The economics of substitution

One product substitutes for another if it offers buyers an inducement to switch that exceeds the cost or overcomes the resistance to doing so. A substitute offers an inducement to switch if the substitute provides the buyer with more value relative to its price than the product currently being used. There is always some cost of switching to a substitute because of the disruption and potential reconfiguration of buyer activities that must result, however. The threat of a substitute will vary depending on the size of the inducement relative to the required switching costs.

In addition to relative value to price and switching cost, the pattern of substitution is influenced by what I term the buyer’s propensity to switch. Faced with equivalent economic inducements for substitution, different buyers will often evaluate substitution differently.

The threat of substitution, then, is a function of three factors:

  • the relative value/price of a substitute compared to an industry’s product
  • the cost of switching to the substitute
  • the buyer’s propensity to switch

This simple statement of the economics of substitution masks the often subtle analysis required to understand it. The inducement a substitute offers to switch is properly measured over the entire period the buyer will use it, and discounted to the present. The cost of switch-jng to a substitute is typically incurred immediately or even before the substitute provides any benefits at all. Both relative value/price (RVP) and the costs of switching are functions of a wide variety of factors, and are subject to change over time. Both can also involve considerable uncertainty. Understanding both requires a clear understanding of how a product affects the buyer’s value chain, as well as the structure of the industry producing the substitute. Understanding the buyer’s propensity to switch requires a further knowledge of the buyer’s competitive circumstances, resources, and other characteristics that play a part in predicting its behavior towards a substitute.

1. Relative Value/Price

The value/price of a substitute is the value it provides to the buyer compared to the price the buyer pays for it. Relative value/ price is the value/price of a substitute relative to the value/price of the product it seeks to replace (which I term the product). When there are no switching costs and the product is consumed quickly, the relevant RVP is solely a function of current conditions. Future circumstances are not important because the buyer can rapidly and without cost shift back and forth between the substitute and the product depending on the RVP at the time. When there are costs of switching or the product is durable, however, the relevant measure of the attractiveness of a substitute is the expected RVP of the substitute over the planning horizon. The current prices of a substitute and a product are relatively easy to determine. The expected relative prices over the planning horizon are what should enter the RVP calculation, and must reflect the price changes forecasted over time. The purchase prices of both a substitute and a product must be adjusted for any discounts, rebates, or free ancillary products or services involved in their purchase. In office equipment, for example, free service is often part of the deal with a buyer, and must be included in comparing the prices of substitutes such as copiers and offset duplicators.

Prices must be also adjusted for any tax credits the buyer gains in purchase.

The relative value of a substitute is based on exactly the same factors that determine differentiation, discussed in Chapter 4. A substitute is valuable if it lowers buyer cost or improves buyer performance relative to the product. This value must be perceived by the buyer, however, and hence a substitute’s ability to signal value relative to the product is part of the value comparison. As with relative price, it is the expected relative value of the substitute over its period of use that enters into RVP, not just its current value.

The role of signaling in substitution is often as or more important than its role in differentiation. Substitution frequently involves a new product replacing a well established one. The substitute is typically unproven and its value may be quite uncertain, while the established product is proven and its qualities are well known. The ability of the substitute to signal value may, as a result, take on a significance that exceeds the role of signaling in differentiation.

The relative value of a substitute depends on its cumulative impact on the buyer’s value chain compared to the product’s, including both direct and indirect impacts. The principles of the analysis are the same as described in Chapter 4, though in practice there tend to be greater complexities in the analysis in substitution not usually present when comparing one brand of a product to another. A substitute and a product are often not directly comparable, and a substitute is more likely to involve a different pattern of impacts on the buyer’s value chain than a competing brand. Two brands of cloth diapers have essentially the same impact on the household, for example, while disposable diapers are used very differently than cloth diapers. The differing patterns of use of a substitute and a product typically necessitate adjustments in order to determine the relative value of a substitute.

The following adjustments in measuring impact on buyer cost or buyer performance are commonly necessary when comparing the value of a substitute with the value of a product:

Usage Rate. The effect of a substitute on a buyer’s cost depends on the amount of the substitute necessary to perform the same function. A substitute can lower buyer cost if less usage of it is required for a given result. For example, aspartame is much sweeter than saccharin, which means that less is necessary to achieve a comparable sweetening effect. Aspartame’s much higher price per pound must thus be adjusted accordingly. The usage of a substitute required for a given outcome will be affected by such factors as its purity, concentration, reject rate, or operating speed.

