You Can't Make It Up on Volume!

Have you ordered groceries online? If you have, you may have found it incredibly convenient. However, new research confirms my intuition, namely that many retailers struggle to make online grocery sales profitable. Knowledge@Wharton recently featured research by Professors Marshall Fisher and Santiago Gallino on this topic. The two scholars published an article in Harvard Business Review titled "How Grocery Stores Should Respond to the Growth of Online Markets."  Interestingly, the authors point out that Trader Joe's does not offer online grocery sales.  Having written a case study about Trader Joe's, I love how they buck the conventional wisdom and profit greatly by doing so.  

Why are online grocery sales unprofitable for many retailers?  The authors found that, "Traditional in-store shopping requires 30 minutes of employee labor per customer. When a customer comes inside the store to pick up an online order, an additional 27 minutes of labor is needed. Curbside pickup adds 32.6 minutes, and delivery adds 37 minutes."  These labor costs are hard to recoup.   Given thin margins and intense price competition in the industry, retailers struggle to charge enough to offset these costs. 

Some retailers seemed to think that they would eventually become profitable through economies of scale.  However, the problem is that a key cost driver is the labor involved in serving the online customer in grocery stores.  That cost is largely variable, and it does not come down as you scale up.  Gallino explains: “Many grocery retailers have been pushing for this with the hope that scale will bring profitability. But we’ve been in this effort for a number of years now, and it’s not true. There is a physical reality that scale is not going to fix. Broadly speaking, it’s very challenging to make a profit.”  In short, the research confirms the old joke that, "you can't make it up on volume."  If variable costs exceed price, then no amount of scale is going to make you profitable.  

Companies should take a key lesson away from this research, and it extends well beyond online grocery sales. Firms need to have a good handle on fixed vs. variable costs, and they must understand the contribution margin per item. If the contribution margin is negative, then economies of scale will not likely save you. How might increasing volume lead to lower costs and more profits? If variable costs come down through something such as volume discounts in procurement, that would be helpful. Or, if variable costs come down because of a steep learning curve, that could make a service or product more profitable as volume increases.

The Xerox Bid for HP

This week, Fortune's Jonathan Vanian reports on Xerox's takeover bid for HP.   Vanian writes:

HP Inc.'s printing division was once the envy of Silicon Valley for its billions of dollars in annual revenue and supersized profits. But in the increasingly digital world, consumers and companies are printing less, causing HP's printing business to fade. Last week, HP Inc. confirmed getting an acquisition offer from copy machine giant Xerox worth over $30 billion, a premium to HP's market valuation. The massive deal would combine two venerable but troubled names in tech, in the hopes that they would be stronger together. The takeover bid highlights the difficult position HP Inc. is in. If it rebuffs the deal, or any rival offer, it risks continued decline, while combining with another troubled company is also dangerous.

I have a few thoughts on this takeover bid.  First, I'm not sure how the Xerox takeover addresses the fundamental weaknesses in the HP business.  The printing business, as Vanian reports, has been profitable, but declining for some time.  There is no obvious upturn in site for that business.  Vanian reports that the personal computer business has been a bright spot, in that HP's PC sales have risen substantially in recent years.  The firm has reached #2 in global market share, and it has received very favorable product reviews for its laptops recently.   Having said all that, Vanian does not note the one most obvious concern about the PC business, namely that the industry is incredibly challenging.   If we conduct a simple five forces industry analysis, we can see why margins are slim in the PC business.  The competitive forces are not attractive/positive (i.e. consider buyer and supplier power, for instance). Thus, despite HP's recent success, it faces an uphill slog in that market.   It may achieve strong sales and market share, but strong profits will be hard to come by. 

Second, the history of mergers between two weakened companies is not a positive one.  Generally speaking, putting two weak companies together does not make a strong organization.  In fact, the challenges of merging two organizations and cultures can actually distract management from many of the key strategic challenges that it faces.  Companies can become inwardly focused during a merger integration process, and rivals can take advantage of the distraction at the newly merged entity.  

Finally, as NYU Professor Melissa Schilling noted in a recent tweet about the merger, "Both companies are huge and unlikely to gain further economies of scale (HP: 21.4% share in printers; Xerox: 23% share in copiers)."  In fact, one could argue that they will face potential diseconomies of scale and scope due to the increased complexity of the organization.  

