Threat of substitutes: what it is, with examples

The threat of substitutes is the risk that customers meet the same need with a different kind of product or service, rather than with a rival version of yours. Michael Porter defines a substitute as something that "performs the same or a similar function as an industry's product by a different means." Videoconferencing substitutes for business travel. Email substituted for express mail.

It is one of Porter's five forces, and the one most often left blank, because substitutes rarely look like competitors.

Substitutes vs competitors

A competitor sells what you sell. A substitute sells something else that does the same job.

Porter adds three substitutes that apply to almost every business: doing without, buying second hand, and doing it yourself. Some people file substitutes under indirect competitors. The label matters less than remembering they exist.

Why the threat of substitutes matters

Substitutes put a ceiling on your price. In Porter's words from his 2008 Harvard Business Review article, they limit "an industry's profit potential by placing a ceiling on prices." An accountant can charge much more than tax software costs, but not unlimited amounts more, because past some point the client does it themselves.

They also cap the good years. When demand surges, a strong substitute absorbs part of it, so the boom is smaller than it would otherwise be.

When the threat of substitutes is high

Porter gives two conditions. A third is worth adding.

The substitute offers a better price-performance trade-off. Not a better product, just better value for what the buyer cares about. Porter's example is cheap internet calling services such as Skype eating into long-distance phone revenue.

Switching to it is cheap. Moving from a branded drug to a generic costs the patient almost nothing, which is why, Porter notes, that shift is "so substantial and rapid."

Buyers are willing to try it. Habit, confidence and the stakes all matter. Most people will try a free yoga video. Far fewer will try DIY electrics.

Watch for substitutes that improve. Porter's advice is to be "particularly alert to changes in other industries that may make them attractive substitutes when they were not before." What cannot do your job today may do it well enough in three years.

How to assess substitutes in your own market

Evidence beats a brainstorm. Five sources, all free.

Ask what customers would have done instead. Add one question to onboarding or a post-purchase email: "If we did not exist, what would you have done?" The answers name your substitutes, usually including some you had not considered.

Compare search demand over time. In Google Trends, set your category term against the substitute's term over five years, for example "personal trainer" against "workout app". If the substitute's line rises while yours is flat, the threat is growing. The Google Trends comparison guide covers reading the chart without fooling yourself.

Read the "do I need" searches. Type "do I need a [your service]" and "[your service] vs" into Google and note the autocomplete suggestions and People also ask questions. Each one is a substitute customers are actively weighing.

Search Reddit for the decision. Threads titled "is it worth hiring" or "did it myself instead" show the price-performance trade-off in the buyer's own words, including the point at which they would pay.

Check who advertises on the problem. In the Meta Ad Library, search the problem ("back pain", "bookkeeping") rather than your category name. Substitutes advertise against the problem too, and their ads show how they pitch against you.

Then score it plainly: how much cheaper is the substitute for the core job, how much worse is it, and how easy is it to switch to?

An example

Say you run a yoga studio charging $20 a class. Your competitors are the two other studios in town. Your substitutes are free video classes, a gym membership that includes yoga, and simply not exercising.

Video classes offer a superb price-performance trade-off for confident regulars and cost nothing to switch to, so for that group the threat is high. For beginners who need correction and want a teacher who knows their name, it is low.

The sensible response is not to cut your price towards zero. It is to aim your marketing at the group the substitute serves badly, and sell what a video cannot do: hands-on correction, a timetable that holds you accountable, and a room full of people doing the same thing.

Common mistakes

Listing only direct rivals. Most competitor analyses never mention doing nothing, which is often the biggest substitute of all.

Fighting on price. You cannot undercut free. Compete where the substitute is weak.

Treating the list as permanent. Substitutes improve, and one that starts using your vocabulary in its ads is becoming a direct competitor.

The other four forces each have a page: the threat of new entrants, the bargaining power of buyers, the bargaining power of suppliers and competitive rivalry.