Delivered and Installed Cost. The effect of a substitute on buyer cost depends on the delivered and installed cost of the substitute relative to the product. Delivered and installed cost may include such factors as the cost of transportation, installation, calibration, expanding or modifying space to house the substitute, and many other costs that frequently differ for a substitute and the product.

Financing Cost. The effect of a substitute on buyer cost depends on the cost of financing the purchase of the substitute relative to the product. In comparing mobile homes and conventional houses, for example, it is important to recognize that mobile homes are financed as vehicles while conventional houses are financed as real estate. Interest rates and/or terms differ for these different types of financing, generally in the form of easier credit availability but higher rates for financing mobile homes. Financing costs can be a large fraction of total cost in some industries.

Relative Variability of Price or Availability. The cost of a substitute to the buyer is a function of expected fluctuations in its price or availability (of both the product and ancillary items such as parts or service). Price fluctuations are often costly for a buyer to deal with, as are periods of tight supply. One of the potential benefits of ceramics, for example, is that it uses a plentiful and cheap raw material while metal parts are subject to greater price fluctuations because of changing metal prices. Both price fluctuations and the risk of nonavailability are partly a function of how many credible sources there are for a substitute relative to the product.

The cost of a substitute to the buyer is also affected by whether adequate capacity is present to serve key buyers’ needs, particularly in the case of important inputs. Buyers are often unwilling to switch until enough capacity and suppliers are available to place the buyer in a tenable bargaining position. This creates the need in many substitutions to add capacity ahead of demand.

Direct Costs of Use. The effect of a substitute on buyer cost depends not only on its initial cost, but also on the present value of the cost of using the substitute over its entire life compared to that product. Direct costs of use involve such things as:

  • cost of labor (reflecting the quality of labor necessary)
  • consumables such as materials, fuel, or filters
  • insurance
  • time before replacement
  • frequency and cost of maintenance
  • cost of spare parts
  • breakdown time (valued at its opportunity cost or the cost of reserve capacity)
  • costs of maintaining the space required
  • salvage value
  • dismantling cost

In consumer goods, the cost of labor to use the substitute is the implicit cost of the buyer’s time. In frozen entrees, for example, a major benefit to the buyer is time savings in preparation compared to most other meal types. Valuing a consumer’s time is often difficult because it does not involve a money cost, though the techniques described in Chapter 4 provide a place to start.

In many industries, such as elevators and aircraft engines, the costs of using a substitute over its life are equal or are greater than the initial purchase price, and can be decisive in determining its attractiveness. For example, radial truck tires get approximately 25 percent more mileage than bias ply tires. Radials also have lower downtime from punctures, and can be retreaded twice compared to once for bias ply tires. Radials also improve the fuel efficiency of a truck on the order of 2 to 6 percent. These improvements in cost of use more than offset the 40 to 50 percent price premium for radial truck tires.

Indirect Costs of Use. The relative cost of use of a substitute must reflect costs throughout the buyer’s value chain, and not just costs in the value activity in which a substitute is directly employed. Such indirect or system impacts are often overlooked by both firms and buyers. An automated material handling conveyor, for example, can reduce the number and required skill levels of workers on the assembly line, the number of lift trucks needed in the factory, and the required strength of shipping containers compared to conventional materials handling methods. Similarly, disposable diapers eliminate the need for storage and laundering of soiled diapers in addition to making diapering the baby easier because of attached fastening tapes and a form-fitting shape. Another example is the electronic cash register, which can help a retailer to lower required inventory and to control operating costs better than a mechanical cash register that cannot generate extensive on-line transactions data.

A substitute may affect the cost of other activities in the buyer’s value chain if it:

  • affects productivity in other value activities
  • influences the need for other raw materials or their required quality
  • requires different ancillary equipment
  • affects the need for inventory
  • affects the frequency and complexity of required quality control checks
  • affects the amount and type of packaging materials needed in shipping
  • affects product weight and hence transport costs

Buyer Performance. The value of a substitute must reflect any differences in its impact on the buyer’s performance relative to the product. An electronic switching system for telecommunications can be more easily adapted to new requirements than an electromechanical switch, for example. A color TV provides more realistic pictures than a black and white set and therefore greater entertainment. Another example of a substitution based heavily on improving buyer performance is disposable diapers. Disposable diapers offer greater cleanliness than cloth diapers and are softer and less likely to cause diaper rash. As is often true in differentiation, the performance of a substitute from the buyer’s perspective may involve intangibles such as perceived status and the quality of personal relationships. The effect of a substitute on buyer performance is not always easy to measure, though it always can be estimated.