Scale and Profitability: The Link is Not As Strong as Many Executives Believe

James Allen, co-leader of Bain Consulting's strategy practice, has written a short article for the Wall Street Journal about the scale advantages (or lack thereof) of industry leaders. Allen reviews the findings from research the firm conducted across 45 industries.   Certainly, scale had its advantages in many of these industries.   However, it's far from a guarantee of success.  Allen summarizes the conclusions:

Strikingly, we found that on average, 80% of the economic profit pool was concentrated in the hands of just one or two players in each market. These strong performers generated nearly two times their cost of capital in profits. And among these economic leaders, 40% were not scale leaders at all. These best-performing companies, it turns out, achieve economic leadership in other ways.

As I've written before on this blog, executives consistently overestimate the benefits of scale.  This study should cause them to reconsider their beliefs.   Moreover, the biggest firms should ask themselves:  In what ways are our scale and scope key disadvantages relative to innovative newcomers?  

Overestimating Barriers to Entry: The Rise of Craft Distillers

The alcoholic beverage industry has experienced a significant change in the past few years, as a wave of new entrants has emerged.  A large number of "craft distillers" have exploded onto the scene.  According to the American Distilling Institute, the number of small distilleries has risen tenfold over the past ten years.  According to a recent article in the Wall Street Journal, the large players are taking notice. They don't want to get caught unprepared, as they were to some extent when craft beer began to disrupt their business.  

The rise of craft beer and craft distilleries raises an important strategy point.  For years, people argued that the barriers to entry in markets such as beer and distilled spirits were high because of economies of scale, brand equity, route to market advantages, and the extensive advertising and marketing required to launch a new product.  What's happened?  How have startups cracked these markets?  It's become easier to enter these days for a variety of reasons.  Perhaps most importantly, one can launch a new brand more easily today than in the past.  You don't need traditional marketing and advertising approaches, which can be very expensive.  You can use guerrilla marketing and social media to introduce a new product.  Authenticity has become a key product attribute for consumers, and entrants can play on that trend.  Retailers are looking for new, high margin, premium products to add to their portfolio.  Deregulation has occurred, with some laws restricting the sale of alcohol at certain days, times, and locations coming off the books.  Moreover, some rules restricting production have changed as well.  

What's the broader lesson here?  Economies of scale might be significant, but we can't overestimate their ability to prevent entry.   Niche players can still emerge.  Other entry barriers can decline, precipitating entry despite scale disadvantages.   Moreover, some advantages of being small often are overlooked.  While no one niche player may take substantial share, as a group they may create a significant disruption in the marketplace.  The strategic threat is not from one particular entry, but from a class of entrants.  That's a concept that incumbent players in many industries should keep top of mind. 

Questions about Amazon

Vacation was wonderful, and now it's back to preparations for the new academic year... as well as a return to blogging.  As I'm catching up on various business news, I began thinking a great deal about the future of Amazon.  I have a few questions for readers to ponder:

1.  Will Amazon reach a point of  diseconomies of scale and scope sooner rather than later?   Many firms strive to achieve the benefits of size and scope, hoping it will juice their profit margins and overall return on invested capital.  At some point, though, size and scope become a handicap rather than a strength.   The complexity of managing a large, multi-business enterprise becomes problematic.  As we watch Amazon, as well as its founder Jeff Bezos, moving into more and more lines of business, one has to wonder whether the company will reach that point of diseconomies BEFORE it ever generates strong profit.  For years (17 years, in fact), investors have bet on Amazon, in hopes that its strategy would eventually yield high profits.  They have been very patient, incredibly so in fact.   What if the profits never materialize because Amazon gets too big and complex to manage?  I'm not predicting this fate, but I am wondering about how thin Bezos may become stretched as the company expands, and as he engages in other ventures such as the Washington Post.

2.  What exactly is the Amazon business model, and how new is it?    I read the other day that Amazon Prime accounts for a significant share of the company's rather thin profits.   That reminded of another business model.  Think about Costco.   The successful company makes a big chunk of its money from the membership fee.  Amazon Prime is essentially the membership fee.  In other words, Amazon's business model resembles Costco much more so than a traditional retailer.   Most warehouse clubs operate with very thin margins, and they use the membership fee as their profit engine.  Amazon may be the same, more similar to brick-and-mortar retail than many have imagined.

Budweiser: Can It Go Global?

