Identifying substitutes of firm’s product-service

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 activi­ ties. 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 adjustm ent and for after­ sale servicing, for example. Linkages affecting a product can also influ­ ence 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 im portant 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 manu­ facturer 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 usu­ ally are.

In the more complex forms of substitution, a substitute performs a different range of functions than an industry’s product an d /o r 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 offunctions 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 mov­ ies, 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 func­ tions. In water meters, for example, the primary  substitute  is not to meter  water usage   at   all.   Similarly,   the   leading   U.S.   salt   producer, M orton-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 o f 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 im portant substi­ tutes 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 rema­ chined 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 inter­ nally. 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 consult­ ing 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. M ulti­ ple 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 aspartam e and saccharin are substi­ tuting for sugar. The success of aspartam e is expected by some observ­ ers 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 medium­ sized 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 seri­ ously.

Source: Porter Michael E. (1998), Competitive Advantage: Creating and Sustaining Superior Performance, Free Press; Illustrated edition.

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