Amazon and the Showroom Effect

The Little App That Caused So Much Trouble

I have this little app on my smartphone called Amazon Price Check. I can take it into Target, scan the bar code of any item I’m thinking of buying, and Amazon will check its catalog to let me know if it offers the same thing at a better price. If so, I make an instant decision whether to walk out of Target with purchase in hand or wait for Amazon to deliver it to my doorstep, exercising some patience in exchange for saving a little cash. 

This is a ruthless test of how well stores are maintaining the protection of the convenience barrier; how well “have it now” is holding up against the customer decision to delay gratification and wait for delivery. 

The real melee from this little app came last Christmas when Amazon went right for the stores’ jugular. Not only could you conduct the price check, but Amazon would subtract an additional five percent of the purchase price if you bought it from them on the spot. Vicious! 

The promotion created a maelstrom, turning Amazon into a political punching bag as even U.S. Senators weighed in on how this little app might usher in an online retail dystopia. They conjured images of abandoned shopping centers blighting the landscape with legions of unemployed cashiers rattling tin cups for donations as everyone turns to online retailers to buy their stuff. 

The grandstanding brought, of course, loads of media attention which – to Amazon’s resounding pleasure – provided what was sure to be millions of dollars in free publicity for the app, leading to more downloads and wider usage during the holiday season. 

I used it. It made me feel a little sheepish. I would glance furtively around as I scanned some potential gift for my daughter, fearing the judging glare of some Target associate watching me erode some tiny sliver from her means of earning a living. It seemed almost immoral. But the more I did it, the easier it became. The less guilt I felt. Amazon knows this. Amazon understands how habits are formed.

Showrooming 

The practice has been dubbed “showrooming.” Shoppers use the shelf space at Best Buy, Target, or any another traditional store to look at a product, touch it, turn it over in their hands, try it on for size, and then order it for less at Amazon. The store becomes a testing ground for all sorts of merchandise, but never wins the sale. 

It’s been happening for a while, but it’s only with the introduction of simple little apps like Price Check that the practice has become nearly frictionless. Where shoppers used to plan their showroom tours in advance - collecting product and price information online in preparation for their store visits – now they do it without the effort of premeditation. 

All traditional stores have been forced to consider their tactical responses. Target has been most aggressive in its response, treating Amazon’s Christmas promotion as an act of war (which it was). It responded first by pulling the Amazon Kindle line of products from its shelves. And sensing that it’s fighting for its life (which it is) it then upped the ante. Target pulled a page from the Lowe’s vs. Home Depot battle plan and adapted it for the showrooming battle.

Target Learns from Lowes 

Amazon wants to set the agenda for how much selection is presented by retailers and the price at which it’s offered. They want complete, universal selection, and they want the lowest prices. This will bring the shoppers. It’s the low-cost, low-price strategy for winning the patronage of the broad middle of the market. 

But the retail wars do not take place on a fixed field of battle. The players move constantly; the tactics evolve; the momentum swings. The industry is such a brutal place to compete because everyone can see what everyone else is doing. Once a new tactic works, your opponent either adopts it for himself or counteracts it with his own maneuver, negating whatever benefit it provided. 

For example, have you ever felt perplexed by the never-ending tug-o-war between Lowe’s and Home Depot? Both make some form of a low-price guarantee, making assurances you won’t find their competitors offering the same product for less money. If you do, they’ll match the price and perhaps throw in an additional discount to boot. These programs have all the hallmarks of a war of pricing attrition. (Think back to our pricing game theory discussion here.) The consumer certainly benefits, but at what cost to the businesses? 

But these retailers are a cunning bunch. Their price match guarantees are legitimate, but they have taken great pains to offer very little overlapping merchandise. They are masters of stocking items that count as functional equivalents but not exact matches. They get big manufacturers to build special models, or entire product lines, just for them. Lowe’s version is very similar to Home Depot’s, but it’s rarely the same thing. 

Because of their size, the volume of sales they drive for manufacturers, and the sophistication of their merchant operations, the home improvement giants can make demands for tailored products. The practice creates a sort of détente in their ongoing battles. They fight over plenty of other things, but they’ve figured out how to avoid doing grievous harm to each other on the pricing front. 

Target executives are no dummies either, and they have plenty of muscle to throw around with manufacturers. They’ve demanded that suppliers provide them with exclusive items unavailable at any other retailer, most notably Amazon.  I’ve noticed this for some time when looking at, for example, Sesame Street toys for my daughters. An increasing number of the Elmo products come in packaging with the distinct Target bulls eye stamped prominently on the front with the words “Only at Target.” 

These items brings with them unique barcodes. Using the Price Check app or not, you won’t find this Elmo in the Amazon catalog. Much like the price guarantees with the home improvement stores, there won’t be an exact match to spark a pricing war.

Fighting Showrooming By Playing a Different Game 

Expect more and more of this from Target and other traditional retailers. Because they move such high volumes of product for all the national brands, they can exert some pressure to get help in the showrooming war with Amazon. 

Target is a grizzled veteran in fighting companies with wider selection and better means of offering lower prices. They’ve managed to co-exist with Walmart (not as happy neighbors mind you, but they co-exist nonetheless) despite the latter’s firm commitment to what I’ll call the Glass Doctrine…that statement of intent from former Walmart CEO David Glass: 

We want everybody to be selling the same stuff, and we want to compete on a price basis, and they will go broke five percent before we will.

If Walmart wants to commoditize everything and sell it for less, Target (in addition to pushing its “upscale discount” corporate brand approach that we featured in an article here) will source alternatives to the nationally branded products. It will (and has) invest heavily in its own store brands, price them for less, and give shoppers a choice. It won’t be able to beat Walmart on the price of Tide detergent on a day-in, day-out basis, but it will provide its Up & Up alternative at a nice discount. 

As an aside, this can be a tremendously effective approach to differentiate your selection from the competition, escaping the deep wounds suffered in toe-to-toe pricing battles. Think Trader Joe’s. Its entire business is built on the idea that a store can be stocked almost exclusively with its own brands. Trader Joe’s IS the brand. It doesn’t carry Tide, Oreo’s or Wheat Thins, so customers can’t make direct comparisons on price against national brands. This has proved an effective way to avoid the Glass Doctrine altogether. Just refuse to play the game by another retailer’s rules. 

Perhaps this becomes the model for fighting the showrooming effect…Don’t play their game; make up your own rules. 

Back to Amazon 

Amazon will continue its push toward universal selection and cheaper prices. It will find brilliant tactics to help consumers compare its offers against the same items being offered at stores. But don’t expect the stores to cede their advantages without a major fight. 

They will work hard to impede Amazon’s attempts to commoditize everything, to offer everything at a lower price, to adopt the Glass Doctrine as its own. There’s a long history of fighting the selection wars this way, and Target is leading the defense now. 

Expect retailers to look for similar ways to frustrate Amazon’s attempt to offer universal selection and win on price.

Third Party Sellers and Amazon’s Drive for Universal Selection

Amazon has stated over and again that it wants to be THE place where shoppers can find anything being offered on the internet. It wants to go as far down the long tail of selection/demand as it possibly can, offering products even in the deepest niches being purchased by the fewest customers. 