The substitution of robotics for a conventional manned machine tool provides an example of a complex substitution that involves direct cost of use effects, indirect cost of use effects, and effects on buyer performance. A robot reduces labor cost by increasing capital cost, and may increase the output rate of the production step in which it is employed. Robots can also save raw material cost and do not take sick leave, though they must be maintained. Indirectly, robots can alter the material preparation needed in previous production steps as well as material handling needs. Potential performance effects of robots include higher reliability, greater flexibility, and higher work- place safety.

Number of Functions. The effect of a substitute on buyer cost and performance must be adjusted for the range of functions it can perform relative to the product. Wider functionality usually improves the relative value of a substitute if buyers value the additional functions.

This is not always the case, however, since wider functionality may come at the expense of the quality of performance of particular key functions. For example, personal computers that play video games have many more functions than video game machines, but video game machines are still easier to use and the games playable on them have better quality graphics. Lower functionality usually reduces the value of the substitute but this can be offset by the corresponding reduction in price or superior performance of the narrower range of functions. Changing functionality can not only affect buyer performance but also alter the buyer’s cost of use, as the electronic cash register example demonstrated.

Attaching a value to additional functions (or missing functions) that affect performance in RVP calculations is often difficult, just as it is in differentiation analysis. The problem is particularly severe in consumer goods, because buyer performance often involves satisfying intangible needs. The principle of valuing different functionality is to examine how the functions involved impact the buyer’s value chain, and calculate the effect on buyer cost or performance. One approach to valuing particular functions is to look for stand-alone products that perform the functions, and see what buyers are willing to pay for them. Valuing differences in functions that affect buyer cost is typically easier than valuing those that affect buyer performance.

Cost and Performance of Complementary Products. The effect of a substitute on buyer cost and performance may be a function of the cost and performance of complementary products used with it relative to those used with the product.2 For example, movie theaters face the threat of substitution by home TV and videotape recorders, among other products. The cost to the buyer of going to a movie in a theater includes the time and cost of transportation to the theater and parking, and the cost of buying popcorn. The cost of these complementary purchases that are not necessary with home entertainment is one of the reasons movies fell from 8.2 percent of U.S. recreational expenditures in 1936 to under 3 percent by the mid-1970s.3 Similarly, substitution of recreational vehicles such as motor homes depends on such complements as gasoline, roads, and campgrounds.

Uncertainty. There is usually some uncertainty involved in how a substitute will affect the buyer’s cost or performance, arid this must be reflected in the RVP calculation. One major source of uncertainty is the possibility that the substitute will be improved in subsequent generations of the product. This can substantially delay switching by buyers. Uncertainty can be introduced into RVP by lowering the assumed value of a substitute by some discount factor.

Perception of Value. It is the buyer’s perception of the RVP of a substitute that will determine the threat of a substitute, not necessarily the reality of RVP. Buyer awareness of a substitute is often not as great as that of the established product, and knowledge about the benefits and features of a substitute is often incomplete. Relative inability to signal value will thus effectively reduce the perceived RVP of a substitute. Buyers are least likely to perceive the benefits of a substitute when:

  • the advantage of the substitute is in lowering the costs of use over time rather than immediately
  • the advantages of the substitute are indirect and involve a number of value activities rather than direct advantages in the value activity in which the substitute is employed
  • the advantages of the substitute are in raising performance over time rather than immediately
  • gaining the advantages of the substitute requires a significant change in behavior or use patterns by the buyer
  • the credibility of the substitute’s benefit is hard to assess

In all these cases, a buyer may not fully understand the impact of a substitute on its value chain; hence the need for signaling value through a variety of means is great. The substitution of robotics for conventional production equipment, described earlier, is a good example of a substitution where accurate perception of value has been a barrier to substitution, particularly in the United States relative to Japan.

While it is more common that buyers have difficulty recognizing the value of a substitute, sometimes the opposite occurs. Sometimes substitution occurs for glamour or to appear progressive, with little understanding of the actual value of the substitute. In power supplies, for example, some buyers are changing to the new switch mode technology whose needs are probably better met by the older linear technology. In such cases, time may lower the perception of a substitute’s actual value.

