Why Is Business a Game of Margin, Not Volume?
Remember k-Mart and Sears, and all other once-great companies that competed on being the low price leader that no one seems to remember any longer.
The question is why?
My contention is a follow:
Being the low price leader is not a sustainable strategy or a competitive advantage, let me show you why. First, anyone can come into your market with loads of cash with the goal of running you out of business, they can undercut your prices by 20%, sometimes companies will come into a market with the intention of acquiring customers at lost. They will spend their cash until every competitor is out of business and then increase their prices. An Example of this will be Verizon Wireless. Verizon came into the market offering free cell phones and low monthly plans. With time they acquired small local cell phone companies such as the Airtouch, LACellular, BellSouth etc… Once they became the market leader their prices soared and the company is now the most expensive cell phone service carrier.
Most businesses go broke during periods of high Sales Volume
Surprisingly, most entities that go broke do it during a period of an increase in sales volume. This statement shocks most people (especially those involved with sales) because most everyone mistakenly believes that a business fails as a result of a lack of sales volume. The facts are, however, that business is not a game of volume. Business is always a game of margin. If a business doesn’t maintain gross margin at an adequate level, it is going to go bust, regardless of its sales volume. Cheap seats, cheap products or services, and giveaway prices really do have a way of attracting more and more customers. Have you ever seen a yard sale go wanting for customers? We don’t think so. Lots and lots of items for sale and all at very low prices.
Business Is a Game of Margin, Not Volume. Many large company leaders seem to sincerely believe, albeit blindly, that volume and market share are the secrets to business success. If that is the case, then why are multiple billion-dollar corporations filing bankruptcy every year in the United States? In the years between 2000 and 2004, 23 of the 40 biggest bankruptcies of all time occurred.
The year 2001 was a record year for big dollar bankruptcies—there were 257 major organizations that filed in the United States in that year alone. Since then, we’ve seen even more high-profile bankruptcy filings such as:
Pacific Gas & Electric Co
Filed Chapter 11: 2001
Value at bankruptcy: $36.15 billion
What happened: PG&E, California’s largest utility company, fell victim to the state’s electricity crisis of 2000-2001. Blackouts swept the state and costs soared, blamed in large part on California’s deregulation of the energy industry in 1996—the first state to do so.
Enron—who also made this list—even cut off power to manipulate prices, worsening the crisis. PG&E left bankruptcy in April 2004.
MF Global’s Chapter 11 filing officially knocked PG&E off the top ten.
Data source: Wall Street Journal
Filed Chapter 11: May 2009
Value at bankruptcy: $36.5 billion
What happened: The housing crash and credit crunch doomed the mortgage lender. Thornburg’s fall demonstrated that the crisis went far beyond subprime lenders; Thornburg “specialized in making mortgages larger than $417,000 to borrowers with good credit.”
The company was liquidated.
—the record holder with assets worth more than $103 billion on the day before its default and credited with a bankruptcy worth $11 billion.
Westpoint Stevens, once one of the largest home fashion manufacturers in the United States, filed for Chapter 11 protection before agreeing to be bought by an investor group, WL Ross & Co., which had already purchased failed textile companies Cone Mills and Burlington Industries. The Fleming Companies, which not only was a supplier to Kmart, but owned IGA and Piggly Wiggly grocery stores, filed for bankruptcy in 2003 with revenues of $15.6 billion.
Even these few examples should provide a fairly graphic picture that business is, indeed, not just a game of volume and market share. A business must maintain an adequately high price against its costs (a high gross mar- gin), or it is going to follow these well-known predecessors down the well- traveled path to bankruptcy court.
But We Can Make It Up in Volume.
When businesses get into financial difficulty, it’s inevitably because some genius gets the bright idea that one can cut price and make it up in volume—to at least be “competitive.” Most people get that idea when they take a course in economics. In fact, if you have anything to do with selling or pricing, one of the worst things that may have ever happened to you was taking Econ 101 when you went to college.
Just to emphasize the point that the bulk of our population thinks that the only way to do business is to cut price and make it up in volume, consider what happened as a result of airline deregulation. Way back in 1978, then-President Jimmy Carter deregulated the airline industry. This meant that the airlines were free to charge any price they wanted. How many raised prices? Answer: None. How many kept the same prices? Answer: Virtually none. They all, in varying degrees, began to cut their prices. How many airlines have filed for bankruptcy since deregulation? Answer: Hundreds. And some predict that the twenty-first century will see a further culling of the airline industry so that just a few airlines survive.
