An interesting conjunction of two business stories highlighted an issue that businesses often overlook. It is so easy to become focussed on price, and the competition, without looking at other aspects of the business model that also affect sustainability, and profitability.
The most common reaction to competition is to cut prices, i.e. discount. Now there is a place for discounting as a marketing tactic, but not as a strategy. The problem with discounting is that it cuts your gross profit margin; a short term gain in sales, but……
My mantra is that it is not the volume of sales that’s important in determining the profitability of your business, but the volume of Gross Profits.
The second reaction, and usually from more savvy businesses, is to look at how they can increase value. After all, people buy on the value they receive from their purchase. And yes, discounting does increase value, but a better strategy is to look at how you can add value, without cutting your margin.
There is a third way to maintain or even increase your margin, and do so while cutting prices.
Now the two stories; yes, my examples are all major businesses, but that doesn’t mean the principle espoused cannot be applied to your business. It can.
The industries are retail, in the form of Aldi and Amazon, and mining, specifically Fortescue Minerals, to which I’ll add some direct experience I had in a similar exercise.
I’m talking about costs. Costs are only relevant in the pricing process because they establish a lower boundary for the price. In certain circumstances, there are strategic reasons a company may decide to sell a product below its cost for a period of time, or to a certain market segment as a “loss leader.”
But that is not what I’m going to discuss. As you shall see in a moment, I’m not talking about incremental reductions, but significant reductions - I’m talking about real cost reduction.
The source of this story is the online newsletter Smart Company, and an article by Kevin More, “Why Aldi and Amazon are not Discounters”.
When it comes to price, we often hear some retailers referred to as “discounters.” Retailers like Aldi, Lidl and Amazon. But here’s the thing. They’re not discounters and don’t think of themselves as discounters.
Firstly, Aldi and Amazon have a fiercely won and maintained a low “cost of doing business”. There are as few costs as possible between the receiving dock at the warehouse and the trolley in the store, and this includes their head office.
Aldi has no phone numbers to call the stores. This allows the managers to be on the floor filling shelves or at the receiving bay receiving products or on the checkout. And that’s just the manager.
The Aldi trolleys all have gold coin locks so shoppers invest their time in finding and returning trolleys. In fact, no store staff or suppliers to Aldi probably ever touch a trolley, other than to repair it. Only the shopper. Why is that important? Well collecting a fleet of 300 trolleys probably costs around $32,000 a year per store and for 700 stores with trolleys, this equates to a lazy $22 million a year.
So how can you offer lower prices all day every day ever since you were founded? And how can higher priced retailers compete?
Amazon chief Jeff Bezos is famous for his phrase, “your high margins are my opportunity”. He didn’t set out to sell groceries and electronics but the margins he saw were so attractive he had to compete. And it’s not just retailers that have high embedded cost, but major branded manufacturers too.
What he actually meant by the phase “your high margins are my opportunity” was that the combined high costs of many suppliers and retailers allow Amazon to offer either its own products vastly cheaper or branded products a lot cheaper.
Discounts in brand marketing means lowering the price of a branded item from the level the manufacturer would normally like to sell at and the shopper would normally expect to pay. Aldi and Lidl have exactly the same philosophy.
They aren’t discounting; they just operate on a lower cost of doing business and are supplied by companies with a lower cost base. When you combine these two low cost bases, retailers like Aldi and Amazon need lower cash margins and so offer lower cash prices to shoppers.
Does this mean it is all over for full-service retailers and branded goods manufactures? Well no. It just requires a long-term plan to lower operating costs via massive capital expenditure.
Retailers have to apply money from today’s profits to protect future profits. They need to put money into new lower cost ways of doing business to allow them to sell at lower prices and still make a return for shareholders.
Now for Mining
The source for this story is an article in The Australian Business Review by Stephen Bartholomeuz, “Fortescue’s Great Achievement”.
Five years ago, when the iron ore price “crashed’’ to $US90 a tonne, Fortescue Metals was in crisis.
Today, after a year where the price averaged just under $US70 a tonne, Twiggy Forrest’s group reported a $US2.1 billion profit.
As is now well understood, the core of the explanation for the transformation of Fortescue from an overtly-leveraged and vulnerable minnow into a genuine third force in the Pilbara with a stable balance sheet has been its performance on costs, coupled with an increase in iron ore volumes from the 55.8 million tonnes it shipped in 2012 to the 170.4 million tonnes it shipped in the year to June.
From a starting point of C1 costs of more than $US48 a tonne the group has steadily and significantly shifted itself down the cost curve to the point where, in the year to June, C1 costs averaged $US12.82 a tonne, adding another $US445 million to the $US2 billion benefit it gained from reducing costs in the previous financial year. In June this year its C1 costs — which represent the “direct” production costs of iron ore — were $US12.16 a tonne.
Note the 75% reduction in the direct production costs of iron ore!
Now for my mining example. Some years ago, I was asked to join a team tasked with reducing a major mine’s operating costs by 22% in cash terms.
This was a strict guiding rule for the team; no fancy accounting tricks. The client was looking for real cash savings, much like Fortescue, except that we looked at more than the “direct” production costs. Real savings were being targeted across the board.
The team was divided into small groups that looked at everything from the mining costs, to travel, vehicles, and the costs associated with the mining town which supported the operation. All costs were on the table.
I must admit I was dubious that this could be achieved, but it was. Much like the Fortescue example, the outcome achieved made a significant difference to the survival and prosperity of the mine.
• Discounting is not a lower-cost way of doing business.
• Adopt a “lower cost of doing business” business model and challenge all high, embedded costs.
• Significant cost reductions can be achieved, but it requires detailed study.
• It also requires working with suppliers who have a similar “low-cost” approach.
• A lower-cost way of doing business allows you to sell at a lower price, and still give shareholders a return.
• You will need to apply money from today’s profits to achieve a lower cost way of doing business.
You can build a low-cost business model. The key questions are – how much do you want to reduce your cost of business, and why? What do you want to achieve? What difference will it make to you?
If you can articulate your response to these questions, we should have a chat about HOW you might do that.
For more than 29 years I’ve been helping small business owners plug the profit leaks in their business and restoring their cash flows by assisting them understand where there profits really come from, where they’re leaving money on the table, and where their sales are costing them profits.
If you would like to discuss with me how you might do that, book a Strategy Consult here.
© Copyright 2017 Adam Gordon, The Profits Leak Detective
Some profit losses are pretty obvious - so you fix them.
BUT, what if you don't know profits are leaking, cash out the door?
Possible leaks could be anywhere.
Are there some clues or symptoms that are tell-tales?