The economics of computers: the consequences of discounts

Might be a good thing to break this off from the other thread so it falls off the front page:

Just a few points to get us started: Manufacturers don't like to see products discounted* (this is not a universal - some manufacturers and products are all about discounts - they are about saturation, market-share, and volume). Discounts lessen the perceived value of products and brands. They do several things to combat this. They introduce MSRP's - (Manufacturer Suggested Retail Price) and get distributors to sign MAP agreements (Minimum Advertised Price). Manufacturers are especially sensitive to this as they attempt to introduce new lines or brands in new markets where they are trying to establish their products.

There are also several sales drivers at play -- demand from customers is one, and something I'll call supplier driven demand. The higher a margin a product has for the seller, the more incentive they will have to sell a product. When the seller works hard to sell, this creates sales - higher sales mean more orders and larger production runs for manufacturers. Higher manufacturing volumes mean (usually) cheaper manufacturing costs for manufacturers (we'll skip the whole analytic of marginal costing and plant efficiencies and just take this as a truism).

The "Cost" of a product to a reseller or distributor is just a part of the cost of doing business. It is a significant cost but not necessarily the largest cost to that business. Without laying out every cost and cost category under the sun let's just say this: You have COGS, (Cost of Goods Sold) which is the raw product cost, plus every other cost associated with running that business - from salaries, to rent, the office supplies and phone expenses, to fees and permits .... you name it -- lots of other costs. The "profit" a business makes is what's left over after all those other costs are added to the mix.

Comparing the COGS to the selling price gives you something called Gross Margin. In business this is what most people are talking about when they say margin. (not profit margin --- gross margin). Margin is defined as ((Selling Price - Cost)/Selling Price). link A computer sold for $1200 by a reseller may be purchased for $500. The margin for that product is ((1200-500)/1200)*100%= 58 (most of us don't multiply by a hundred when we do the calc so our spreadsheets show the margin at .58, but we call it a fifty-eight margin in speak).

All other costs are also broken up into ratios and percentages of sales to make for easy comparison and calculation. Rent might be 10% of sales -- wages and benefits might be 30% of sales. Utilities might be 2% of sales - operating expenses might be 20% ---- you start adding these all together and you quickly see that the gross profit is literally being squeezed away...

In the above, where the COGS was 42% of sales add the rest and what do we have? 42+10+2+30+20..... -- we actually have 102% costs over revenue -- that's a loss. As a retailer or reseller, the only way I can make money on this game is to somehow raise my gross margin (lower my COGS) and squeeze efficiencies out of the other costs.... Maybe I can get a cheaper rent --- let's drop that to 5%. Maybe I can pay my guys less -- we'll drop that to 25% (just gave them a 15% pay cut). Let's do the math...
42+5+2+25+20=94 --- woohoo Looks like my profit margin is around 6%. On that $1200 laptop I just made $72 --- oh wait ---- tax --- well let's take off anywhere from 15 to 45% for tax -- let's say 30% (state plus federal, plus municipal if any....that leaves me with a profit after tax of $50

Now lets look at that $50 --- how much money did I invest in this company and operation to finance it's activities? Let's say 25% of gross revenue was invested by owner of the company to finance only the operating expenses. What's the ROI on those and how does it compare with other opportunities out there? Well that 300 invested in the stock market through mutual funds should give me a return somewhere around 12% -- not crazy high risk -- just a well managed fund. So doing absolutely nothing but investing my cash, my 300 should give me a a ROI (return on Investment) of $36.

So in this example my ROI net of alternative investments was about $14 - around 5% of my capital invested --- my actual ROI was about 16% of my capital invested. The real question is then -- what were the risks and is this a good ROI -- in our model here it's okay. Not great -- not stellar -- just okay. I'm certainly not getting rich.

The problem with most lay people when they think about business and margins is that they confuse something called Markup with Margin. They also have no understanding of the other costs associated with businesses...

$500 x 2.4 = $1200 -- wow -- and 240% markup!!! Must be easy street for the retailer right? Certainly they can afford to offer me a discount!

Let's go back to the model -- What happens if we discount the product by 10% -- say $120 while keeping all other things the same?

Selling price is now $1080 -- gross margin is ((1080-500)/1080)*100%= 54
COGS is now 46% of sales

If all my original costs stayed the same (ignore the percentages and deal with real dollars) I now have a 2% profit margin -- so my net profit before tax is $22. Taxed at 30% --- this leaves me about $15 in my pocket. Now how does the ROI look? Dang! -- I would have made twice as much letting it sit in a mutual fund. That 10% discount literally wiped out my ROI advantage.... What to do?

