Competitive Strategy: Substitution, Switching and Switching Costs

Businesses come and go. Products come and go. What is the future of your business? Your industry? The answer often lies in issues related to substitution, switching and switching costs. As a business owner, your future may hinge on your understanding of these concepts.

Substitution: An Alternative Method or Solution

Substitution is the process by which one product or service supplants another in performing a particular function or functions for the buyer. For example, a customer chooses to buy a color printer and print their own fliers rather than have a commercial printer print them. Or, a teacher chooses to buy school supplies from an Internet-based supplier rather than by driving to their local school supply retail store. Or a new building chooses an electronic sign rather than a traditional wood moniker.

Will it be your product that is being replaced by an alternative offering provided by someone else? Or will the product sold by another be dropped in favor of your product or service?

If you are a manufacturer of two-way radios (commonly referred to as walkie talkies), the advancements of low cost, feature rich cellular phones has introduced a powerful threat of substitution. Users of walkie talkies, such as construction companies, can have their need for quick, two-way communication “in the field” met with some types of new cell phones, such as Nextel’s phone that has a two-way radio function. The traditional radios might get the job done, but the new cell phones offer the same function plus many more features. Absent a dramatic strategy for countering this threat with an offer that equals or betters the price-to-value offer of the cell phone, the walkie talkie business may quickly become extinct.

Identifying Substitutes: Threats and Opportunities

As a business owner, you need to be on the look out for substitutes that could arise and threaten your market and your ability to control your pricing. Doing so requires that you search for products or services that perform the same generic function or functions as your own. For an obvious example, the development of cheap commercial air flight took customers away from passenger trains. Fiberglass snow skis provided a substitute for steel skis, and snowboards have provided a substitute for snow skis altogether. More broadly, winter vacation alternatives, such as snow skiing, compete with summer vacations options for our limited vacations time each year.

When looking for substitute threats, look at alternative products as in the above examples. But substitutes can also come in these forms:

- Buyer does not purchase anything at all. For example, he decides not to eat eggs anymore due to cholesterol. Or, a business discontinues offering a certain product, thereby eliminating the need for you to supply component parts.

- Lower usage rate. For example, aluminum can manufacturers are making the walls of the cans thinner, reducing the aluminum usage. Or, new, highly reliable heat and air units are reducing the demand for your repair and maintenance services.

- Used, recycles or reconditioned products. For example, manufacturers need tooling. They can buy new tooling; recondition their own tools or buy already reconditioned ones.

- Backward integration. For example, a customer that has historically bought through your distribution company could decide to begin buying direct from the manufacturer.

Business owners are much more prone to not take the threat of substitutes seriously enough, and be blindsided by a substitute to their product or service, than to take these threats too seriously.

Switching Costs: Barriers to Switching

Substitution, or a buyer’s changing from one product or service to another, always involves some costs. The higher cost of switching, the more difficult it is for them to switch. Switching costs create barriers to switching and which can either protect your product or service from threats of substitution or prevent potential buyers from switching to your product.

Switching costs include the direct costs of the alternative product or service as compared to the established product or method, as well as the indirect costs associated with switching to the new alternative. Indirect costs include how the alternative product or service affects other parts of the buyer’s business. For example, switching to in-house printing of some multi-color fliers will require the purchase of a color printer, but might also require the purchase of other software and hardware, additional labor, or the trainings of existing labor.

Relative Price/Value: How Buyers Decide Whether to Switch

Buyers, formally or informally, decide whether or not to switch by comparing the real and/or perceived value that they expect to get from each option, compared to the costs associated with each. So, each alternative – existing method verses the new substitute method – has a price/value ratio.

When the buyer has not used a certain product or service before, it is the perceived value of using the product that is most important. If you are trying to get a buyer to switch to your product or service, your task will be to get the buyer to believe that the value offered by your products is greater than the value offered by their current method or source. More specifically, your challenge will be to help them understand that the price/value ratio for your offering is superior to the price/value ratio of their existing means for fulfilling their particular needs.

Promoting Substitution

Expansion strategy for your business should include the finding of new markets for your product or service. When an alternative use/market is identified, consider the following as you formulate a plan for penetrating the market and getting customers to switch to your product or method:

Target Early Switchers: Some buyers are more apt to try new things. These types of buyers may be identified in various ways, such companies that are under pressure or threatened in some way that might make them desperate to find new ways to reduce costs or offer more value to their customers. Or, they may be firms that simply have a history of adopting new ways and embracing change more rapidly.

Subsidize An Early Adopter: The power of testimonials is substantial. The risk that a buyer perceives in adopting your new method will be a barrier to their switching. By reducing their risk, somehow, such as by improving the potential price/value ratio, you could aid their choice to adopt. Then, testimonials for this customer can be used to lower the perceived risk felt by other buyer prospects.

Target Uses or Customers that Stand to Gain the Most: As perceived or potential value rises relative to the perceived costs, the propensity to switch will increase. That is, customers will switch more readily. So, it makes sense to identify the buyer prospect types that stand to gain the most by your new product or service, to achieve more rapid penetration.

Defending Against Substitutes

The first step in defending against substitutes is to identify them. This task can be difficult, but start by talking to customers that you lost. Also, talk to your peers via your industry association. Find out what they are learning, to whom they are losing customers, what is causing pricing pressure, industry developments, etc. Strategies to combat substitutes are the reverse of the steps described above to promote substitutes, and include:

- Improve the price-to-value proposition of your offering

- Raise switching Costs

- Block attempts to lower switching costs and perceived risk of switching

- Find new uses for the product or service that are not threatened by substitutes

- Redefine the competition away from the strengths of the substitute

- Enlist suppliers in the defense against the substitute

- Redirect strategy to those markets that are least vulnerable to the substitute

- Enter the substitute industry

- Exit the niche if it is at the end of its life cycle

In summary, all of life is an evolution. Business is no different. Products, services, needs and markets change and evolve. As new technologies, products, processes and uses are developed and disseminated, competitive positions wax and wane. Every business owner must embrace change and harness change to his or her advantage. One does so by monitoring trends, searching for new ways to serve clients, and being open to new uses for the products and competencies that one possesses. One also watches for competitive threats and then fashions a response that makes strategic and economic sense.

To learn how your company can benefit and best position itself within the M&A landscape, call or email me now to receive 3 hours of free consultative analysis. Our analysis offers clarity, based on your objectives, if a full or partial exit, recapitalization, divestiture, acquisition or pre-sale exit strategy provides the greatest benefit to you and your company.

Vercor has been delivering M&A expertise for over 25 years. We serve as a trusted partner to help build long term, iterative strategies that ensure you are positioned to meet your unique personal and financial goals whether it is selling, recapitalizing, acquiring or divesting of a division. Now is the time to evaluate, strengthen, prepare and increase the market value of your company regardless of your timeframe.

Todd Cummiskey

Vercor

704-926-6564

ToddC@Vercor.com