The path of substitution of firm’s product-service

The path of substitution  in an industry  is a function of how RVP, the perception of  RVP,  switching costs, and   the propensity  of buyers to switch evolve over time. The rate of penetration of substitutes differs widely from industry to industry. Some substitutes  gain quick accep­ tance, while others penetrate  slowly or not at all and are discontinued. In many industries, however, the path of substitution for successful substitutes looks like an S-curve, when  substitution  as a percent  of total demand is plotted against time (see  Figure 8-2).

The S-shaped substitution curve is closely related to the familiar product  life cycle curve, because products  early   in   their   life cycles are frequently substituting for some other products. An S-shaped sub­ stitution path is not characteristic of  every successful substitution. However, it is im portant  to understand  why an S-curve might occur so that  the economic  factors that  underlie it are recognized.7 Where the underlying economics of a particular  substitution  suggest an S- curve path,  a number of techniques  are available to help forecast the rate of substitution.

In an S-curve path  such as that shown in Figure  8-2, substitution is initially modest and often continues at low levels for a considerable period of time in what can be called the “ informing and testing phase.” Unless a product flaw emerges with the substitute or the threatened industry responds to nullify the substitute’s advantages, the penetration of the substitute then often climbs rapidly  in a “takeoff phase” toward an upper bound that represents maximum penetration. This upper bound is determined  by the number of buyers  for whom  the substitute is potentially valuable. The  upper  bound  of  substitution  can itself change over time as changes in technology or buyer needs bring buyers in or out of the pool.

Figure 8 -2 .    A   Typical S-Shaped Substitution Path

The reasons that  an S-shaped substitution  curve occurs  reflect a set of assumptions about the interplay of actual and perceived RVP, switching costs, and the buyer’s propensity  to switch over time. Ini­ tially, the performance of a substitute  is likely to be uncertain,  and there may be few capable firms to supply   it.   Many  buyers   are not even aware of the substitute  or what its characteristics  are. The  price of the substitute is likely to be high because of its low volume or because suppliers are skim-pricing.   Though  the   value of the   substitute is often uncertain, however, the cost of switching is usually very clear and made particularly high by the unfamiliarity of both buyers and suppliers with how the substitute  should  be used. Moreover,  the cost of switching must be borne up front, before the benefits of the substitute are realized.

During the informing and testing period, some adventurous buyers or buyers who attach a particularly  high value to the substitute’s quali­ ties will switch to the substitute to experiment with it or will switch permanently because the RVP of the substitute to them appears partic­ ularly high.   During  this period, either  the substitute  begins to prove its value or product flaws become apparent. The product flaws prove uncorrectable (and penetration never increases), or the substitute is improved (sometimes the substitute is completely withdrawn from the market and then reintroduced).  A t the same time, marketing  activity and word of m outh  tend to widen the group  of buyers that  are aware of the substitute and thus the perception of value improves.8

Assuming that the substitute eventually achieves acceptable per­ formance with early buyers,   the   rate   of penetration  of the substitute can start to increase rapidly along the S-pattern  for a number of rea­ sons. First,   the uncertainty  of perceived   value and   the risk of failure of the substitute both fall as early buyers have successful experiences. Second, once a few buyers successfully switch,   competitive pressures force other buyers to switch to maintain their cost position or differenti­ ation (or self-image for consumers). Third, the cost of switching may decline for reasons   discussed   earlier.   Fourth,   rising   adoption   leads to increasing awareness of the substitute and raises its credibility. Fifth, rising penetration of the substitute often reduces its cost through econo­ mies of scale   and   learning.9 Sixth,   introduction  of new   varieties of the substitute opens up new industry  segments. Finally, increasing penetration of the substitute prompts its suppliers to become more aggressive in pricing, marketing,  and  R& D, often as a result of entry by new competitors  into the substitute  industry.  All of these factors tend to be self-reinforcing, and can lead to the extremely rapid penetra­ tion of the substitute.

Eventually, the   penetration  of a substitute  begins to   approach 100 percent  of  the buyers to which   the substitute  is attractive.   As this happens, penetration tends to level off as the penetration of new buyers becomes more and more  difficult. However,  improvements in RVP or new varieties of a substitute may  widen the pool of potential buyers beyond those initially foreseen, fueling new opportunities  for growth of the substitute. The  upper  bound  in Figure  8-2 can thus expand to contain a larger and larger number of buyers.

