Monday, July 23, 2012

Unlocking the Broad Middle (Hint: Price Is the Key)

This is the second post in a series about Amazon's Feedback Loop, the mechanism most responsible for the company's success. See also the previous post, The Growth Levers in Retail: Price, Selection, Convenience.

In the previous post in this series we discussed the growth levers for retail, that retailers must decide how to allocate their resources among price, selection, and convenience (the levers) in the unending competition for customers. 

In a retailer's utopia, it would have enough resources to push simultaneously on all the levers. For the retailer that offers the lowest price, the widest selection, and the best convenience will win the most customers. When you win the most customers, you get the most growth. 

But traditional storefront retail just won't allow that perfect combination. It's held back, for one reason among many, by real estate constraints. Convenience is driven primarily by location, location, location. Every retailer wants to be as close as possible to the most customers, so those shopping locations that provide that access carry steep rents. But if you're forced to pay too much for rent, you can't afford to lower your prices or expand your selection. You'll still win some less price-sensitive shoppers who prize convenience most of all, but others will drive past your store on the way to your competitor in the suburb that offers cheaper prices. So we're back to the trade-offs. 

(We'll see later that in web-based retailing, the constraints are very different; the trade-offs less demanding; the ability to invest in all the levers, while hard, is not just a pipe dream. Amazon knows this very well.) 

While you get to the most customers by striking the right balance among price, selection, and convenience, the lowest common denominator of the growth levers is price. If you must choose one to define your service in the mind of the buying public, price will earn you the most business. 

Let's say the world of consumers can be depicted in a bell curve distributed according to how important price is to their buying decisions. The vast majority of shoppers fall in the broad middle part of the curve. 

Those with the highest price sensitivity (the left side of the curve) are so driven by price that they will forego convenience and selection in pursuit of the best bargains. They drive miles from their homes to shop at Aldi, they don't mind generic brands, and they will walk into your store with fists full of coupons if you allow it. It's a big enough population that businesses like Aldi can thrive by catering to the desire for the deepest discounts, but it's not big enough to sustain massive growth. 

The right hand side of the curve shows declining price sensitivity. Here I'll point to Whole Foods (Whole Paycheck?) shoppers. While they trade low price for a wide selection of organic food, they really stray from the Growth Levers altogether because they're motivated by variables such as brand loyalty, good customer service, and retailers that tailor experiences to their particular wants. (Together, those three represent another category of levers we'll consider later in the discussion). This population, with its low price sensitivity, gives certain retailers the chance to charge higher prices and earn large margins. But it sits on the downward slope of the bell curve, has fewer consumers, and therefore can't offer the growth opportunities of the middle. 

The bulk of consumers fall into that Broad Middle of the curve. This group is very price sensitive, but it doesn't rein absolutely supreme (i.e., they aren't going to drive across three counties to save $10 on items they could buy at a more convenient store). While you must have the right selection and decent convenience, price will win the day, earning you access to the broad middle and the opportunity to grow into this fattest part of the market. 

Price is ultimately the lowest common denominator, that lever which provides the greatest opportunity for growth.  Why? Next we'll highlight Sam Walton's discovery of power law relationship between low prices and high sales volume.