The objective is clear: Amazon wants no excuses for shoppers to go to competitive sites to peruse potential purchases. And if Amazon can press its growth levers to the extreme – offering the best convenience, the widest selection, and the lowest prices – why would shoppers even bother looking somewhere else? For that matter, why would they even bother running a Google search when they can just go straight to Amazon and save an extra step? 

In short, Amazon wants to be ubiquitous. 

Having the widest selection possible is crucial to achieving ubiquity. Amazon can offer a wider selection than Walmart by virtue of escaping the tyranny of physical space. Well, mostly escaping that tyranny anyway. It can pack a wider selection into its 70 or so fulfillment centers than a traditional retailer could ever imagine stocking in its stores. But those warehouses – as big, efficient, and cheap to run as they may be – are still constrained by their four walls. 

Third Party Sellers = Amazon’s Freedom from Tyranny of Physical Space 

So Amazon turned to third party sellers to escape the confines of the four walls; to expand its item catalog. These sellers are a motley crew of merchants, ranging from established store-front retailers to product manufacturers; from grizzly wholesalers to small-time entrepreneurs. They bring their wares to this marketplace to gain access to some 200 million customer accounts Amazon offers. And, in return, Amazon gets to embellish its catalog with the additional selection, all of which comes at no direct inventory cost to the web giant. 

This is the secret to pushing one’s selection far down the long tail of demand without running afoul the tyranny of physical space: let others source, stock, and ship the inventory for you. 

It has been a booming business for Amazon. 

Scot Wingo, CEO of ChannelAdvisor – a business providing software and services to help these third parties organize their selling activities on Amazon, eBay and other marketplaces – writes an excellent blog about the Amazon retail business. It’s at amazonstrategies.com, and I recommend it highly. Scot tracks the portion of Amazon’s overall unit sales that can be attributed to third parties. Amazon’s retail sales are growing at an impressive clip, and third party unit sales are growing even more quickly. As of the end of Amazon’s second fiscal quarter 2012, the company reported that 40 percent of all unit sales came from outside sellers. 

(You can find the above chart here.)

For the privilege of selling in its marketplace, Amazon takes an average toll of about 13 percent per transaction. Analysts estimate about 80 percent of that is gross margin. Not a bad business for Amazon to be in, especially considering how little investment it has to make (in terms of buying inventory and running the risks of it not selling quickly enough) to earn those margins. 

As such, many observers have concluded that Amazon’s long-term goal is to expand this line of business; to keep growing its third party sales. That may be true. But as we’ll explore further below, there’s plenty of evidence that should give the sellers pause about tying their destiny to Amazon’s wagon with too tight a knot. 

Platforms & Marketplaces…A Predictable Amazon Model 

Part of what makes Amazon such an interesting company to follow is its tendency to find a premise that works and push it to an absurd extreme. So if you identify that premise, understand how the model works, it’s not unreasonable to extrapolate the pattern into the future. Despite its cloak of mystery, Amazon hides many of its secrets in the wide open. 

For example, Amazon tends to cling to the following playbook as it grows its operating businesses (retail, digital media, web services): 

Step 1. Create a base of customers. Offer something compelling (i.e., in high demand) at a low price point to bring the customers in. Once you earn their business, be fanatical about keeping them. This is where the price, selection, convenience growth levers come in, but it’s also about anticipating what customers want and innovating on their behalf. 

Amazon treats this base of customers as its most valuable asset. And it is. 

Step 2. Build a platform around these customers. For retail the platform is comprised of 70 fulfillment centers to store and process its inventory along with that of some third party sellers (those participating in “Fulfillment By Amazon”); the software and technology powering the familiar user interface and background functions with which we customers are so comfortable (customer reviews, 1-click checkout, quick search, etc.); and all the software and technology that runs in the background to let third parties add their items to the catalog, manage customer orders, and even use Amazon templates to build their own web stores. 

Amazon makes the platform extensible and highly scalable. It’s built for growth, to always allow more customers to join in and also to welcome more sellers to the party. Its scalability means Amazon can continue offering access to it at lower prices as more players decide to participate. 

Step 3. Establish a marketplace. The platform then powers a marketplace, that meeting place for sellers and buyers to swap money for goods. Amazon opens access to its most cherished asset (the customer base) provided sellers follow strict rules of engagement, all of which are designed for the benefit of customers. The rules tend to make products less expensive, services better, and delivery cheaper. 

Step 4. Ruthlessly disintermediate middlemen and inefficiencies. Steps one through three tend to happen quickly as Amazon acts swiftly and cleans up the messes here in step four. It improves the operations of its fulfillment centers, allowing it to move a much higher volume of inventory for the same costs. It channels more work through its employees by building technology that makes many processes systematic or more efficient. Its employs a methodology by which it roots-out errors in the operations and fixes them at their core. 

But, most significantly, it ruthlessly chases down and cuts out middlemen that slow things down or otherwise increase the cost of doing business. More on that in the next section… 

The Amazon Credo & Disintermediation 

We’ve talked about the Amazon Credo before. It works like this: 

The world is composed of three types of entities. 

First, you have creators. They write books. They invent things. They code software. They record music. They program video games. They design and manufacture products. These people and entities are the basic unit of innovation and productivity in the world. They are to be empowered. 

Next, you have customers, the consumers of the output from creators. They are the buyers, the readers, the end-users, the watchers, the listeners, and the players. They are the core asset of Amazon. They are to be invested in. They are to be defended. 

Finally, you have middlemen. These are the people and entities that stand between the creators and customers. Oftentimes they have a purpose. But when they become gatekeepers that prevent access to the market by creators...or when they become toll-takers, charging fees to creators or customers in excess of the value they generate, they are the enemy of Amazon. They are to be disintermediated. 

Amazon operates on a pretty straightforward credo. It goes something like this: 

Fidelity to the customer; Fraternity with the creators; and Contempt for the Middlemen. 

The problem becomes understanding what a middleman is. It’s a fungible concept to Amazon. The cherished partners of today are often the middlemen of tomorrow. There are all these shades of gray to deal with. 

Let’s consider the third party sellers. A seller is not a seller is not a seller. Amazon wants to get as close to design and manufacturing source as it can. These are the creators, the originators, with which Amazon feels a certain fraternity. The marketplace-platform diagram might be better presented with this additional detail: 

The sellers exist on a continuum, and the value of each is measured by how far removed it is from the original design and manufacturing of the product being sold. That source is the creation, and the further removed you are from the creator the more likely you are to be deemed a middleman. Maybe not quickly, but the closer Amazon can get to the source, the more danger you’re in of being disintermediated; of falling victim to step four in its playbook. 

Let’s now consider the case of a third party seller being disintermediated. 

The Threat…Competing Directly With Amazon 

In July I wrote a post referencing a Wall Street Journal article by Greg Bensinger. (See Amazon Sellers Competing with Amazon…On Amazon.) Greg featured an Amazon seller that specialized in NFL-theme pillow pets. His business had been building momentum, when all of a sudden Amazon started selling the exact same products for much, much less. 

It’s no easy task competing with Amazon on Amazon. It’s a fool’s game. 

