. Used products are important substitutes for new products in many industries producing durable goods, such as automobiles and recreational vehicles. Reconditioned products are an important substitute in aircraft engine components, where remachined and recoated engine parts are a threat to new spare parts.
A final potential substitute is for the buyer to perform the function internally, or backward integration. For example, the key substitute for many distribution industries is for the buyer to purchase directly from the manufacturer and perform the distribution function internally. Or in property and casualty insurance, a buyer can self-insure or establish a captive insurance subsidiary.
The relevant substitutes will differ by industry segment (Chapter 7).
Different buyers use a product in different ways and hence value its functions differently. At a racetrack, for example, some buyers will come to enjoy the spectacle and an evening with friends, while others will spend most of their time at the betting windows or consulting tip sheets. Thus the relevant substitutes will differ by buyer or buyer segment. Similarly, different product varieties are used differently and hence may face different substitutes. Thus the pattern of substitutes changes by industry segment, and a firm’s most threatening substitutes will be a function of what segments it actually serves.
Several substitutions can occur simultaneously. In the video game industry, for example, programmable video games with replaceable software cartridges are substituting for dedicated games that cannot be changed, at the same time that personal computers (on which game programs can be run) are substituting for programmable games. Multiple substitutions often involve the broadening or narrowing of product functions, as this example illustrates.
Multiple substitutions interact in shaping the overall substitution rate in an industry and may lead to counterintuitive consequences. Aspartame is a new artificial low calorie sweetener, for example, that is substituting for saccharin. Both aspartame and saccharin are substituting for sugar. The success of aspartame is expected by some observers to increase rather than decrease the demand for saccharin for a time, by expanding the overall market for artificial sweeteners faster than it substitutes for saccharin. Here the later substitute benefits an earlier substitute. The process can also work in reverse. The success or failure of the first substitute can make it harder (or easier) for the next one.
Even if an industry faces no direct substitutes, it may still be affected by substitution if there is the threat of substitution downstream if the buyer’s product faces substitutes. For example, diesel engines and gasoline engines are contending substitutes for use in mediumsized trucks, diesel engines having long replaced gasoline engines in heavy trucks. If diesel engines win out, the demand for gasoline engine parts will fall, even though the parts themselves face no substitutes directly. Downstream substitution can also occur when the buyer’s product depends on the sale of a complementary product that is threat- ened. If microwave ovens replace conventional ovens, for example, not only will the manufacturers of parts for conventional ovens be adversely affected but so will the manufacturers of cookware used in conventional ovens. In downstream substitution, the buyer no longer needs to perform the function of the firm’s product.
Downstream substitution can both lower industry demand, and can alter buyer behavior. A threat of downstream substitution will often be transmitted to suppliers in the form of greater price sensitivity It may also lead buyers to look for help from their suppliers in meeting the threat through innovations in suppliers’ products or other actions that raise the buyer’s differentiation or lower the buyer’s cost.
The number of substitutes for an industry’s product will vary widely from industry to industry. Potential substitutes will differ in how they replace a product and in the level of threat they represent. It is important in substitution analysis to begin with the longest list of potential substitutes, because firms are much more prone to be blindsided by a substitute than to take a particular substitute too seriously.
Source: Porter Michael E. (1998), Competitive Advantage: Creating and Sustaining Superior Performance, Free Press; Illustrated edition.