At the same time, the buyers’ usage of the substitute  may change in ways that increase or decrease demand.  In TV sets, for example, sales of black and white sets were very robust  even after color sets began to penetrate because buyers bought second, third, and even fourth TV sets. Similarly, in the substitution of electric shavers for conventional razors, the recent introduction of small, portable electric razors may well be shifting the upper bound of penetration of electric shavers by making them more versatile and less expensive. Thus  the upper bound  in Figure 8-2 can include  a growing  volume  of units. The length of the informing and  testing phase   is a function of a number of factors. Clearly im portant is the size of the RVP  improve­ ment offered by the substitute— the bigger the inducement,  the shorter the period will be. The length of  time necessary to prove the perfor­ mance of a substitute also differs by product,  and can greatly influence the length of the testing period.   The  performance  of   an   automatic drip coffee maker can be proven in weeks or months,  for example, while a new piece of capital equipment  may require years of production line testing to assess its true performance.  The  period required for the industry producing  the substitute  to make  necessary improvements in performance or cost, and to build adequate capacity to serve major buyers, also influences the length of the testing phase. Finally, the intensity of competition  of the buyer’s   industry  and   the   significance of the specific RVP of the substitute to that competition influence the length of the testing phase, by determining the pressures for imita­ tion if one buyer switches to a substitute.

The steepness of the takeoff phase  is a function  of how compelling in an industry  are the reasons for rising   penetration  described above. In selling a substitute to an intensely competitive buyer industry, for example, takeoff can be very rapid. The steepness of takeoff is also a function of the time required to change over to a substitute  and the adequacy of capacity. The  purchasing  cycle in the buyer  industry  is also important, because buyers are more likely to switch to a substitute when they would normally  reorder  or replace the   product  anyway. This reduces the switching costs associated with scrapping  a product which has years of useful life remaining or where the buyer has substan­ tial inventory on hand.  For  similar   reasons,   switching   to   a   substitute in durable goods tends to occur  faster when the buyer  industry  is growing and therefore investing in new facilities and equipment.

The response of the threatened  industry  is also clearly important to the path of substitution. An aggressive response by the threatened industry can sometimes stop the penetration  of a substitute  altogether or delay it considerably. Conversely, entry into the substitute  industry by credible competitors  can accelerate  penetration,  as IBM ’s entry into personal computers  and K odak’s entry into instant cameras seem to have done.   Smooth  substitution  curves such as the one portrayed in Figure 8-2 are most  characteristic  of industries  where there are many buyers of a substitute.   W here there  are few buyers,   a decision by a major buyer can dramatically shift the curve overnight. In such cases, substitution analysis is best conducted on a buyer-by-buyer basis.

1. Segmentation and  the Substitution Path

The substitution  path  in an industry  is often very closely related to industry segmentation. Early penetration occurs  in industry  seg­ ments where a substitute offers the highest RVP, requires the lowest switching costs, an d /o r encounters the most adventurous  or highest value buyers. Early segments support  the cost reduction  or perfor­ mance improvement necessary to penetrate  later segments. The  high value of the substitute  to early segments either offsets the high initial cost of the substitute, or allows its producers  to earn extremely high profits.   Margins  often   will fall over  time in   the substitute  industry as additional segments are penetrated where  the substitute  has lower value.

The substitution of minicomputers  provides a good example of how the substitution path relates to industry segmentation. The early segments penetrated by minicomputers were scientific and computer center applications where computational power was needed but where users could do their own programming, adapt machines to their needs, and perform some maintenance in-house. Later penetration was in applications such as industrial controls, where the buyer was still so­ phisticated and support requirements were moderate. Only after some time did minicomputers  develop the   service and   support  capabilities to penetrate small business applications.

The same factors that lead to early penetration  in some segments also mean that the rate of penetration within segments will vary. Since segments vary in RVP and switching  costs, penetration  will proceed much faster in some segments than others. Hence the industry substitu­ tion curve is actually a collection of segment substitution curves.

2. Substitution   Forecasting  Models

The observation that successful substitution often follows an S-shaped penetration curve can be used in forecasting. A variety of models that are based on the assumption of S-shaped penetration have grown out  of research  on diffusion processes. D ata from   the early years of a substitution  can be used to forecast the entire substitution curve using such models, under the assumption  that an S-shaped pro­ cess will occur.   The  forecasted   substitution  curve   may   then  become a base case from   which  an   analysis   of  the   underlying  economics of a substitution can begin. Adjusting  the standard  S-shaped curve to reflect the economics of a   particular  substitution  allows   a prediction of the extent of substitution  in future  years. The  premise underlying such a procedure is that the tendency toward an S-shaped penetration curve is strong enough so that  the plotting  of such a curve— derived from the early penetration data— is a useful beginning point for analy­ sis.