Amazon, notoriously tight-lipped, does not comment on its business practices. But I think we can make some fair assumptions while Seattle remains quiet. 

Even if it can charge the pillow pets seller a nice 13 percent commission for using the marketplace, Amazon’s average gross margin is about 23 percent. That means it stands to get a lot more cash per transaction from sourcing, storing, and selling items itself than by handing that off to third parties. Sure, it has all that overhead to pay for – it’s not cheap hiring buyers to source products – but when the teams are all ready in place (say, a toy buying group), you can leverage their operating efficiency. You can get more output from your overhead by folding more products, like pillow pets, into their selling mix. They can handle it. 

But what about the inventory risk? Well, there’s not too much risk in sourcing and selling pillow pets when you’ve been able to watch how supply and demand play out by peaking into the performance of your third party partners. 

What Sellers Are Safe from Distintermediation? 

Amazon is striking a delicate balance here. It does want to grow its third party seller business. It’s the most efficient way to extend down that long tail of the demand curve; offering wider selection without taking the inventory risk in doing so. 

But there’s more money to made working back toward the product originators on the seller continuum. The gross margins from direct sales are better than the commissions from third party sales. 

It will be interesting to watch how Amazon manages the natural tension that exists between the desire for wider selection and the urge to get rid of the middleman and earn more profits. 

After my post on the WSJ article, I got an interesting call from an Amazon third party seller. We bandied about thoughts about what sellers might be safe from Amazon stealing their business as it did to the pillow pets guy. How can you make sure you don’t get labeled a middleman? Here are a few of the conclusions we reached. 

First, operate in a low-demand product line with low margins. Amazon has only so many resources to put into its growth. It must prioritize, and so it goes for the biggest bang for its buck. It wants items that move quickly off its shelves and create cash from customers before Amazon has to pay the bill to the originator. 

To be able to operate a low-demand, low-margin business, you must be doing something right. Third party sellers who can do this likely have some edge that is hard for Amazon to disintermediate. They’re probably safe. 

Second, operate in products outside the scope of Amazon’s current in-house merchant operations. If Amazon has a store through which it sources and sells inventory directly, the infrastructure is in place for it to expand that in-house merchandise selection. I’ll bet top dollar that Amazon consistently trolls its third party seller data to see what low hanging fruit is ripe for plucking; what items show enough demand and enough margin for Amazon to take it internal. 

Third, sell products to which you have some sort of protected access to the originator; products that Amazon can’t easily procure. When Amazon can step in between you and your supplier, it will. If you have your supplier locked-up with exclusivity, because of material scarcity, or some form of business arrangement, Amazon won’t be able to disintermediate you by going directly to the source. 

Finally, sell products that require a high level of expertise and sophistication to merchandise them effectively. For most product categories, Amazon wants to apply technology to interpret the demand and satisfy it with the right supply at the right price. If the economics of your market make for high volatility in supply and demand that a computer can’t easily identify and programmatically address (in other words, it requires human skill and intelligence), Amazon is unlikely to operate very well in this market. Amazon likes markets in which it can fix problems with technology solutions rather than people expertise. 

If You Have Stories to Share 

The stories from the third party seller trenches are fascinating in and of themselves and illuminating of Amazon’s approach to growing its business. If you have good information to share, I’d love to hear it. You can contact me at pauldryden@gmail.com. I will always honor confidentiality and will not share information that you want to withhold from readers of this web site.

Selection, Demand and Amazon’s Long Tail

The Long Tail 

Chris Anderson of Wired.com popularized this metaphor with a thought-provoking piece in 2004, The Long Tail. He followed it up in 2006 with a well-received business book of the same name. Both are worth reading. 

(We introduced the idea in the last article, Walmart’s Selection and Long Tails.)  

The key points are these: 

1. Store-based retailers fall victim to what Chris calls the “tyranny of physical space.” They are limited by real estate location and a finite amount of shelf space. As he puts it: 

An average record store [for the young readers, this breed went extinct about two months after Chris wrote his article] needs to sell at least two copies of a CD [likewise extinct] per year to make it worth carrying; that’s the rent for a half inch of shelf space…retailers will carry only content that can generate sufficient demand to earn its keep. But each can pull only from a limited local population – perhaps a 10-mile radius for a typical movie theater, less than that for a music and bookstore…

2. Web-based stores, by contrast, are “demand aggregators.” They don’t have that 10-mile radius limitation for drawing shoppers. When you pull from a national (or international) market of customers, you effectively pull together all potential buyers for a particular product or piece of content. 

3. Although it’s fractured into tiny individual sales, there is still tremendous demand for products even as you push into the narrowing part of the long tail. Chris uses the following example, pitting Barnes & Noble against Amazon in a story with which we’ve all become very familiar: 

The average Barnes & Noble carries 130,000 titles. Yet more than half of Amazon’s book sales come from outside its top 130,000 titles. Consider the implications if the Amazon statistics are any guide, the market of books that are not even sold in the average book store is larger than the market for those that are…the biggest money is in the smallest sales.

That long tail demand – fractured as it may be – makes for a good business opportunity for web retailers. Their lower operating costs allow them to turn a profit offering products in lower demand that consumers won’t find in a traditional store. 

The Long Tail in Perspective 

Retailers attempt to match their selection to the demands of their customers. Despite all the statistics and MBA-level analytics at their disposal, the process of picking a store’s assortment is as much an art as it is a science. There remains a vibrant market for hiring retail buyers that possess that mystical merchant touch; those employees able to divine the desires of shoppers and put together the right mix of assortment to pry open their wallets. 

Walmart has dedicated itself to being the one-stop shopping destination by offering the widest array of merchandise of any traditional retailer. Its supercenters stock, on average, about 150,000 unique items meant to draw customers that want to consolidate their weekly shopping excursion from multiple store visits to just one. They know that Walmart will have the vast, vast majority of what they want to buy. 

And when compared to Costco, for example, Walmart satisfies that goal. Costco offers somewhere in the ballpark of 4,000 items per store. It clings tightly to the narrow-selection, high-demand portion of the curve. 

4,000 to 150,000 is a big difference, and that delta brings a lot more customers through Walmart’s doors than Costco’s. Walmart’s wide selection makes up for Costco’s lower per-unit prices and earns the retail giant a much larger chunk of that broad middle of the shopping market. 

But that difference in selection is dwarfed when you introduce Amazon into the mix. I haven’t been able to track down a good source for the number of items Amazon offers in total, but I’ve pieced together some thumbnails to come up with what I believe to be a very conservative guess…two million. (If any readers have a better number they can provide from a trustworthy source, please share!) 

I think Walmart would love to offer much more than 150,000 items. It is committed to being the one-stop shopping destination, but it must balance that with remaining realistic about the limits of its economic model. It is constrained by, to borrow Chris’ term again, the tyranny of physical space. If something cannot sell quickly enough, Walmart simply cannot justify renting out its shelf space to that product. And its potential customer market for selling that product is limited to (I’m guessing here) a 25-mile radius around its supercenter. 