It could be argued that the first airline to really figure this out was Southwest. Here was an airline that intelligently attacked key issues head-on and won. However, it took them a long time after deregulation to enter the scene and become competitive. Perhaps they learned from the losers. Some of the traditional airlines have (and are) going broke, because they are cloned knockoffs of the model. Southwest keeps labor costs down by hiring younger, non-union employees and sustains margin with a series of maneuvers that cut costs. For example, flying a limited number of aircraft models eliminates training redundancy, a huge parts inventory, specialized tools, and other costs. In addition, they eliminated the wasteful hub concept and, instead, fly from point to point. The result? They can sell cheaper seats, but keep labor costs in line, control other expenses, and still sell more seats. However, they are a minority player, and it took many years for someone to discover the formula. We cannot help but wonder what the future holds for them as costs, labor demands, and all the rest potentially escalate. There are other airlines merging and following suit as well—making the terrain even more competitive.
Some airlines that have filed for bankruptcy since deregulation include:
Air Florida Systems Metro Airlines America West Airlines Midway Airlines, Inc. Braniff International (twice) Northwest Airlines Capitol Air, Inc. Pan Am Corp.
Conquest Industries, Inc. People Express
Continental Airlines (twice) Provincetown Boston Airlines Crescent Airways Corp. StatesWest Airlines, Inc
Delta Airlines Tower Air, Inc, Eastern Air Lines, Inc. Trans World Airlines (three times) Fine Air Services Corp. UAL Corp. ( United Airlines) Frontier Holdings (twice)
The ability to fail creatively is widely documented. The depths have not as yet been plumbed as to the new, novel ways somebody is going to figure out how to mess up a business. But they all go back to one common pattern: They cut the price (to make it up in volume). If you think you can match (or sell below) your competitor’s prices, you need to understand that you will have an on-going, lifetime battle for survival that, sooner or later, you are going to lose.
Why Companies Cut Price When They Get into Trouble
Perhaps you’ve heard the story of the industrious entrepreneurs who set out to make their fortune by buying watermelons for a buck each and selling them for $10 a dozen. And, like any good joke, it is readily adaptable to anything. Just change the subject—watermelons, exit signs, carpeting, hammers—and make the local meathead the butt of the joke. The way we originally heard it ran as follows:
There were these two guys from Texas who had a little money and an old pick-up truck. They heard they could buy these watermelons in Mexico for $1 each and they decided that they could sell them for $10 per dozen.
So, they went to Mexico, loaded the truck with watermelons and headed toward Dallas, selling off these watermelons for that $10/dozen. They did a great business and sold out of watermelons before they even got halfway to Dallas. But, while sitting on the side of the road, counting their money, they noticed they were a little short of the amount they had started with. They wondered what the problem was since they had done a brisk business and it finally dawned on them—what they needed was a bigger truck.
Although you may have thought this was a new story, there is clear evidence that it has been around for over a century. Paul Nathan,2 who wrote How to Make Money in the Printing Business, published the following in 1900:
If there is any one thing in the business management of a printing office that particularly commands the utter disapproval of successful printers as being worse than other evils that beset the trade, it is the cutting of prices. The method of getting work by lowering the price has absolutely nothing to recommend it, and it is contrary to common sense. The practice is absolutely wrong in principle, and the reasoning advanced in its support, stripped of its verbiage, is the equivalent of that of the old apple-woman who bought apples at a cent each and was selling them at ten cents a dozen, and when asked how she could make any money at that replied: “By doing a very large business.”
When a business gets into trouble, it has a cash-flow problem and a margin problem—not a profitability problem. For example, let’s consider the following:
Question: Do the vendors to your company care whether: (A) you’re profitable or ( B) pay your bills?
Answer: ( B) pay your bills.
Question: Do an organization’s employees care whether: (A) their employer is profitable or ( B) meets its payroll?
Answer: ( B) meets its payroll.