A substitute signals value in the same ways a firm does generally (see Chapter 4), using tools such as advertising, the sales force, demonstrations, and placement of units with opinion leaders. The stock of knowledge about a substitute as well as the expenditures by the substitute industry on signaling will determine how accurately the value of a substitute is perceived. Word of mouth and other sources of information not directly controlled by a firm are also vital.

2. Switching Costs

Substitution always involves some costs of switching to the substitute for the buyer, which are weighed against RVP. The higher the switching cost relatively, the more difficult substitution will be. Switching costs in substitution are analogous to those of changing from one supplier to another in an industry.62 Switching costs are usually higher in substitution than in switching suppliers, however, because substitution may require switching to a new supplier plus switching to a new way of performing a function.

Switching costs potentially arise from all the impacts a substitute has on the buyer’s value chain. Both the value activity in which the substitute is employed as well as other value activities it indirectly affects may require one- time costs of changeover. Switching costs most common in substitution are the following:

Identifying and Qualifying Sources. Finding sources for the substitute and gathering information about them are switching costs. So is the need to test a substitute to see if it meets performance standards. The cost of qualifying a 64K memory chip to replace a 16K chip has been estimated at $50,000, for example, and the process can take as long as a year.

Cost of Redesign or Reformulation. A buyer’s product or value activities must often be redesigned to accept a substitute. Reformulating a consumer food product to accept high-fructose corn syrup instead of sugar, for example, requires out-of-pocket costs as well as the time and opportunity cost involved in testing the reformulated product.

Redesign costs can affect many value activities. The layout of an entire plant must be changed to get the benefits of a new materials handling system, for example. Similarly, purchasing synthetically produced gas made from coal gasification instead of natural gas requires a user to modify gas burning equipment because of synthetic gas’s slightly different qualities. The cost of redesign or reformulation will be lower if the buyer is changing product generations or building a new facility anyway.

Retraining or Relearning Costs. Switching to a substitute often requires learning how to use the substitute or changing use patterns. A typist who has been using a manual typewriter must get used to the much lighter touch of an electric one, for example, while a cook must learn a new set of cooking procedures to use a microwave. Similarly, plant engineers and maintenance personnel must go down the learning curve with a new type of machine tool.

The cost of retraining includes the cost of downtime and higher reject rates during the shakedown period and other such costs besides the out-of- pocket costs of learning or training themselves. Retraining costs will be highest where a substitute is used very differently from the product. Shifting from black and white to color TV is easy, for example, while shifting from conventional ovens to microwave ovens requires learning about oven operation, procedures, cooking times, and how to get the best results with different foods.

Changing Role of the User. Quite apart from the need to learn new behavior, substitution frequently involves a change in role for the user that can be a positive or negative influence on the cost of switching. Automating a manufacturing process can relegate equipment operators or engineers to passive or noncritical roles, for example, which can be reflected in subtle or open resistance to a substitute. A husband or wife who cooks for the family may resist a food product that removes all the opportunity for a personal touch that demonstrates caring.

Risk of Failure. The risk that a substitute will fail to perform is a cost of switching. The cost of failure will vary widely from product to product. In fiber optics, the severe consequences of failure because of the role of fiber optics as the communications link in larger systems have made buyers conservative in switching from copper wire and cable.

New Ancillary Products. Changing to a substitute may require investments in new related equipment or material such as testing gear, spare parts, and software. While the cost of use of such ancillary products is included in the RVP of a substitute, the one-time cost of reequipping is a cost of switching. The need to invest in new ancillary products depends primarily on the compatibility of the equipment or parts used with the substitute with those used with the product, and the extent to which the substitute involves different types of inter- faces with related products. Like redesign costs, the cost of investing in new ancillary products is lowest when the ancillary products would have been replaced anyway.

Switching Costs Versus Switching Back Costs. Both the cost of failure of a substitute and the risk that its RVP will shift adversely are a function of the cost of switching back to the original product. If it is easy and inexpensive to switch back, the risk of switching is lower. The cost of switching back to the original product is usually less than the cost of switching to the substitute, because prior use of the product implies that the buyer already knows how to use it and has the required ancillary products. However, some switching costs, such as changeover costs and layout changes, cannot be avoided in switching back. There may also be some unique cost of switching back, such as confusing the buyer.