Even though Walmart dominates the selection game for store-based retailers, its 150,000 SKUs can’t hold a candle to what Amazon is able to do. Not only does Amazon aggregate demand by providing access to any couch-surfing shopper with a tablet on his lap, but it also has significantly lower operating costs in offering those products. You can run build and run a fulfillment center at a much lower cost per item sold than that required to operate an extensive network of retail stores. 

The Best Place to Buy, Find and Discover any Product 

The economics of Amazon’s model allow it to move aggressively down that long tail curve; to build its selection to meet the most niche demand; to realize the potential that all those individual low-demand transactions – when aggregated – amount to a lot of sales…for the company whose economic model allows them to chase after it. 

Amazon has not been shy about stating its intentions on the selection front. Amazon has stated loud and clear for many years that: “The Company’s objective is to become the best place to buy, find, and discover any product or service available.” (From it's 1998 10-K filing.)

Amazon’s Inflection Point and Lessons from Brer Rabbit

To close out our discussion of Amazon’s convenience infrastructure, we turn now to current events and consider how collecting sales tax might be the biggest boon to Amazon’s retail business, a body blow to the stores, and the end of the convenience barrier. 

Of Inflection Points 

Andy Grove’s excellent 1996 memoir, Only the Paranoid Survive, injected the term “strategic inflection point” into popular business parlance. The former leader of chip maker Intel recounts the crossroads in his company’s history where the decisions he made led to momentous, industry-altering outcomes. 

For example, since its founding, Intel had made its name by packing more space onto smaller wafers of silicone in the memory chip business. It did very well in this market until Japanese companies killed them on price and quality in the early-1980’s. They were at an inflection point. Market circumstances had changed. The dynamics of the industry had changed, and Intel simply could not compete. The company was hemorrhaging money and needed a different strategy. 

Groves led his teams to the difficult conclusion that they must get out of the memory chip business altogether. They threw themselves into becoming the leader of microchip processing technology. As the history books tell us, these decisions forever changed the trajectory of Intel as a company as well as that of the entire computer industry. 

Such inflection points are hard to identify in the real-time fog of battle. When looking backwards, however, the events stick out; the specific decisions define the future of the organizations involved. 

But every once in a while the variables line up in such a way that the outcomes seem all but inevitable. We’re now at one of those times with the retail industry…an inflection point that’s sure to force a dramatic shift in market share balance from shopping centers to online stores. 

The Sales Tax Inflection Point 

We’ve discussed in some detail the concept of the convenience barrier, that human desire for immediate gratification that keeps shoppers heading for the stores rather than buying more of our stuff online. For so much of what we buy, we simply don’t have the patience to wait a few days for our favorite web-based sellers to deliver the goods to our doorsteps. We endure the hassle of regular shopping for the pay-off of trotting out of the store with our purchases in hand. 

But the convenience barrier is not as fixed a defense as retailers like Walmart have long assumed. By continually compressing the time it takes to deliver its packages, Amazon has demonstrated a certain gratification continuum whereby any improvement in delivery time leads to more consumers opting for the online option over the tedious experience of heading out to the stores. 

The more Amazon compresses that delivery time, the more shoppers it attracts. That’s why the company invests so heavily in the delivery portion of its convenience infrastructure. By building more warehouses (and improving the efficiency of those facilities), Amazon gets closer to you – its customer – and reduces the lag time between your 1-Click purchase and that package being dropped on your front porch. Those investments to enhance customer convenience are whittling away at the convenience barrier, earning Amazon the business of more consumers in the broad middle and stealing customers from traditional retailers. 

Despite the tremendous growth these investments have wrought over the years, Amazon can do more. The convenience barrier has not yet been breached. It is holding together – albeit tenuously – by the lag between getting your stuff today at Walmart and having to wait an average of two business days when buying on Amazon. The company can do more both in terms of improving delivery speed and in taking more market share. 

What’s holding it back? Oddly enough, it’s tug-o-war with various states over whether Amazon should be compelled to collect sales tax on behalf of its customers. Amazon has long argued, with a zealot’s fervor, that a 1992 Supreme Court ruling prevents any government from forcing a business with no physical presence in the state (like a warehouse) to tag a sales tax levy onto purchases made by residents. It’s the responsibility of the shopper to tax himself, self-report it to his local department of revenue, and cut the government a check every quarter of so. Not surprisingly, only the most earnest of Boy Scouts ever follow the rules. 

Amazon has enjoyed this loophole exemption since its founding, and it has used the five, six, seven percent “rebate” as a pricing advantage over store-based retailers. This has long infuriated the stores, and they’ve lobbied the states and Congress to change the law. Amazon has fought those attempts. But with budgets in such perilous condition these past few years, states have upped the ante. They’ve been pressuring Amazon in every way imaginable to start contributing to the coffers. 

And Amazon has begun capitulating, negotiating agreements with various governments to start collecting in return for incentives to build fulfillment centers and create new jobs. In the meantime, Amazon lobbyists are walking the halls of Congress, pressing for a national, uniform sales tax. 

Herein lies the sales tax inflection point. Amazon wants to build those fulfillment centers. As we discussed previously, it takes the warehouses from rural areas (cheaper land, cheaper labor) and puts them right against the perimeters of the largest U.S metropolitan markets. Los Angeles, San Francisco are likely to join New York City, Philadelphia, Chicago, Boston, Phoenix, and others as cities in which Amazon offers same-day Local Express Delivery. 

By paying sales tax, Amazon can operate freely in states with lots of paying customers. It will be able to build many more fulfillment centers in close proximity to those customers and work hard to improve its delivery speeds. Sure, the total price of its goods will go up, but the company seems confident it can weather that problem. (Indeed, it’s not hard to imagine Amazon suffering lower margins for a time in order to minimize the impact of sales tax on its prices.) Because ultimately, these fulfillment centers will put Amazon within striking distance of achieving nirvana for web retail convenience: delivering a product to customers as quickly as they could get in the car, drive to the store, and buy it themselves. 

The sales tax inflection point doesn’t require Amazon to reach the nirvana state. The convenience barrier is breached, I believe, when a critical mass of consumers can get their orders delivered overnight. 

Brer Rabbit Begs, “Please! Not the Briar Patch!” 

The great irony with the sales tax is how hard the traditional retailers are lobbying Congress and state legislatures to bring Amazon to account. They see it as a matter of price, not of convenience. They believe Amazon will finally lose its pricing edge and hardly worry what it means in terms of Amazon taking full advantage to provide faster delivery and better convenience. 

They seen an opportunity inflict pain on their web-based foes, and they’re blind to the unintended consequences of their campaign. In particular, they’re blind to what it means for their own best competitive advantage, the convenience barrier. 

I’m reminded of the Uncle Remus story of Brer Fox and Brer Rabbit. Fox was keen on catching rabbit and teaching him a fatal lesson for outwitting him one too many times. Fox concocted an elaborate ruse involving a tar baby, and managed to snare Rabbit in the trap. Once caught, Rabbit begged for mercy: 

“Drown me! Roast me! Hang me! Do whatever you please," said Brer Rabbit. "Only please, Brer Fox, please don't throw me into the briar patch." 

Fox, imagining his enemy being torn to pieces, tossed Rabbit into the thorns with the bitterest contempt, and cocked his ear to listen for the sounds of anguish. 