According to the Wall Street Journal, Anheuser Busch Inbev is making a big push to take the Budweiser brand global.   A quick look at the brand's performance in the United States tells us why the company is focused on expanding Budweiser's global reach.  The historic brand's consumption in the US has fallen for twenty-four straight years, and it has now fallen to number 3 in market share in the United States (behind Bud Light and Coors Light).   Budweiser faces challenges winning over customers in foreign markets though.  As the Wall Street Journal reports:

"Adolphus Busch launched a pale lager in St. Louis fashioned after beer from the Bohemian town of Budweis—has never won over most beverage connoisseurs. It scores only a 56, when any rating below 70 is "poor," on the website Beer Advocate. In Europe, where some beer brands have been popular for 500 years, Budweiser 'is not seen as a real beer by beer aficionados,' says Ian Shackleton, a London-based analyst with Nomura."

Budweiser faces a more fundamental challenge though.   In global markets, the local beer brands still dominate.  Many companies, including Anheuser Busch Inbev, have pursued acquisitions across the globe, because they understand this dynamic.  In the article, SAB Miller CEO is quoted: 

"We remain convinced beer is fundamentally a local business,'' says Alan Clark, SABMiller's chief executive in an interview. Although SABMiller is expanding international distribution of brands such as Miller Genuine Draft and Italy's Peroni, it puts far greater stock in its local beers, like Snow. "There's an emotional resonance we find consumers have with beer brands which frankly is different," he says. "We just see it continuing."

Of course, the question is:  How large are those global economies of scale, if local brands dominate so much.  What value does the global parent add?   I wish that Alan Clark had commented on those core questions.

Can It Scale Quickly? Is it the Wrong Question for Many Startups?

Does your business model enable you to scale quickly?   That's the question facing many start-ups these days as they seek capital from investors.   The question proves most pertinent for tech start-ups, but it seems to be thrown at founders in many different kinds of companies these days.   Is there a danger to focusing on this question?   I would argue that founders and investors must be aware of two significant downsides.    First, focusing on scale, and trying to scale too quickly, can cause start-ups to lose sight of their target market.  Who precisely do they aim to serve, and who they do not plan to serve?    A strategy can become "all things for all people" very quickly as the scale question comes to dominate conversations.   Second, founders and investors often can underestimate the challenges associated with scaling quickly.    Sometimes, it makes sense to take a bit of time to get the business model right before trying to grow rapidly.   I find it very interesting that many investors proclaim the mantra of fast iteration and experimentation, yet they also push for scale at the same time. 

Amazon and Online Grocery

Forbes has an article titled, "Why Amazon is Happy Breaking Even With Online Grocery."  Author Tom Ryan argues that the firm doesn't plan to generate profit from the online grocery business, but simply to break even.  According to the article, based in party on research by RetailNet, "It’s all about helping Amazon attain the scale to support its ambition to build a national same-day delivery shipping model."   I don't quite understand this point about scale economies.  Amazon isn't going to be shipping books on the same truck as vegetables.  It is not likely to be using the same distribution center.  What is the scale advantage for other products from having an online grocery business?  

Later on, the article provides a much stronger argument for Amazon's entry into the online grocery business, a market where it has traditionally been very difficult to make money.   Quoting an analyst at RetailNet, Ryan writes, "Finally, Amazon views steady grocery delivery as a 'powerful way to drive frequent customer interaction,' and opens up avenues to entice consumers to shop for other products with each order."  Now we have the key rationale!   Consider why Target has expanded its grocery offerings.  It wants to build traffic in its stores.   Target knows that the margins are very slim on grocery items.  However, when guests come to buy groceries, they also buy apparel, home goods, and the like.  The firm can make healthy margins in those areas.   Target has learned that offering more grocery items brings people to its stores more often, and that foot traffic yields higher margin sales in other departments.  Amazon clearly believes that the same dynamic applies when people shop its website.  Engaging people to buy groceries will hopefully yield more sales of books, electronics, and other items that do produce better margins.   Moreover, Amazon may be able to use its strong predictive algorithms to help drive those kinds of profitable sales, based on a deep understanding of this online grocery customer.  

Our Obsession with Scale

Nilofer Merchant has a terrific blog post on HBR today.   She describes "our obsession with scale."   She explains:

Giants have a view of the world that often makes new markets "too small" to pursue. When we see scale as the thing they must do all by ourselves, then only "big" opportunities are worth investing in. Scale, in the traditional view, means that what they produce and how they function has to be about efficiency, productivity and being bigger than the other guy — because that is, above all, the source of profits. And for sure, it means they skip right past $50M or $100M or even $500M opportunities because they are not "big enough" to work on. And it is this thinking — this mindset — that is the central reason so many industries (automotive, financial, health care, and even education) and their companies are failing all around us today. It's not that our economy is stalled, but that our thinking has stalled. It means that industries are stagnating because nothing new ever shows up as a $1B market right away — market opportunities show up first as the $50M or $100M opportunities. And markets that need to be served should not be killed off because the giants can squash it. 

