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Eventually, It All Boils Down to Cost

We should be grateful that accountants invented the concept of gross margin.

The simple formula — revenue minus cost divided by revenue — really becomes valuable once we get past the arithmetic and view it as the extra value seen by a customer over a product's manufacturing cost. This extra value can be a result of superior technology or service or lower costs of manufacturing from better business processes or procurement.

Customers determine price. Their buying decisions set the price and assess this value. However, shareholders set the gross margin. Those who buy or hold stocks bias a company’s valuation through a correlation with gross margin. Therefore with customers determining price and shareholders setting gross margin expectations, the supplier is left controlling the company's costs and its superior technology or service enhancement differentiation.

For a company to be successful in the long term, it must be the low-cost provider of the products or service in the market it chooses to be in. There are two reasons for this: The first is that companies need high gross margin dollars to fund the development of a differentiating technology or service. Second, technology and service differentiation is fleeting; sooner or later a company will find itself in a battle on price. It had better be ready with low costs when that day comes.

How does a company know if it is the low-cost producer, and, if it is not, how does it determine its gaps and leverage points for improving its cost position? Benchmarking is one good approach. Companies can benchmark their business processes and overheads as well as transformation and materials costs. If a company determines it is not the low-cost producer it must take steps to improve.

Another action that can be taken is to ensure that the company does not suffer unnecessary costs from poor security of supply, for instance, due to single-source issues or unexpected end-of-life surprises. When these unnecessary realities occur, overhead costs rise significantly.

The gross margin equation plays out every day, over and over again, as competitors enter the market with innovative new products that disrupt the status quo. The best companies keep tight control on costs in good and bad times and always know their value and competitive position.

7 comments on “Eventually, It All Boils Down to Cost

  1. Barbara Jorgensen
    November 22, 2010

    Hi Ken,

    Do you think that a suppliers' ability to measure their costs will help in determining the fair market value for their products or services? How effective are they in communicating this to customers? I agree with you–for customers, it's all about price–but it's also not in the customers' best interest to drive their suppliers out of business. I wonder how many supply chain decisions are based on cost, as opposed to price.

  2. Ken Bradley
    November 22, 2010

    Barbara,

    I think a supplier’s cost and price are somewhat independent. As such, being able to measure costs does not determine fair market value. Fair market value is determined by what the customer thinks the product is worth, not what it costs to build. I think customers should want to see suppliers with healthy margins that are earned through efficiency and effectiveness and it may be in everyone’s best interest to drive inefficient suppliers out of business. What customers need are prices that make their own gross margin equation work.

    Suppliers with healthy gross margins should be able to paint a compelling story as they have achieved this position through efficiency and investment in technology or service delivering differentiation. They probably have a great product roadmap, high quality, exceptional service and fair pricing. This is what customers want to hear.  Low margin (in their market space) suppliers probably don’t have much of a fact based story (start up and transforming companies excluded).

    Some customers try to make the price equation a cost plus one by trying to model the supplier’s manufacturing cost and assign an allowable (usually low) gross margin. This is an example of a supply chain decision based on cost. It works when the supplier has lost differentiation and has been commoditized. In other words, the supplier has no differentiated value as seen by the customer. If a supplier wants this business, it had better be the low cost producer to compete.

    Ken

  3. SP
    November 22, 2010

    Yes everything boils down to cost. No matter if you have high revenues if the cost is high margins would be poor. Although there are different measures to redue cost but sometimes its almost not possible to reduce. I know every account holder would love to do that.

  4. AnalyzeThis
    November 22, 2010

    It seems like a fairly obvious thing, but it's amazing how many companies lose sight of the importance of cost. Especially in the technology sector.

    I did stop and think about what you said about the unnecessary costs associated with poor security of supply. I think this can be somewhat tricky. There have been times in the past where I have sacrificed cost to protect against potential risks, paid more to diversify in order to avoid potentially serious problems if a single supplier somehow failed, for instance. I think there are some decisions I would make differently, in hindsight.

    Anyhow, also wanted to say that you had a very good point about the importance of benchmarking. I have found that benchmarking is nearly always a worthwhile process to undergo and you will more times than not find unexpected things that could be improved on.

  5. Tim Votapka
    November 22, 2010

    Key phrase there “differentiation.” There are many examples where a supplier had a great product or solution to sell, yet lacked enough branding traction to be a serious player in the game. It isn't so much what you think of your product or its price; it's what the customer base thinks that's senior to all else. If you've successfully differentiated your organization, product or service, you'll be in a far better position vs. competitors including those twice your size, and you just might quibble less over pricing with your customers too.

  6. bolaji ojo
    November 23, 2010

    Ken, Suppliers seem to get the cost-gross margin story even better than their customers. Nowadays, most component suppliers base their product costs not just on their own manufacturing and SG&A expenses but also by marking themselves against rivals' competing products and the price OEMs are willing to pay. Their gross margins are therefore based on what the market is able to support, hence, we see in the DRAM market, for instance, years during which sales are well below costs of goods sold.

    I do have a follow up question for you, though. What happens when a company tries as hard as possible to drive up manufacturing efficiencies but still find itself selling below costs simply because of market doldrum or as it happened a couple of years ago when demand stalled because of problems in the finance market?

  7. Ken Bradley
    November 23, 2010

    Bolaji,

    Good question and I had to search for data to support my answer.

    We are saying similar things: price is based on the market and DRAMS, despite their high technology attributes, are undifferentiated and thus a commodity. The market sets a low price so a supplier must be the low cost producer to meet the price or exit. Meeting the price may result in selling below cost.

    When a company can’t compete despite its best efforts, it exits the business or fails. I think DRAMs are no different.  We have seen many DRAM companies either fail or exit.  It’s also hard to find a pure play DRAM company as most have diversified.

    DRAMS are different only over the time horizon for which their business performance needs to be viewed. A  DRAM supplier will sell below cost to keep the factory running in tough times. This short term tactic is offset in better times with higher pricing. DRAM suppliers generally maintain positive cash flows and EBITDA when selling below cost because of the high depreciation component from the capital intensive nature of the semiconductor industry. One needs to look over the life of the assets to see if the long term return on assets justifies being in the business. If on a long term basis a company is losing money, there has to be a compelling reason to stay in. Historically DRAMS were a technology driver of the micron race where the new advanced manufacturing platform could be applied to other higher margin products. If there is no compelling technology leadership reason to be in the game and a company can’t achieve the required returns, I believe they will exit either by choice or bad fortune.

    Ken

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