He heard nothing. 

Then Brer Fox heard someone calling his name. He turned around and looked up the hill. Brer Rabbit was sitting on a log combing the tar out of his fur with a wood chip and looking smug. 

"I was bred and born in the briar patch, Brer Fox," he called. "Born and bred in the briar patch." 

And Brer Rabbit skipped away as merry as a cricket while Brer Fox ground his teeth in rage and went home.

The Difference in Scale: More Amazon v. Walmart

This is the third post in a series about deconstructing Amazon's Feedback Loop, an attempt to understand how its components work both as individual units and together as a collective system. See the previous posts, Convenience (and Diaper Stench): Amazon v. Walmart and All Convenience Infrastructures Not Created Equal. 

The Feedback Loop is about pressing those levers (price, selection, convenience) for the purpose of earning the patronage of millions of shoppers that comprise the broad middle. It’s about driving growth. 

Here’s the big difference between being a web retailer as opposed to a traditional one; an Amazon versus a Walmart: 

To become more convenient and attract more shoppers, Walmart must build ever more stores. It must go where the customer is. Proximity between seller and buyer is a function of how far a shopper must drive to reach a supercenter. 

To become more convenient and attract more shoppers, Amazon benefits from more consumers being connected to the internet with each passing day. Proximity between seller and buyer is a function of how many steps a shopper must take between his seat on the couch and the nearest web-enabled device. 

The same forces that bring more people onto the internet every day bring those people to Amazon. It must simply be prepared for their business.

Scalability and the Check-Out Scenario

Those are the starkest of contrasts when considering the factors that drive convenience in the physical world versus the digital realm. And while differences in cost are big, the implications for scaling – increasing sales faster than infrastructure – are staggering. 

Consider the programming logic that turns the gears behind Amazon’s 1-Click check-out process. While that code base was enormously expensive to develop, requiring high-salaried programmers to build it, test it, and improve it over months of iterated effort, it now sits on an Amazon server. It may require occasional maintenance tweaks, but by and large that digital instruction manual can facilitate millions of check-outs each day about as easily as it can conduct just one. 

More importantly, that code can facilitate thousands upon thousands of check-outs simultaneously without slowing down the flow of commerce, the speed of transactions, or the convenience of quick turnarounds for shoppers. 

That is ultimate scalability. The kind you get when you depend on a convenience infrastructure built on technology. 

To keep picking on Walmart, let’s consider the contrast of store-based retail scalability. Its cashiers are cheap on an individual basis. Each is paid a piddling hourly wage, but each can only facilitate the check-out of one customer at a time. 

If it wants to be able to check-out 100 shoppers at the same store simultaneously, it must have 100 different check-out aisles with 100 different cashiers working 100 different cash registers at the same time. Since that’s impractical, it permits long lines to form at each register during peak hours, thereby reducing its convenience to customers. 

Scaling its convenience infrastructure is – for Walmart and its ilk – always constrained by physical world limitations. In the physical world it’s difficult to scale many of your convenience factors too far beyond that one-to-one ratio (like one cashier to one shopper). In the digital realm, scaling seems nearer to one-to-infinity (theoretically at least) than that one-to-one ratio.

The 1:1 Ratio Rears Its Head Again

Consider this other constraint of store-based retailing… 

In 2010 Walmart added about 1,400 stores to its existing world-wide base of 10,000 (give or take a few). All that additional real estate – those stores that brought Walmart closer to more shoppers – funded a nearly ten percent increase in revenue, taking the business to $447 billion in sales. If we assume each new store cost, on average, somewhere around $10 million (to build, equip and stock each), it means Walmart invested $14 billion in the main component of its convenience infrastructure. 

So, to increase revenue ten percent, it invested $14 billion and grew its number of physical locations by about 14 percent. This suggests something pretty close to a one-to-one relationship between opening new stores and growing revenue.* And while that ratio is not a precise formula for Walmart’s growth, it does highlight the natural constraints that exist for growing your business under the rules of a physical world: you have to invest significant cash to build more stores to access more customers and (finally) to grow your revenue. 

This puts to a cap on how quickly Walmart can grow because everything is governed both by how much cash it has to plow back into its convenience infrastructure and how many new stores it can possibly open in a 365-day span of time. 

It’s almost like a gravitational pull that keeps its ability to scale in check, making it difficult for traditional retailers to get much beyond that one-to-one ratio of having to increase its base of stores by (for example) ten percent in order to increase its revenue by about the same amount.

Walmart’s Rate of Growth Anchor

Those physical world limitations create an anchor on rate of growth as the base of legacy stores (those that have been open for more than a year) gets bigger and bigger. 

Let’s consider that 1,400 new store openings push the upper limit of what Walmart (or any retailer for that matter) could do in a given year. That’s a lot of construction, requiring a lot of resources in the way of cash, management attention, and use of supply chain bandwidth. They could probably do more (in fact, I believe they have done more in previous years), but I doubt they could do considerably more on a sustained basis. 

When calculating rate of growth (a percentage), new stores are the numerator and the base of legacy stores is the denominator. If 1,400 is the max new stores in a given year, the numerator is pretty much a fixed number. But the denominator grows larger with each passing year. Those 10,000 or so from 2010 become 11,400 after 2011, 12,800 after 2012, 14,200 after 2013 and so on. So, for each of those years, 1,400 divided by the growing legacy base gives us a smaller percentage (14 percent drops to 12.3 percent then 11 percent then 9.9 percent, etc.) as time passes. 

The rate of growth slows. The ability to get to ever more customers is bounded by the constraint of only being able to open so many new stores in a given year. 

Now this is mostly theorizing. I’ll grant that the numbers are likely a decent-sized understatement of reality. Walmart can probably open more than 1,400 stores a year if it wanted to. But not a dramatically higher number. So the general rule stands true: the base of existing stores creates an anchor on rate of growth. It will slow as the legacy base gets bigger. Trees can’t grow to the sky. 

Conclusion and Segue to Convenience Barriers

The point is that Walmart operates in a world of limits, and while we can quibble about the exact numbers, the facts remain that the limits approximate (at least roughly) 1.) that one-to-one ratio for new stores to revenue, and 2.) the rate of growth slowing with a fixed numerator being anchored down by an expanding denominator. 

Web retailers don’t have that same challenge. Investing in technology – those pieces of code whose logic churn across millions of server processors to transact millions of transactions – is much less expensive and much more scalable. 

Over the long haul, this scale difference has a compounding effect. Much like the difference of a few (seemingly) small interest rate points for savings accounts may not amount to much over a few years’ time, the difference is amplified to dramatic proportions as time marches on and the effects of compounding take hold. 

Amazon’s advantage of lower convenience infrastructure expense and better scalability means it can take those savings and invest them in making up for any deficiencies it might have in the competitive struggle with traditional retailers. 

And Amazon has been very disciplined in making these investments both in the other growth levers (lower prices and wider selection) and also in attacking the bulwark of the best convenience defense store-based retailers retain against web competitors; namely, the ability to satisfy customers’ desire for immediate gratification, that ability to walk out of a store with purchase in hand. 

