Wednesday, July 25, 2012

Sam Walton, Panties and Power Laws

This is the third post in a series about Amazon's Feedback Loop, the mechanism most responsible for the company's success. See also the previous posts, The Growth Levers in Retail: Price, Selection, Convenience and Unlocking the Broad Middle (Hint: Price Is the Key).

Sam Walton understood the power of price better than anybody. From the earliest days of Walmart, he decided price would be the lever he pressed the hardest. He pressed it with a fanatic's zeal.

In those early days, even before it was called Walmart, Walton unearthed a truism about low prices. He found that in lowering prices, sales didn't just bump up a little bit. The bump was dramatic. It was disproportionate to the discount, as if the relationship between price reduction and volume of sales followed some sort of power law. Cutting your price 30 percent didn't increase sales by a corresponding 30 might triple them. Walton saw that deep price cuts at his first five-and-dime store had the effect of not only drawing customers from the competitors across the way, but it also opened the purses of shoppers who might not otherwise buy his product. They couldn't pass up the bargain. It was as if he uncovered a secret of human nature.

Which brings us to an important discussion of panties from Sam Walton: Made in America:

If you're interested in "how Wal-Mart did it," this is one story you've got to sit up and pay close attention to. Harry [a wholesaler with whom Walton did business in the beginning]was selling ladies' panties - two-barred, tricot satin panties with an elastic waist - for $2.00 a dozen. We'd been buying similar panties from Ben Franklin for $2.50 a dozen and selling them at three pair for $1.00. Well, at Harry's price of $2.00, we could put them out at four for $1.00 and make a great promotion for our store.
Here's the simple lesson we learned...say I bought an item for 80 cents. I found that by pricing it at $1.00 I could sell three times more of it than by pricing it at $1.20. I might make only half the profit per item, but because I was selling three times as many, the overall profit was much greater. Simple enough. But this is really the essence of discounting: by cutting your price, you can boost your sales to a point where you earn far more at the cheaper retail price than you would have by selling the item at the higher price. In retailer language, you can lower your markup but earn more because of the increased volume.
Low prices were the key to growth, and Walton built a retail empire predicated on that simple, parsimonious concept. Everything flowed from low price. It drew more customers and increased volume of sales. It delivered that broad middle and all its glorious growth. 

As long as Walmart could keep the lowest price, it could pull customers away from Kmart in towns where they went head to head. It could also open shop in the smallest of Southern hamlets, selling pallet upon pallet of cheap merchandise in markets every other retailer thought too small to support a store. Walton knew that, as long as he kept low prices, no one could challenge him. And so he built a culture around it and shared with the world his strategy - brazenly - almost daring others to follow suit.

They didn't follow. They couldn't. None could give up those nice fat markups, those comfortable margins that propped up big executive salaries, bloated corporate overhead, and layer upon layer of bureaucracy. And so the small discounters fell by the wayside, the great Sears started collapsing under its own weight, Kmart fell further and further behind. Woolworth faded into history. Walmart turned itself into the hegemonic power of all the traditional retailers. 

Walton's price insight was the catalyst. His fanatical pursuit of it was the clincher. He saw that power law in play and he constructed methods to reduce price as doggedly as he could. He liked the growth and what it brought. And so he created the first feedback loop, something Walmart called (as it still does today) the productivity loop.

The more this feedback loop churned, the further Walmart pulled away from the competition, creating such an advantage that no traditional retail foe would be able to catch up. 

Not on price anyway.

Next, we'll discuss Walmart's feedback loop.