Threat of substitutes definition
/What is the Threat of Substitutes?
The threat of substitutes is the availability of other products that a customer could purchase from outside an industry. The competitive structure of an industry is threatened when there are substitute products available that offer a reasonably close benefits match at a competitive price. In this case, price points are limited by the prices at which substitutes are available, thereby limiting the amount of profitability that can be generated within an industry.
When there is a strong threat of substitutes, industry players must pay more attention to operating in the most efficient manner possible; otherwise, their high cost structures will interfere with profitability and may drive some firms out of business.
When there is a reduced threat of substitutes, industry players tend to be more lax with their cost controls, resulting in higher prices charged to customers. Because there is little prospect of competition from outside the industry, there is a higher potential for profits within the industry. Thus, firms tend to generate higher profits at the expense of their customers.
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What Causes a Higher Threat of Substitutes?
The following factors cause a higher threat of substitutes for an industry:
Customers can easily switch between products.
Substitute products are readily available to customers.
Substitute products have better features than comparable products within the industry.
Substitute products have higher quality/reliability than comparable products within the industry.
Substitute products have lower costs than comparable products within the industry.
How to Reduce the Threat of Substitutes
There are a number of ways in which a company can mitigate the threat of substitutes. For example, it can inspire brand loyalty through its marketing efforts, product quality, and support services. Or, it can focus intently on specific market niches, so that the value it offers to customers within those niches exceeds the value that customers can obtain from substitutes. Another possibility is to identify those customers who are most likely to shift to substitutes, and target them for enhanced service and marketing efforts, so that they are aware of the particular value that the organization brings to them. Yet another possibility is to lock in customers with systems that are specific to the company - such as by not using industry-standard specifications that would allow customers to easily swap in competing products.
Investment Interpretation of the Threat of Substitutes
From the perspective of an investment analysis, an industry is a better prospect for investment when the threat of substitutes is low, since firms within the industry have a higher potential to earn an above-average profit. An investor would want to watch for increases in the threat over time, since changes in this direction could lead to a decline of profitability within an industry, and therefore a decline in the value of the shares of businesses in that industry.