That’s the convenience barrier, and Amazon’s has been whittling away at it over the years. 

* Note that this is the roughest of calculations on several fronts, the most important of which is that Walmart’s revenue growth does not only come from new store sales. In most years, the lion’s share of growth comes from selling more through its existing base of stores (a better scaling proposition because they don’t have to invest much more in the existing stores to drive more sales volume through them). However, given how anemic same store sales growth was in fiscal years 2010 and 2011, it’s fair to conclude that new stores were responsible for most of its added revenue. 

The bigger point is, however, that there exists some sort of gravitational pull – governed by the natural constraints of a physical world – that pulls store-based retailers back toward that 1:1 limitation on scale. Even if they do better than 1:1 for some time (say a ten percent increase in number of stores increases revenue 50 percent), gravity will pull down that ratio over the long haul. 

All Convenience Infrastructures Not Created Equal

This is the second post in a series about deconstructing Amazon's Feedback Loop, an attempt to understand how its components work both as individual units and together as a collective system. See also the previous post, Convenience (and Diaper Stench): Amazon v. Walmart.

All retailers must invest in a convenience infrastructure, plowing cash into those components of their businesses that make it easier for consumers to shop with them. 

But not all convenience infrastructures are created equal. 

For traditional retailers like Walmart, that infrastructure is composed overwhelmingly of stores. And to enhance the convenience it offers customers it must build more and more stores plus staff them, stock them, and maintain them to some reasonable aesthetic and hygienic standard. While this has been a lucrative business for Walmart investors over the years, having an infrastructure rooted in real estate – an inflating asset whose costs increase over time – is pricey. Especially when compared to the alternative. 

For web-based retailers like Amazon, convenience is a much different proposition. It’s driven by technology (software, hardware, internet connectivity, etc.) and the speed with which it can deliver packages to shoppers. 

To build on our Amazon Feedback Loop schematic, here’s the convenience infrastructure addition: 

With such a chunk of its convenience being based on technology, Amazon has a tremendous cost advantage over retailers that are forced to plow so much cash into real estate in order to grow. As we’ll discuss in this article, a convenience infrastructure that depends on technology investment is inherently less expensive and much, much more scalable. 

Convenience through Technology 

We outlined in the previous article how web retailers (and Amazon specifically) use technology to enhance the convenience of their services to shoppers. In my close call with being overwhelmed by diaper stench, I needed bin liners quickly to stave wafting odors from my daughter’s nursery. Amazon made the process of buying them convenient, using technology to: 

1. Provide quick ACCESS to Amazon’s website through various internet-enabled devices. 

I just grabbed the Kindle Fire, pressed the “on” button, slid the Android hibernate bar across the screen, and clicked on the Amazon shopping app icon. This all took about three seconds. 

Amazon could just as easily (and almost as quickly) grant me access through my laptop, iTouch, smartphone, and a host of other devices that connect to the web. Therein lies its commitment to providing the easiest access to its products by taking advantage of any one of the host of rapidly proliferating devices that connect to an ever-faster moving internet. 

A few years ago, the only option would be booting up a computer, clicking on a browser, and typing in the Amazon URL. Which is pretty fast, too, but Amazon wants access to its shopping experience to move as quickly as the fastest device available. And it has spent years investing in that convenience factor. 

To that point, Amazon’s commitment to providing access through a wide variety of internet-connected devices is nothing new. Anyone remember the Palm VII? (Um, for that matter, I should ask whether anyone even remembers Palm now.) It was a digital handheld organizer, a clunk of gray plastic – in terms of design aesthetic, decidedly unsexy – with Palm’s calendar and contact features. This particular model happened to have a flimsy antenna that, when flipped upright, provided spotty mobile access to the web using an even spottier browser. Well, way back in 1999, Amazon was stretching its innovation muscles with a service called “Amazon Anywhere.” (You can read the Amazon press release about it here.) You could actually log-on to Amazon and place a mobile order more than thirteen years ago! 

Amazon has long been prepared for this concept of shopping its stores using apps on mobile devices. 

2. Quickly SEARCH Amazon’s wide catalog for the specific product I needed. 

I knew I needed those specific diaper bin liners, and all I had to do was type the brand name into the search box and hit “Go.” Even with a product catalog that easily tops many millions of items, Amazon served back the option I wanted with sub-second speed. 

One might assume that whether the search results come back in one second or a half-second wouldn’t affect the shopping experience too much either way. Amazon disagrees. The company has invested countless resources organizing its catalog, streamlining its databases, and increasing its server processing power for the sole purpose of shaving milliseconds off your search. It deems search speed that important a convenience factor. 

In 2004, Amazon showed the world how serious it was about investing in heavy duty search capabilities. It took all the algorithms it had built for searching on its site, and offered a service for searching the full web. A9, as it was called, was among Amazon’s first attempts to spin-out its internal innovations for use by wider audiences. It wanted to test whether that market so dominated by Google and Yahoo! was open to an alternative. It wasn’t successful outside of Amazon, but those investments continue to reap benefits by enhancing the convenience factor for customers searching for products on Amazon.com. (You can read more about the A9 launch here.)  

3. CHECK-OUT quickly and easily. 

When Amazon sent my Kindle Fire several months ago, the company did me the favor of pre-connecting it to my account. I take it this adds layers of complexity to the various steps of prepping and shipping each of these devices to customers. And while I won’t suggest Amazon is benevolent for choosing to do this, it sure made my life easier. More importantly for them, it reduced the likelihood that I (or any Kindle Fire buyer) would be too lazy (or so lacking in technical skill) to make that connection myself. 

In buying those liners, it made the check-out process quick and easy. Once the product was in my cart, I had maybe two additional clicks until the transaction was complete. No delays, no extra steps, and therefore fewer chances for me to change my mind. 

That’s present day e-commerce shopping. Let your mind wander back nearly 20 years to the dawn of web retailing. While internet usage was famously growing at the breakneck annualized rate of 2300 percent, it was far from clear that it would be a medium consumers would trust for shopping. At that point, shoppers guarded their credit cards as if they were cash. I remember traditional stores often required an ID for a credit card purchase, verifying the identity of the buyer each time out of fear of penalty from Visa or American Express if fraud occurred on its watch. This paranoia with person-to-person transactions was amplified when making a catalog purchase over the phone. It was not at all clear that consumers or card issuers were going to be comfortable with the risk of punching their credit information into a keyboard, transmitting them across a dial-up modem into the great unknown of the internet. 

What nefarious agents might be lurking in the web’s shadows, eager and ready to nab your credit card digits and run up a big bill on your tab? 

In this brave new world, Amazon managed to convince shoppers to store their credit information on its servers, to link it to their usernames, and to keep a shipping address on file. Amazon called it the “1-Click” process, launching it in 1997 and patenting it in 1999. (Reference Amazon's press release about it here.) All so Amazon could help them check out more quickly, thereby increasing the convenience factor and losing fewer sales to the dreaded abandoned cart. 

How Moore’s Law Makes Amazon More Convenient for Less Money 

Despite all these investments in technology improvements to make the shopping experience more convenient, the very nature of technology as a driver of convenience (and hence a driver of growth) makes the process of growing much, much less expensive. 

