The economics of substitution

One product substitutes for another if it offers buyers an induce­ ment 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 pat­ tern of substitution is influenced by what  I term   the buyer’s propensity to switch. Faced with equivalent economic  inducements  for substitu­ tion, 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 switch­ing 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 under­ standing 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 im portant 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 attrac­ tiveness 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 hori­ zon 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 substi­ tutes 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 substi­ tute 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 necessi­ tate 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. Inter­ est rates an d /o r 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 o f Price or Availability.       The cost of a substi­ tute 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 nonavail­ ability 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 im portant  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 substitu­ tions to add capacity ahead of demand.

Direct Costs o f 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 o f 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 m ajor 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 de­ scribed 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 attrac­ tiveness. 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 o f Use.      The  relative cost of  use of a substitute m ust 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 regis­ ter, 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  perfor­ mance 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 substi­ tute 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 o f 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.  W ider 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 o f 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 comple­ mentary   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   m otor  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  m ajor  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 as­ sumed value of a substitute by some discount factor.

Perception   o f Value.      It is the buyer’s perceptionof  the RVP of a substitute  that  will determine the threat  of a substitute,   not necessarily the    reality   of RVP.  Buyer  awareness  ofa     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 per­ ceived 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 num­ ber 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 exam­ ple 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 technol­ ogy 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, demon­ strations, and placement of units with opinion leaders. The stock of knowledge about a substitute as well as the expenditures by the substi­ tute   industry   on   signaling   will determine  how   accurately  the   value of a substitute is perceived. W ord of m outh 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 substi­ tute for the buyer, which are weighed against RVP. The  higher the switching cost relatively, the more difficult substitution  will be. Switch­ ing costs in substitution are analogous to those of changing from one supplier to another  in an industry.4 Switching costs are usually higher in substitution than  in switching suppliers,   however, because substitu­ tion 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 stan­ dards. 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 o f Redesign or Reformulation. A buyer’s product or value activities must  often be redesigned to accept  a substitute. Reformulat­ ing 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 differ­ ent 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. Simi­ larly, 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 o f 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. Autom ating a m anufacturing  process can relegate equip­ ment 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  o f 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 m atter  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 technologi­ cal change may be less concerned  with   some kinds  of substitution risks, while extremely aware of others that a less technologically sophis­ ticated 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 o f 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 substi­ tute 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, switch­

ing 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 dramati­ cally   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 seg­ ment 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 indi­ cates, the degree of penetration of personal computers in small busi­ nesses 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 pur­ chases.

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 pro­ cessors 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.

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