January 19, 2017

Pricing, Profit, Who You Are

There are many ways to run a successful business.

Facebook makes a few dollars from a billion users.

I earn $25,000 from a handful of users.

For many of my clients, the approach has always been to earn a lot of profit from a small number of users. The math goes something like this, per order (before subtracting marketing costs).
  • Net Sales = $100.
  • Cost of Goods = $40.
  • Gross Margin = $100 - $40 = $60.
  • Add Pick/Pack/Ship Revenue = $15.
  • Less Pick/Pack/Ship Expense = $10.
  • Contribution = $65.
Amazon and other brands decided to play a different game.
  • Net Sales = $80.
  • Cost of Goods = $60.
  • Gross Margin = $80 - $60 = $20.
  • Add Pick/Pack/Ship Revenue = $5 
  • Less Pick/Pack/Ship Expense = $10.
  • Contribution = $15.
Amazon was willing to generate $15 of contribution per $80 order, allowing their value proposition to be more valuable to a lot of customers.

You were willing to generate $65 of contribution per $100 order, causing your proposition to be valuable to a small number of customers.

Always remember that Amazon could generate a profit anytime it wanted to - instead it invests future profits in current operations.

Here's another interesting tidbit - Amazon spends +/- 5% of net sales on marketing. A typical catalog client might spend between 25% and 30% of net sales on marketing.

In other words, we have consciously chosen who we are. A traditional catalog brand chose to generate hefty gross margins, and then spent gross margin dollars on catalog marketing. Amazon chose to spend minimal dollars on marketing, instead spending on future technology and merchandise assortment, allowing Amazon to appeal to a large audience willing to generate small amounts of profit.

The problem arises when the traditional catalog brand and Amazon intersect on comparable merchandise. The customer will generally pick the better value proposition (Amazon). Hence, their p&l isn't impacted by this decision.

But your p&l is impacted by this decision. Your sales decline, and your fixed costs don't change. Bad news. So you change your value proposition - 20% off plus free shipping.
  • Net Sales = $80.
  • Cost of Goods = $40.
  • Gross Margin = $80 - $40 = $40.
  • Add Pick/Pack/Ship Revenue = $0.
  • Less Pick/Pack/Ship Expense = $10.
  • Contribution = $30.
Just like that, you're making less than half as much per order as you did in the glory years. And worse, you "cheated" - you went from a Tier 1 strategy to a Tier 5 + Tier 6 strategy ... now you cannot go back to Tier 1 without a negative hit to net sales.

Will you generate more than 2x as many orders to make up the contribution loss? Maybe.

Now we've changed "who we are". We're heading toward lying about prices. Next year we need to be 30% off to generate the same net sales level, then 40% off, then the 50% off bloodbath of 2016.

Think about iOS vs. Android for a moment. iOS is able to charge more for the exact same device, allowing Apple to print money. Yes, Android has market share, but of what value is the market share if there isn't much profit associated with it? Apple has a minority market share and a majority of the profit.

This is the decision we're all being forced to make, courtesy of Amazon.
  • Do we want to be iOS, small market share / tons of profit?
  • Do we want to be Android, large market share / minimal profit?
Who do we want to be?

When we offer 30% off plus free shipping, we're trying to have it both ways ... we want the profit of iOS and the market share of Android ... we're buying time hoping to find a path to iOS in the future.

Wal-Mart went large market share / minimal profit. Retail adapted.

Amazon went large market share / minimal profit. You will adapt.

But in order to maintain a large amount of contribution per order, something has to change.
  1. You either shift on the Pricing Tier strategy and consistently employ a strategy that yields many customers and minimal profit per customer.
  2. Or you create a Unique Point of View that yields a Low Cost Customer Acquisition Program that allows you to generate a ton of contribution per order (but with a minority of customers).
In other words, you pick iOS or you pick Android. 

What we've been doing for the past five years is an average of the two ... and that strategy isn't working.

We have to decide who we are.

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