Convenience is different for web retailers than it is for traditional stores. As we’ve discussed, stores rely so heavily on location to customers as their primary means of being “convenient.” Real estate is inherently expensive, its price tag tends to expand with time, and each new store brings with it the need to constantly stock it, staff it, and maintain it. 

Not so on the internet. 

For web retailers, convenience is more a matter of the factors we explored above. How quick and how easy it is to access the web store? How quick and how easy is it to search for the product the shopper wants? And how quick and how easy is it to check-out? 

Each of those is a function of technology, and herein lies an advantage for web-retailers over those operating out of stores. While traditional retailers are pouring cash into real estate as they push the convenience growth lever and seek more shoppers, web-retailers are enhancing their convenience factors by investing in technology. 

To that point, Jeff Bezos sat down with Charlie Rose in 2001 and had this insight to share: (You can watch the interview here.) 

One of the things that’s totally different about e-commerce from physical world commerce is that real estate doesn’t obey Moore’s Law. Moore’s Law says that microprocessor performance doubles for the same price point every 18 months. That’s held true for more than a decade. What you’re finding now is disk space is getting twice as cheap every 12 months. And bandwidth is getting twice as cheap every nine months. So if you take the bandwidth doubling rate of nine months and assume it holds constant for the next five years, that means that we can spend the same amount of money on bandwidth per customer that we spend today five years from now but use 60 times as much bandwidth. That’s a big deal!* 

As microprocessor speed doubles every 18 months, it powers the Amazon technology for even easier product searches and faster check-outs. As disk space is getting twice as cheap every 12 months, Amazon can provide more rich content supporting its products and still help customers search through all the information quickly. And as bandwidth is getting twice as cheap every nine months, Amazon is ensured that more customers get online and get easy access to its website. No matter if they’re at home, work, or out about, the internet is nearly ubiquitous and fewer shoppers are ever without some sort of device that connects them to the web. 

To harness technology, Amazon must invest in software developers, database designers, system architects, and the like. These professionals are expensive. But the work they do is scalable. A single piece of well-written code can perform its function for all of Amazon’s 200 million customers with the same amount of effort and investment as it could to do the same thing for one customer. That makes the first customer very expensive to Amazon, but the additional 199 million quite cheap. 

Contrast that to traditional retailers. While Walmart’s hourly workers at each store might be inexpensive on an individual basis, the company requires a lot of them in order to serve customers. And a single worker can only help so many customers in any given period of time. Unlike that piece of code sitting on an Amazon server, that worker is decidedly un-scalable. 

It’s a big deal, indeed, when an asset that helps drive growth depreciates in cost over time (technology) rather than appreciates (real estate). To reach more customers, retailers like Walmart must constantly build new stores. The cost of which only grows over time. For Amazon to reach more customers, it must only make sure the bandwidth is sufficient, server processor speeds fast enough, and disk storage space deep enough to handle the exchange of data. That particular cost of growth is significantly lower for a web-based retailer. 

But Wait, Says Walmart, We Have an Ace up Our Sleeve…the Convenience Barrier 

In my experience shopping for diaper-bin liners, I mentioned one convenience advantage that Walmart held over Amazon: If I wanted those liners immediately, if I couldn’t postpone the gratification of holding my new purchase in my hands immediately, then Walmart would have won my business. 

This is the convenience barrier, and it has been the most important piece of protection the traditional retailers have had to keep Amazon and its ilk at bay. The need for immediate gratification – to get what you want now versus waiting three to five business days – is a big deal to shoppers. 

Amazon, however, has counted delivery time as part of its convenience infrastructure, investing heavily in it over the past several years. In the next article we’ll discuss how these investments have whittled away at Walmart’s convenience barrier advantage and what that might mean for the future of both companies. 

* For an interesting read on Moore’s Law, see the article Was Moore’s Law Inevitable? 

Bringing It All Back to Amazon: Summary and What’s Coming

This is the seventh 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; Unlocking the Broad Middle (Hint: Price Is the Key); Sam Walton, Panties and Power Laws; The Productivity Loop (Walmart's Feedback Loop); Why Is Price the Ultimate Competitive Advantage? (Playing Games); and Sophie the Giraffe and the Productivity Loop.

Amazon's Feedback Loop

After six entries in this series, and spreading it out over two weeks, we're finally getting back to Amazon and its feedback loop. I hope you’ve muddled through all this build-up. 

Here’s the quick version of what we’ve covered so far: 

The three variables most important to a retailer’s growth are prices (the lower the better), selection (the wider the better) and convenience (make it easy for the customer to buy your stuff). There are other variables of course, but these three – dubbed the Growth Levers – earn you access to the Broad Middle of the market…that portion with the most customers. By reaching the broad middle, you get high growth. 

The key that gains you entry to the best growth in the broad middle is low price. Sam Walton discovered a power law relationship between lowering prices and increasing sales, the more you lower them the higher your sales volume goes. And it’s not a 1:1 type relationship; Walton found that it was more like 1:3. So Walmart built its business on this premise, even instituting the productivity loop as a way to keep costs down so it could pass those savings on to customers in the form of lower prices. Those lower prices complete the productivity loop by driving an even higher volume of sales. 

Finally, we delved ever so lightly into game theory, putting together a scenario to test former Walmart CEO David Glass’ statement: 

We want everybody to be selling the same stuff, and we want to compete on a price basis, and they will go broke five percent before we will. 

We constructed the Price-Cost Matrix and tested how each quadrant would fare against the others. Our simple logic led to the equally simple conclusion…Low Cost, Low Price is the best competitive advantage because it will win the price wars. For the fanatic willing to lower prices over and over and over again, he will win as long as his cost structure is the lowest, too. The other competitors will go broke five percent before he does. 

And now (FINALLY!) we’re back to Amazon… 

It's all too obvious that Jeff Bezos spent plenty of time internalizing the lessons of Walmart's success, most importantly that low prices strike a chord with consumers. The lower your price, the more your sales grow...in exponential fashion. 

Bezos would also recognize that the right combination of investment in the growth levers would deliver the astute retailer to the broad middle of the consumer market. That fattest portion of the bell curve distribution. That area that offers the greatest potential for growth. 

And Bezos is nothing if not ambitious. Growth is what he wanted from the outset. And he did not face the same limitations as Sam Walton and other retailers in the physical world of selling goods out of storefronts. That need to balance your investments with the bulk going into real estate (location, location, location). Location was far less important when selling goods over the web. Shoppers could access your store from any computer, and you could ship products from any warehouse location. The merchandise would get to the customers all the same. 

The web - theoretically at least - would allow a retailer to push all the growth levers simultaneously. Moreover, the web could allow a SINGLE web-based retailer the ability to offer the lowest prices, the widest selection, and be the most convenient place to shop online. The implications of that are huge (and I believe Bezos understood this intuitively): if Amazon could push all three growth levers further than anyone else, it had the potential to dominate. It could be the sole place shoppers would go when ordering something (anything!) online. It could be so dominant, shoppers would never bother trying other sites at all. It had, in short, the potential to be UBIQUITOUS. 

