Saturday, August 06, 2011

Porter’s Five Forces Series Part 3 – Threat from Substitutes and Customer Power

In this third part of the Porter’s Five-Forces series, I shall be combining two of the five forces into one post as the threat from substitutes is very short and sweet, while customer power has more to elaborate on. This continues the series on Porter’s Five-Forces which was left behind some time back as I concentrated on doing corporate analyses. Now with those behind me and the two recent AGMs of MTQ and Boustead concluded, it’s time to dive back into some academic discussions.

Threat from Substitutes

Substitutes are products or services which perform essentially the same function, and this can arise to become a serious problem for companies should their product be substituted for either a cheaper alternative, or a more efficient one. The example given in the book was that of the beverage packaging industry, whereby consumers do not differentiate between plastic, aluminium or glass. Imagine your Yeo’s Soya Bean Milk – it can come in an aluminium can or tetra-pak but the contents are still the same. Hence, those packaging companies have to be wary of materials which can eventually replace their own material to such an extent that it will become obsolete. History has shown that some products seemed invulnerable to substitutes, until one actually appeared and took away market share (and profits) by storm. One example is Eastman Kodak who were too slow to switch to digital photography; and ended up being left behind in the dust.

Even some companies which seem to be doing very well in their own industry may be vulnerable to a newfound discovery which would stun experts and revolutionize the way we live. An example would be petroleum (oil) – it seems almost impossible to envisage a world not using oil, and many industries and companies have sprung up to capitalize on the continued demand for black gold. Currently, other technologies such as nuclear power and solar energy are still not viable due to high costs and inefficiency (energy emitted), and so they lag behind as potential substitutes. But should the day come when these technologies improve by leaps and bounds, oil companies will start to sweat, and with good reason. I also recently read another article from BBC about Graphene, which is an amazing material as it can conduct electricity, is just a layer of atoms thick and has a host of other interesting properties. The article also mentioned that it could eventually replace silicon in semi-conductor wafer chips. Though this new material’s research is still in its infancy (compared to more established materials), it still goes to show how threats from substitutes may render an entire industry obsolete once it can be mass-produced commercially in a cheap way, and offers either the same or even better functionality.

Admittedly, the threat of substitutes is made even worse when switching cost for the buyers is low, and the ratio of price to performance is better; meaning that even though the substitute may not work as well as the original, it is so much cheaper that people still embrace it.

Buyer (Customer) Power

Buyer power enables customers to negotiate for better terms, prices and materials and can force down prices in an industry. Buyers are in a strong bargaining position if one or more of the following apply:-

1) There is a concentration of buyers – In an industry where there are only a few major buyers, this puts most of the purchasing power in the hands of the customers, rather than the supplier. The supplier is in a weak position if there are not many customers for it to supply to, and they can become beholden to the buyer if the buyer exerts pressure on them.

2) Product is standardized or commoditized – If the product features are much the same across all suppliers, then the buyer has the choice to freely switch between suppliers who give them the best rates. Thus, the supplier is in danger of losing business from the buyer if it fails to price competitively.

3) If the product accounts for a large percentage of the buyer’s costs – Buyers are more likely to push for bulk discounts for items which make up a large proportion of their cost of goods sold.

4) If the buyer has low switching costs – If it is costly for the buyer to switch suppliers then the supplier’s power is enhanced.

5) Buyers suffer from low profitability – If the buyer suffers from poor margins and low profits, they may continually pressurize the suppliers to co-operate with them to lower prices together, in effect cutting their gross margins down.

6) If buyers can integrate backwards – If buyers can threaten to integrate backwards and make the product then they can use this to threaten the supplier. These involve “make or buy” decisions and if the buyer can make the product without much hassle or almost at the same cost as purchasing from an outside vendor, then they are deemed to have power over the supplier in negotiating prices or terms and conditions.

7) If the consequences and risks of product failure are low – If the product or service is crucial to the buyer in terms of their system of operations then the buyer is less likely to haggle on price. A very good example of this is the Blowout Preventer (BOP) for MTQ. The costs of failure of the BOP are very high (in terms of $ and human lives as a result of the Deepwater Horizon disaster), thus the customers of MTQ are not likely to haggle if MTQ raises the price of repairs and maintenance of their BOP.

8) Buyer has plenty of information – It goes without saying that if the buyer has a lot of intimate knowledge of the supplier’s cost of operations and margins, then they are in a better position to bargain since they will be aware of how low prices can be set before the supplier makes a real loss.

This concludes Part 3 of my Porter’s Five-Forces analysis. The next part of this analysis will focus on Supplier Power.


Black Cat said...

Regarding substitutes, I always ask if a company's product is affected by the internet (and mobile). eg: music, books, TV, newspaper, credit card. I also avoid tech (eg: microsoft, apple) as the product cycles are too fast (who now remembers yahoo, myspace, sun?...perhaps soon to be joined by nokia, blackberry...all leaders in their day).

Musicwhiz said...

Hi Black Cat,

Yes indeed, I guess all products to some extent will be affected by technological change and innovative advances; but those which can hold their own will continue to evolve and perhaps find new uses; or else the companies will "diversify" to the new promising product instead.

On the other hand, service companies may have a better deal as it is harder to substitute a service and also harder to find competitors (requires training).