An organization gets into trouble when it can’t pay bills and/or can’t meet payroll. It has a cash-flow problem (or more correctly, a cash-trickle problem). This creates an intolerable situation for the organization. If the bills aren’t paid, it will be cut off from needed services and supplies; if payroll isn’t met, there will be no one to do the work. So, the first thing executives start worrying about is, “How can we get some cash? . . . How
can we get that cash in the fastest way?” You guessed it. It has got to sell something! How to sell that something? Use the old standby: Cut the price. Unfortunately, cutting the price immediately creates the three danger signs that signal the organization may soon become a bankruptcy statistic: (1) gross margin goes down, (2) wages as a percentage of sales go up, and (3) sales volume begins to increase.
Gross margin must go down when prices are cut. But do most organizations cut wages when they cut prices? No. So then, wages as a percentage of sales go up—and sales go up because of the lower prices. Again, remember that those are the three conditions that virtually always prevail when an organization really gets itself in trouble and ends up filing bankruptcy or having to sell off or merge because it isn’t making any money.
Many salespeople have the feeling that when they’re out in the marketplace, the only way to sell and compete is to cut price when the competition starts cutting its price. They think, “Hey, we’re getting killed. We’re getting hammered. Our competitors are selling at a lower price than we are. They keep cutting price. We can’t compete on an unlevel playing field. And, if those guys can sell at that price, we can too.” So they go back to the boss, and say, “Hey, boss, we’re getting smashed out there. Those guys are selling at a lower price. And we need to do the same thing or we won’t ever be competitive.” Well, the bottom line is—If those guys can sell at that price and go broke—you can, too. Just because your competition is selling at a price or offering products or services at a price lower than you are, it doesn’t mean you can—or should even try to—meet their price, because most of that competition is going broke.
Maybe you still don’t believe that most businesses go broke. Perhaps you think it’s only the little start-up companies that lose it—not the big boys that “really know what they’re doing.” Do you think that big businesses don’t go broke? Let us give you another example. Inc. magazine, way back in May of 1988, reported that “We should not expect that our large corporations somehow possess a corporate fountain of youth. We should not mourn the fact that, in the 11 years between 1997 and 2009, 29 percent of the 2000 Fortune 500 companies vanished as companies . . .”3 The article went on to say that the “ ‘vanishing rate’ of a Fortune 500 company is only two-and-a-half times less than the vanishing rate of a mom and pop today.
Notice that what we are talking about doesn’t just involve an isolated segment of the business world. Failure occurs in all avenues—big and small, established and start-up. But there is a commonality that exists—most failing companies believe they can cut their prices and make it up in volume, but they fail to consider what happens to their gross margin when they try to compete that way. As the quote at the start of this chapter says, “The cause of our losses is that the price of the equipment we build has been less than the cost.”
No business opportunity is ever lost. If you fumble it, your competitor will find it.
Just because your competition cuts its price doesn’t mean that you can or should even expect to survive if you do the same thing. Why is that? Because if your competitor has more
money to lose than you do, you will go broke first. The important thing to remember is that your competition does not cut your price; you cut your price. Your competitor may offer its product or service at a price lower than you offer yours, but you cut your own price. Pogo the Possum said it all years ago: “We have found the enemy and he is us.” If anything occurs that causes your price to go down, it’s a self-inflicted wound.
Customers Only Buy on Price— Or Do They?
Unfortunately, many businesses and salespeople operate under the false notion that people (and businesses) buy on price—and price alone. Nothing could be farther from the truth. Research clearly shows that price is almost never the primary reason why anybody buys anything. In fact, if the price were the only reason anybody bought anything, then only one seller—the one with the lowest price—would sell all there is to sell of that product. But that has never happened in the real world. So there must be some other reasons why customers buy from different sources.
There is also another bit of evidence corroborating that prospects and customers don’t buy primarily on price. If price were the only reason anybody bought anything, we wouldn’t need salespeople. In fact, we wouldn’t even need people to answer the phone or give a quote. A computer could handle sales presentations and the Internet could accept the orders. Of what earthly use would a salesperson be if customers bought only on price and aggressively searched for the best price? They would just call 800 numbers, cruise the Internet to get the lowest quotes, and then place their orders by clicking the appropriate button on the websites of their choice.
I can go on and on about this subject but I would like to invite you to consider that the reason most businesses fail is that they ran out of money and money comes into your business by way of margins which lowering your prices doesn’t help lowering prices is surefire way of lowering profits, decreasing cash flow ultimately driving your company to bankruptcy.
Focus on differentiating your company from your competition with your processes, systems or service ( branding). Know your customers so well that you can anticipate their needs ( psychographics) and build a tribe ( Apple).