“Blanks are killing the industry.” “Yeah, but they give the skater a good deal.” “But pros are what builds the industry, and we can’t support pros on blank margins.” “The problem is that we have too many pros to support.” Etc., etc., etc.
In this highly emotional debate, there’s some truth to everybody’s position. A lot of people seem to feel very strongly both ways from time to time, and it’s an unfortunate source of friction in the industry at a time when it would be nice if there could be a little more cooperation.
It’s a Numbers Thing
Once you get past the strong feelings and the concern for the industry that, hopefully, drives them the dilemma for people with skateboard factories comes down to the numbers. There are two basic business models skateboard factories (or any factory, for that matter) can follow that theoretically make sense. One is higher margin, lower volume. The other is lower margin, higher volume. For companies with factories and brand names, there’s also the internal tug of war between wanting to keep the factory running and maintaining the brand’s position in the market.
Let’s look at two factories- one owned by Dr. Jekyll and the other by Mr. Hyde- and see how the operating perspectives and financial circumstances of these theoretical businesses differ.
Dr. Jekyll doesn’t own a brand. Just a big old money eating factory that needs to be fed. Whether he makes a single deck or not, wages, insurance, utilities, telephone, interest, and a hoard of other expenses all have to be paid. He’ll make decks for anybody who can pay him his normal price.
Let’s say his overhead (the money he has to pay every month whether or not he makes a single deck) is $50,000. Notice that he doesn’t have to support a team or pay for any ads. He’s making twenty thousand decks a month and the materials and direct labor for each one is about nine dollars. He sells each of those decks to whoever is going to resell them for, say, fourteen dollars. Here’s how his monthly income statement looks
Revenue $280,000 (20,000 decks times 14 dollars each)
Cost of Goods Sold $180,000 (20,000 decks times 9 dollars materials and direct labor)
Gross Profit $100,000
Overhead Expense $ 50,000
Pretax Income $ 50,000
Great business. If I believed these numbers were real I’d dump consulting and writing and open my own skateboard factory, which is just what the industry needs.
Mr. Hyde has not only a factory, but also a successful skateboarding brand. It’s not that he wouldn’t accept some shop or blank or export orders, but just for the moment let’s assume he doesn’t need to.
His overhead is the same $50,000 a month as Dr. Jekyll. It costs him the same nine bucks to make a deck. But his deepest darkest secret, contrary to his advertising, is that his decks are fundamentally no different from those of his competitors. So he’s justifiably concerned with protecting his brand name, because the perception of that brand name is really the only competitive advantage he has.
He doesn’t want to flood the market with decks, because that would weaken his brand name. Let’s say he makes 10,000 decks a month.
Because the brand name demands a higher price, he can sell them to retailers for $30. Here’s his monthly income statement so far.
Revenue $300,000 (10,000 decks times $30 a deck)
Cost of Goods Sold $ 90,000
Gross Profit $ 210,000
Overhead Expense $ 50,000
So far, this is an even better business than Dr. Jekyll’s is. If the expenses stopped right here, Mr. Hyde would have a pretax profit of $160,000 compared to $50,000. I want to be in the business even worse than the first one.
But the expenses don’t stop here, so let’s keep going. There are going to be operating expenses other than overhead. He’s got more customers to deal with and more selling expenses. In additional to what I’ll call administrative selling expenses, there are the advertising and promotional expenses to support the brand; team, trade shows, stickers, advertisements, giveaway product, sponsorships, printed selling materials, the web site…. Quite a list.
Just for fun, let’s say that those costs total another $60,000 a month, bringing the pretax profit of Mr. Hyde’s business to $100,000. Without claiming that these models really represent existing reality in the skateboard manufacturing business, let’s see what we can learn from them.
By the Book
The textbooks say both of these business models- higher volume, lower margin and lower volume, higher margin- should be viable in the same industry at the same time.
The first, utilizing a price leadership strategy, makes money by spreading costs over a larger volume and eliminating most traditional selling expenses. If Dr. Jekyll can sell 10,000 decks a month, and assuming his overhead remains constant at $50,000, he breaks even that month. Every additional deck he sells in excess of 10,000 generates $5.00 (The selling price of $14 minus the direct costs of $9) that falls right to the bottom line. In our simplified model, he should be theoretically willing to accept any order (after 10,000 decks) that pays him more than $9 a deck. The factory is sitting there anyway with fixed overhead of $50,000 a month and if he sells a deck for $9.01 that’s an extra penny in his pocket.
Mr. Hyde’s breakeven point is 5,238 decks a month even though his expenses below the gross profit line are much higher than Dr. Jekyll’s. Shows you the power of a higher gross margin, and value of maintaining the market position of your brand doesn’t it?
Mr. Hyde has a factory to feed too and even with a successful brand, he isn’t immune to the thought that every deck he makes for more than $9.00 puts some money in his pocket once he’s past his breakeven point. He realizes of course, that he’s essentially competing against himself by making OEM decks and maybe hurting the market position of his own brand, but there’s that factory to feed
It seems at the end of the day that there’s a little Dr. Jekyll in Mr. Hyde.
The Real World
Putting the textbooks on microeconomics back on the shelf (maybe in the section marked “fantasy”), we rejoin Dr. Jekyll and Mr. Hyde in the real world.
You see, lots of other people saw those numbers in the textbook and thought they could have a business like that too. They started factories and brands. When potential customers come to see Dr. Jekyll, and he quotes them $12.00 a deck, they mention that down the street it’s only $11.50 a deck, or maybe that there’s some quantity discounts, or possibly some terms, or an extra deck thrown in for every ten you buy, or something. Well $11.50 isn’t that much different from $12.00 Dr. Jekyll reasons. He still gets a good gross margin. Of course, his break even just went up some decks, but that’s okay. He can accept a couple of shop orders he’d been turning away.
Could be that more than one customer asks for lower prices. Maybe he has to go even lower than $11.50. That breakeven volume of decks keeps going up, and the margin declines further. The lower margin means he has to invest more cash in the business. Getting more volume, from anybody who wants a deck, becomes his purpose in life.
A funny thing happens on the way to higher volume. At some point, he’s got to buy more equipment. Maybe he has to pay overtime wages to support the production volume. His beautiful business model has gotten ugly. Margin is down and overhead expense is up. What’s he supposed to do?
Maybe he can start a brand.
Back at Mr. Hyde’s place, he notices there are lots of new brands, and that it’s getting really cheap to get decks made in small quantities with or without graphics. Determined to defend his brand name and market position, he hires some more team riders, runs some more ads, or whatever. In spite of these efforts, his volume drops a little because there’s an awfully lot of product out there and it’s awfully alike. So his total gross profit is down because he’s now spreading his constant overhead over fewer decks. His expenses have increased because of the new advertising and promotional expenses.
He suddenly remembers the guys he threw out of the place because they wanted him to make OEM decks and scurries to try and find their business cards.
Dr. Jekyll and Mr. Hyde are both to be congratulated on the logical business decisions they have both made. How come things just keep getting worse? What can they do to fix this? Could it be that their existing business models don’t work under emerging competitive conditions and that focusing only on competing in the hard goods market for core (whatever that means) skaters isn’t the answer?
Tune in next issue for the continuing adventures of Dr. Jekyll and Mr. Hyde.
In practice, of course, a brand with a factory doesn’t just sell decks, and its costs aren’t just those associated with the decks. Margins also vary depending on whether or not sales are to distributors or direct to retailers. But I’m trying to make a point here, so give me a little leeway and let me keep it simple.
Tags: Competitive Strategy, Financial Management, Skate Industry