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Measuring Product Substitutability

 
 

Many product-focused companies think the key to success is launching new, innovative products.  While it is certainly important to bring great products to market, oftentimes these products do not add incremental revenue to the business.  Instead, customers purchase new product B in lieu of legacy product A, as they serve very similar purposes.  Such a situation is an example of product substitutability.  Two products that can be used interchangeably are said to be “substitutes.”

As companies cut substitutable products from their portfolios, it is important not just to rationalize low volume, low margin products but also to look for higher volume and margin SKUs.  It is rationalizing the latter set of products that unlocks the sizable inventory and EBITDA benefits for which companies look when optimizing their portfolios. 

When rationalizing high volume and margin products, it is critical to prove that they are indeed substitutable for other attractive products.  When working with clients, WP&C does so in two steps. First, we look for strong correlation in the sales of both products to customers with similar needs.  For example, if a pump manufacturer’s oil and gas customers, all of which need pumps to perform a specific task, purchase similar amounts of Product A and Product B, it can be hypothesized that they see these products as substitutes and use them interchangeably.

To validate the hypothesis generated in step one, we conduct extensive interviews with customers who purchase both products.  In some cases, customers do use the two products differently and do not see them as substitutes even though they are technically similar.  When market perception does not match the products’ technical reality, a company has two choices.  Either it can choose not to fight market perception and keep both products, or it can rationalize one product and educate the market on how the other has similar functionality.  Doing the latter drives greater potential benefits but puts more revenue at risk. If the company does a poor job showing its customers the value proposition of the product that remains, customers may decide to take their business elsewhere.

Factoring in products’ substitutability for others is essential when rationalizing one’s portfolio.  Conducting the quantitative and qualitative analysis required to measure substitutability is particularly key. It allows companies to feel confident in their decision to cut the products that unlock the greatest amounts of benefit.

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