In the early days of web retail, a time marked by vicious competition in pursuit of staking a claim to various niches on the internet, the real constraint to any player looking to grow was cash. But with the right amount of cash and the right approach to pushing the growth levers, a single web retailer could emerge as the sole winner. It could be so big, develop such an advantage based on the growth levers, that no other retailer could catch up. 

Of course the corollary of that was also true: any retailer with access to cash and this same vision could invest in the growth levers in pursuit of its own ubiquity dream. 

This was the hallmark of the web retailing in the earliest days. And this is what prompted Amazon's land rush approach to growth. But we'll get to that later. First, let's deconstruct the Amazon Feedback Loop and wrap our minds around what exactly it’s meant to convey. That’s next…

Why Is Price the Ultimate Competitive Advantage? (Playing Games)

This is the fifth 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; Unlocking the Broad Middle (Hint: Price Is the Key); Sam Walton, Panties and Power Laws; and The Productivity Loop (Walmart's Feedback Loop).

There are two forms of pricing power: the ability to raise prices and the ability to lower prices. 

The ability to raise prices for your offerings - demanding a premium over competitors’ products based on something you do better than they do - is an excellent indication that your business offers some form of competitive advantage. Otherwise you probably couldn’t charge a higher price. If you sell clothing, you must be appealing to some fashion sensibility. If you peddle electronic devices, your technology must satisfy some consumer desire for functionality, novelty, or style. 

Having the ability to charge high prices can be very nice. Of course you must ask WHY you can charge the high price and whether the cause is defensible and durable for the long-term, or whether it's fleeting and likely to dissipate with time. And, of course, most advantages do go away with time. New fashion designs get mimicked, and the public’s taste for a particular style is fickle. Innovation in technology may provide a lead over the peloton of competitors for a while, but it has a tendency to figure out your tricks, duplicate your product features, and draw you back into the pack over time. 

Most competitive advantages are decidedly NOT enduring. 

But when a company dedicates itself to offering the lowest prices (and maintaining a low cost structure to boot), it has a durable advantage that is very, very difficult to compete against. It is the ultimate competitive advantage, better than those that allow a business the ability to charge higher prices. 

Why? 

Consider this statement attributed to David Glass, the former Walmart CEO: 

We want everybody to be selling the same stuff, and we want to compete on a price basis, and they will go broke five percent before we will. *

To understand Glass’s point, we have to dabble a bit here in a rough (very rough) game theory scenario. (My apologies in advance to actual game theorists.) Let’s reduce the totality of competitive capitalism - that unrelenting tug-o-war among firms to gain the slightest of edge over rivals - to the following matrix (the Price-Cost Matrix) and assume that a company must fit into one of the squares. We’ll further assume that no company possesses an insurmountable competitive advantage over another. Any one company might stumble upon a popular fad that drives sales, or its engineers might cobble together a product whose innovation wows customers. But competitors will eventually figure out the advantage and replicate it. Again, the peloton sucks everyone back in. 

So, in this game, the only true differentiation, over the long-term, is price. Who can offer the lowest price?

Price-Cost Matrix

Your prices can either be high relative to competitors, or low. Same with your costs. So we get four possible combinations to define the companies: High Price, High Cost; Low Price, High Cost; High Price, Low Cost; and Low Price, Low Cost. 

Conventional wisdom says you want to be in the top left hand quadrant (High Price, Low Cost) with the power to raise prices. That’s where the fat profit margins reside, that exalted place where you have low costs to acquire or produce your products yet can sell them with a big markup. Everyone loves profits. In fact I’d go so far as to say most people are blinded in their business decisions by an overwhelming profitability bias. 

The problem with profits is that competitors notice them. Nothing grabs more attention than high profits. And they’ll want a piece of the action. They’ll enter your market and go after your customers. And in this game scenario of ours, they’ll woo your customers with the offer of a better price. You get sucked into a price war. 

The game theory part of this exercise (and this is ultimately David Glass’ point) is this: you must extend any business competition to its furthest – and even most absurd – logical conclusion. If it’s a price war, you must imagine which player can engage in battle the longest and prevail. 

So let’s imagine it from the perspective of the game’s predator: Low Price, Low Cost. He will source his merchandise at the lowest possible cost, he will maintain the lowest possible overhead, and he will work with evangelical zeal to uncover inventive ways to make both even lower. Then, he will turn around and put a frighteningly slim markup on his items. He offers everything at the lowest price he can muster, and he keeps his costs below those of everyone else. 

He is a fanatic, and he has an insatiable appetite for growth. How do players in the other quadrants fare in a price war against Low Price, Low Cost?

Low Price, Low Cost Starts a Price War

In our game, Low Price, Low Cost goes on the offensive. First, he attacks Low Price, High Cost. This skirmish is easy. Low Price, High Cost is a terrible business that’s stuck, for some reason, in the unenviable position of having to sell its products at a low price yet incapable of revising its cost structure. It’s limping along on tiny margins. All the predator must do is make his prices just a bit lower (enough that a price match would get rid of any remaining profits from Low Price, High Cost), and then wait it out as the wounded competitor goes out of business. It cannot afford to lower prices enough to compete, and so Low Price, Low Cost wins these customers. 

Next is High Price, High Costs. This battle would be easier than the first, expect that High Price, High Costs has some cash on its balance sheet (from earning decent margins over the years) and is foolhardy enough to spend it on the fight. The predator makes his price dramatically lower, the prey tries to match, but in the end it must relent. Its high cost structure means it cannot afford to offer low prices for long. Low Price, Low Cost wins these customers. 

Finally we have High Price, Low Cost. This is a long, drawn-out battle. High Price, Low Cost has plenty of cash to fight, having built deep reserves over the years from its fat profit margins. It price matches the predator, even ups the ante by lowering its own prices further and challenging the predator to match. It can afford this because its costs are so low. But over time its resolve is tested. It had grown used to that big margin (more importantly, its investors had grown accustomed to the profit). It tries to reinvent its culture to dedicate itself to low prices, too. Alas, cultures are very hard things to change. 

The competitors go back and forth on price, creating a war of attrition with both sides taking deep losses. But in the end, the predator remains fanatical about his cost structure. He lowers it more and more, and High Price, Low Cost just can’t keep up. It goes broke, perhaps just five percent before the predator would have. But that doesn’t matter in the end. At the end of the game, Low Price, Low Cost is the only player still standing. 

You may argue that this game is unrealistic. And, of course, it is. The practice of competition is much more nuanced than a hypothetical game. But history shows that, over time, the competitive advantages that protect businesses and allow them to earn high margins…well, they grow weaker as competition learns the secrets. In the long run, everything is commoditized. 

And in the light of this extreme game – one taken to its absurd logical conclusion - we can reconsider David Glass’ words: 

We want everybody to be selling the same stuff, and we want to compete on a price basis, and they will go broke five percent before we will. 

The companies that want the most enduring competitive advantage commit themselves to staying in the bottom left quadrant in the Price-Cost Matrix, as far below and to the left of the competition as they can. To do it, they muster a fanatical devotion to staying low price and low cost. More on that next…

* Quote from Charles Fishman's excellent The Wal-mart Effect.