The cost of switching back usually rises as a function of the time since substitution, though some switching back costs are typically present no matter how short the experience with the substitute is. The relationship between switching cost and switching back costs has implications for substitution strategy that I will discuss below.

3. Buyer Propensity to Substitute

Buyers with different circumstances and in different industries do not all have equal propensities to substitute when faced with a comparable economic motivation. Differences in their circumstances lead buyers to respond to a given RVP and switching cost differently. While such differences might be treated as factors that modify RVP or switching costs, it is more helpful in practice to isolate them.

Resources. Substitution often involves up-front investments of capital and other resources. Access to such resources will differ from one buyer to another.

Risk Profile. Buyers often have very different risk profiles, the result of such things as their past history, age and income, ownership structure, background and orientation of management, and nature of competition in their industry. Buyers prone to risk taking are more likely to substitute than buyers that are risk-averse.

Technological Orientation. Buyers experienced with technological change may be less concerned with some kinds of substitution risks, while extremely aware of others that a less technologically sophisticated buyer would be oblivious to.

Previous Substitutions. The second substitution may be easier for a buyer than the first, unless the first substitution has been a failure. The buyer’s uncertainties over undertaking a substitution may have diminished if a past substitution has been successful, or risen if a past substitution has led to difficulties. In the soft drink industry, this seems to have worked to the benefit of aspartame.

Intensity of Rivalry. Buyers under intense competitive pressure and searching for competitive advantage will tend to substitute more quickly to gain a given advantage than those that are not.

Generic Strategy. The RVP of a substitute will have different significance depending on the competitive advantage that industrial, commercial, or institutional buyers are seeking or the value of time and particular performance needs of the household buyer. A substitute that offers a cost saving will tend to be of more interest to a cost leader than a differentiator, for example.

Many of these factors that shape the buyer’s propensity to substitute will be a function of the particular decision maker who is involved in the purchase decision.

4. Segmentation and Substitution

Both the identity of substitutes and the threat of substitution often differ by industry segment. This is because the economics of substitution are different for different product varieties and buyers, reflecting their structural and value chain differences. Thus a merging of the analysis in Chapter 7 and that in this chapter will not only expose differences in the substitution threat among segments but also assist in the construction of the industry segmentation matrix itself. The threat of substitution will vary by buyer group if RVP, switching costs, or the propensity to substitute vary. The RVP of a substitute often varies among buyers in an industry because of differences in how they use a product, the value they attach to various product attributes, and the other impacts of the product on their value chain. In the racetrack case discussed earlier, for example, buyers attending primarily for entertainment will have different substitutes than buyers attending primarily for gambling. Similarly, the advantages of radial truck tires in mileage and retreading ability will have more value to a long-haul fleet operator than to a local pickup and delivery service. In the same vein, the value of the convenience of disposable diapers is probably higher to families with two working spouses than to families in which one spouse stays home.

Switching costs also differ from buyer to buyer within an industry. Retraining costs are a function of existing procedures. The need for redesign or new ancillary products will relate to the specifics of how a product is used. Buyer propensity to substitute can also vary dramatically among buyers, a function of buyer resources, orientation, and so on. In many consumer goods, for example, substitution occurs first with high-income buyers who have the resources to purchase new items while they are expensive.

A good example of how substitution threat varies by buyer segment is in the adoption of personal computers by small businesses. Personal computers are a substitute for manual methods (e.g., standard office machines) and computer service bureaus. As Figure 8-1 indicates, the degree of penetration of personal computers in small businesses is correlated to the size of the business. Personal computers have penetrated much further within larger companies because those firms have more complex paperwork needs and thus a greater need for automation, and also greater resources to invest in capital purchases.

The substitution threat can vary not only for buyer segments but also for different product varieties, geographic areas, and channels. In each case the substitute may perform different functions or be used in different ways and hence its RVP or switching costs may differ. Full-size office typewriters are more vulnerable to substitution from word processors than are portable electric typewriters, for example, because the special features and correcting capabilities of word processors are more valuable in office uses than for intermittent personal typing.

The penetration of a substitute often follows such segment differ-ences. A substitute penetrates by expanding the number of segments it serves, penetrating new segments in order of the size of RVP of the substitute and the cost of switching in them. Thus the interaction of segmentation and substitution is often vital to understanding the path of substitution, a subject that I will treat below.

Figure 8-1. Use of Personal Computers in Small Business, 1981

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

Leave a Reply

Your email address will not be published. Required fields are marked *