The most commonly used diffusion model is the so-called “ logistic function,”  a form   of exponential   function.10 The  functional   form   of the relationship as applied to substitution is as follows:

where F = fraction of the total potential  market  that  has switched to a substitute

K = a constant set equal to the  early growth rate of a substitute

The logistic function makes two im portant assumptions: (1) if substitution has   progressed   as far   as   a   few   percent,   it   will   proceed to completion; and   (2)   the   fractional   rate   of  fractional  substitution of a substitute for the product is proportional to the remaining amount of the product  left to be substituted  for. It is the latter  assumption that produces the S-curve shape. If F / ( l — F) is plotted as a function of time on semilogarithmic paper, the logistic function results in a substitution curve   that  is a straight  line   with   the slope   K   as shown in Figure 8 -3 .1

If the logic underlying  an S-shaped substitution  curve is believed to hold in a particular substitution process, as well as the assumption about a constant fractional rate of fractional substitution, the logistic function can be used to forecast the path  of substitution  that will occur. To do this, data  on substitution  history are used to determine F / ( l – F) for each year. Then F / ( l – F) is plotted on semilogarithmic paper against time, and a straight line is fitted through the early history. Extending this line projects the future substitution path under the assumption that it  will follow the logistic curve.

Figure 8 -3 .    A Typical Logistic Curve

The procedure  is shown in Figure  8-4, which   plots the early substitution history of aluminum  for steel in beer cans.   The  early history fits the logistic curve quite closely. Based on this history, we could expect the extent  of substitution  by   1982 to be approximately 91 percent if the assumptions  of the logistic curve hold. The  accuracy of this forecast, however, depends on how well the logistic curve reflects the economics of substitution in the particular industry. One important issue is the size of the   potential market,  and  hence the upper  bound. In the beverage can case the upper bound  is fairly clear. Where  the upper bound is increasing, the logistic curve will have a tendency to overestimate the   rate   of  penetration.  Another  im portant  issue   later in the substitution  process is whether the intensity of use of the substi­ tute required to perform its function will change over time.

Figure 8 – 4 .     Early Substitution of Steel for Aluminum in Beer Cans

Perhaps the most important issue in whether  substitution  will follow the   logistic curve growing out  of the early   substitution  history is the extent to which the RVP  that  is driving the substitution  will change over time. The logistic curve assumes a stable motivation for substitution. If RVP falls, the penetration of a substitute may actually decrease,   something  that  never happens  with   the   logistic curve.   If the RVP of a substitute improves, on the other  hand,  the rate of penetration will increase   from   early   history— the   substitution  path may jum p to a new curve. Figure 8-5 illustrates how this has actually happened in beer cans.

After   1976, the   introduction  of  two-piece steel can   technology helped slow the penetration of aluminum cans. W orking with steel companies, Crown Cork and Seal introduced a cheaper way of making steel cans that reduced the RVP of aluminum cans. In 1978, however, Miller Beer (number two in the beer industry)  announced  a major test of aluminum cans against steel. The  rate of substitution  slowed further pending the outcome.   M iller’s decision   in   1979 was to   switch to aluminum.  Once  M iller’s switch occurred,  substitution  accelerated to a faster pace than  before 1976, in part  because Miller legitimized the substitute. An additional factor in the faster penetration  of alumi­ num after 1979 was the growing recycling of aluminum  cans, which are more recyclable than  steel cans. As   infrastructure  allowed   for more widespread recycling, the RVP  of aluminum  became even better than before because recycling reduced the cost of  metal. By 1982, penetration of aluminum  was actually about  98   percent  instead   of the 91 percent that would have been forecasted using the early history.

As the   beverage can   example  illustrates,   the   logistic curve is not a substitute for  substitution analysis.   It is a simple tool that  can serve as a starting   point  for   more  careful   analysis   of the   economics   of substitution.13 The substitution path  will vary from industry to indus­ try, and will be affected by technological  changes  and competitive moves. In order  for the logistic curve  to be meaningfully used, the factors that determine RVP, switching costs, and propensity to substi­ tute in a particular industry  must be understood and expected changes in them forecasted.   Since the   economics  of a   substitute  often differ by industry segment, logistic curves should usually be plotted at the segment level and not the industry level. Beer producers, for example, have different needs in   cans   than  other  can   users.   A   logistic curve for aluminum’s  substitution  against steel   in   cans   overall   would not be as meaningful as one for beer cans alone.

Figure 8 -5 .    Substitution o f Steel for Aluminum in Beer Cans

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

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