Obviously I need to get this laptop cheaper right? So I start screaming at my manufacturer. I can't sell this laptop for 1200 anymore - street price is already way less and dell has just introduced a model that comes in pretty close spec wise and is selling for $999 -- Help.

Well the manufacturer says - We'll cut the price to you by 50. You now pay $450 for that same laptop --- but remember the manufacturer has a business model similar to the reseller. That loss of $50 for him has to come from somewhere. Guess where? Yup --- the next order of capacitors they make comes from a new supplier. Cheaper capacitors --- Their engineers test 'em out. Yup they'll do -- the bean counters get involved. Even though there will be higher rates of failure during the warranty period, they'll still come out slighter better on the numbers side than if they keep the originals --- besides most of the failures will happen beyond the one year, into years two and ears 3 --- and that's not their problem.

So suddenly the laptop just got "cheaper" -- looks the same -- but it's different. And this cycle continues.....

How could it have been prevented. Well -- one way would have been to have a MAP policy in place. One that would discourage discounting. It doesn't eliminate it, and it requires policing -- but it would help. The other -- would be to train resellers and distributors to sell the products as premium branded items -- for them to ignore the pressure to compete with the latest best buy special. It would be for them to culture a customer base that is not the best buy customer base. In our world here it would be ignoring the discount begging crowd and business models that advertised specials and promos ---- cont...

 

But of course this wont happen because the market for actual premium laptops is pretty small -- small for Clevo -- small for Sagar and all the resellers on this board. The truth is the Clevo's have more in common with the best buy machines than we want to admit so the whole discussion is really academic.

But that's the whole point -- because there is a balance -- Black Friday special -- discount coupon, pricing bundles --- these are all slippery slope elements that put enormous pressure on resellers and manufacturers to cut costs to stay reasonably profitable.... And those cuts actually can HURT you the end user and you might not even be aware. So the next time you are putting the squeeze on price -- ask yourself this -- are you prepared to accept less support or service for that price advantage or discount? Because that's the real cost.

Anyway - just my few cents.

 

So what?
That is a operating model, every business works like that.
Btw, your mutual fund ROI sounds pretty optimistic

 

I'm doing well.

 

Please explain this? I don't see how a Clevo machine has anything in common with a Best Buy SKU other than the fact that it is a laptop. Is that your point?

It has been a well established fact that notebooks are getting cheaper year-on-year and it's not just to do with lower manufacturing costs like capacitors but also huge HUGE volumes and manufacturers that are making next to zero profit. You only have to pull the figures on Acer Global to see the dismal profits in the sub $500 category.

I remember selling notebooks for a ground breaking $1999 here in Australia and that was only 8ish years ago. That's right you couldn't buy for less than that here. But is the quality of that $1999 (compaq by the way) and different from a $299 Clevo or Dell ? Probably not. In my experience they used cheap components then and they still do today to meet a market price.

Yes of course discounting is driving pricing down, but you are forgetting that so is general manufacturing costs like hard disk pricing, memory pricing.

Today the 'sweet spot' for a manufacturer is 4GB RAM, 500GB HDD, Intel Core i processor and 15.6" display.

If you look 24 months ago, this type of machine in our local market was easily over $1000, today it can be had for half that. Why?

General pricing has dropped on components. Memory was $95 for 4GB about 24 months ago, today it is what, $15 ?

Is the quality different? Nope.

The same can be said about hard disks, although we are in a tight spot at the moment because of the floods. But pre-floods, 500GB hard disk from say Hitachi, is about $60 or so. 24 months ago, same 500GB hard disk was $120.

They key to what you are after is purely volume and manufacturing costs.

 

Perhaps I am too cynical, but I rather expect any large company given the choice between Capacitor A(ten cents more a piece, lower fail rate%) and Capacitor B(ten cents less a piece, higher fail rate%) to make the switch immediately to B. Lower profit margin puts more pressure, yes, but even with an exorbitant profit margin they would still switch. Done deal.
tl;dr
Average person/company will put the screws to you as hard as they can in a business deal. Its not the "cheap" customer causing lower quality parts to be put in, but the entire system of capitalism. As long as people will pay X for Y, why not try 1.2X for Y? Or X for .8Y