I agree wholeheartedly.  I have argued on this blog that executives often convince themselves that:

a.  economies of scale exist in every industry
b.  further economies of scale can be exploited in their industry
c.  no such thing as diseconomies of scale exist (or they are far from reaching that point

 We know that these three beliefs are often proven incorrect... yet, companies and their leaders continue to adhere to these notions.   Why?  In some cases, executives like to lead large organizations.  Slimming down, divesting units, and reducing scale doesn't prove very popular.  In other cases, we see leaders whose firms are struggling... and they see a merger to capitalize on supposed scale economies as a "easy" way to juice profits when organic growth opportunities don't seem apparent.   At the same time, leaders often are looking for new organic growth opportunities that will "move the needle" - i.e. impact the top line in a significant way.  Of course, knowing which new ventures will become very large businesses is hard to predict in advance!   Thus, we see too many large firms rejecting new opportunities because they think they will be small revenue generators... only to be proven incorrect years later.

Groupon's IPO

Groupon announced yesterday that it would be issuing an initial public offering soon.   Many analysts expressed concern about the high valuation coupled with the significant losses that have mounted as the company grows rapidly.  Some analysts have talked of this IPO as further evidence of a bubble in new tech firm valuations.

How do we make sense of these concerns?   We have to ask ourselves:  Has Groupon built a significant sustainable competitive advantage?   Are they a successful first mover, or will they be like many early movers in technological industries who actually end up being overrun by later entrants?   To answer these questions, we have to look at several factors.  First, does the company's business model have significant scale economies?   If so, then they can amortize fixed costs as they grow, and therefore, they will become quite profitable.  Second, does the business model have substantial network effects?   Amazon's model has both scale economies and network effects.  Thus, Amazon turned early losses into sizeable profits as it grew, and it built a quite formidable competitive advantage.   At first glance, it does not appear that Groupon has the type of economies of scale and network effects enjoyed by Amazon.   The model seems to very labor intensive, with new staff required to drive new growth.  The jury, of course, is still out though.  As the company goes public and we learn much more about its finances and strategy, we will be able to discern this more accurately. 

Competitive advantage may derive from other sources as well. Groupon itself focuses on its relationships with local merchants.  Undoubtedly, they do have ties at the local level that are quite impressive. Yet, questions remain to be answered.   Have they built relationships that will be hard to duplicate or break?  Are there significant switching costs for these merchants?  The barriers to entry do not look huge at this point, as we have seen a flood of entrants into this space.  Of course, some big existing players also want a piece of this pie, and so we will have to watch the likes of Google, Amazon, and Facebook to see if Groupon can sustain its early lead.

Will Saab survive?

News reports indicate that Saab may not survive much longer. Spkyer Cars bought the firm from General Motors when the American automaker went bankrupt. By the time of the sale, Saab already had been experiencing years of decline. In North America, Saab had a small following in the northeast, but little brand presence elsewhere in the country.

Why will it be difficult for Saab to survive independently? First and foremost, the firm simply does not have enough scale. By most accounts, the minimum efficient scale (MES) for an automotive assembly plant is about 200,000 cars. MES is the point at which a firm has fully exploited scale economies. If a company operates below MES, its costs will be higher than more efficient competitors. Saab sold just over 30,000 automobiles last year - far below MES. It simply cannot remain cost competitive at these volumes.

Of course, some automotive experts believe that firms must be much larger than MES to survive in the auto industry. They argue that the development costs for a new auto platform often exceed $1 billion, and thus, firms need to be substantially larger than the simple MES for an assembly plant in order to be cost competitive. Fiat CEO Marchionne has argued that auto firms must achieve scale of 6 million units to survive in the long term. I believe Marchionne may be overestimating the need for scale. The economics seem suggest that firms can be quite profitable at below 6 million units. For instance, Ford became very profitable the past two years, operating below 6 million units of production. Honda also has been a very profitable automaker despite not exceeding 6 million units.

In the past, we have seen the drive for consolidation, based on a scale economy logic similar to that espoused by Marchionne. How did that work out? Well, the results of auto mergers and acquisitions in the 1990s look pretty ugly (think Daimler-Chrysler, Ford-Volvo, Ford-Jaguar, etc.). Apparently, consolidation isn't all that it's cracked up to be. For more on the risks of global mega-mergers, I highly recommend a classic article written several years ago by Pankaj Ghemawat, "The Dubious Logic of Global Mega-mergers."