December 27, 2009

I’ve been reviewing some of the things I learned this past semester in my MBA classes, and wanted to share some problems and other interesting information. I’ve tried to make it approachable, although hopefully not too dumbed-down that it’s become insulting.

When you look at grocery stores, you’ll notice food sellers make money by selling lots of their products at low profit margins. They may only make 2 or 3 cents per dollar in sales, but they’re able to sell a vast quantity of their products. Plus, it’s relatively cheap to operate a grocery store. It usually goes this way, or the opposite. If you are a cable TV provider, you have to invest heavily in assets–the physical cable network covering a city is extremely expensive, plus set top boxes, an army of individuals to service customers, etc. You’re unlikely to bring in a lot of revenue compared to the amount investment in assets you’ve made, but you’re also in a position where competitors are unlikely to challenge you. This lets you set prices well above the cost to actually operate your network, and gives you a high profit margin. And without competitors, you can take your time in paying off your infrastructure. This idea can also be extended to fashion items that are largely marked up, but come at a greater risk of the public not being interested in and simply not purchasing.

It’s unusual to find a company with both a high profit margin and a high sales to assets ratio, as competitors will see a market they can enter, lower prices, and (hopefully) outsell others. And you also rarely see a company low sales and a low profit margin…at least you rarely see one not headed towards bankruptcy.

Looking at grocery stores, it’s easy to see why a store like Wal-Mart causes trouble. They’re able to enter a market, and because they buy in such huge quantities, are able to negotiate lower prices than their local competitors. And if you’re only making 2 or 3 cents per dollar of sales to begin with, how do you compete with a huge store offering prices 10 or 25 cents under yours?

Wal-Mart is also able to take advantage of something many local stores aren’t able to: they’re able to sell below cost in order to attract customers, and make up the difference in other areas. Also, Wal-Mart is able to actually make money on items it sells below cost. They do this by taking possession of the merchandise and having it sold very quickly–often within a week. This is all done weeks before they have to actually pay for the goods. In that time, they’re able to invest the money they owe and see a higher return than the amount they discounted their product. For instance, say they buy $100 worth of Tide, and it for $98 within a week. The terms of purchase state they have to pay for that merchandise within 5 weeks, so over the next four weeks they invest that $98. They wind up with $102, and have managed to make money while selling at prices lower than their competitors could dream of selling. Admittedly, 4+% return over 4 weeks might be a little absurd. Wal-Mart probably couldn’t run their entire business this way, but it does illustrate a clever way they’re able to keep customers without giving their money away.

The question this leads me to, though, is whether Wal-Mart is justified in selling below cost, or in negotiating massive discounts from manufacturers. Local competitors without Wal-Mart’s resources will say no, but isn’t the company obligated to utilize its resources to maximize its return to stockholders? If Wal-Mart was losing money because it has raised its prices to match competitors, wouldn’t stockholder’s rightfully demand action? (Wal-Mart may have some legitimate claims against its employment practices, but I consider that outside the realm of this post.) Some states have also instituted laws prohibiting companies from selling below cost. Are states justified in involving themselves in pricing? Isn’t it a company’s right to set prices however they want, even if they’re losing money? Aren’t lower prices better for consumers? Wal-Mart isn’t going into an area with low prices, just to jack them up when competitors leave the market.

I’m curious to hear other people’s thoughts on this topic. The questions extend into other areas, such as a company’s rights and regulation. But I’m interested in everyone’s thoughts, from those with successful business careers to those without any formal business training.


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