Alpha: Buy Low, Sell High (Your Lobster Stand)

The Anatomy of Profit – by Dr Margin (AKA Christopher Loder)

Hey all,

The Anatomy of Profit Blog is a medium for sharing educational background, best practices, practitioner insights, and experiences of guest collaborators. The blog focuses on decomposing the seemingly complex drivers of profit, buying, selling, and behavior into bites sized nuggets, in order to help individuals and teams delivery sustainable revenue and growth to their organizations.

We will move through the topics so they build upon each other, exploring all the time, in the pursuit of making YOU - the reader, your organization, and your buying and selling relationships more profitable.

While it is the nature of companies to focus on money (revenue, margins, margin %, GMROI and net profit), process, and technology, (data, features, functions, capabilities, integrations), the profession of buying and selling is founded on relationships (joint interest, negotiation, collaboration, accountability, and trust). These relationships transform us from strangers to partners to friends.

Therefore friend, your feedback and engagement is always welcome.

Alpha: Buy Low, Sell High (Your Lobster stand)

In an effort to teach my children about the economics of a small business (read, have them use their own money at the village store, not liberate any and all cash from my wallet in an effort to buy candy and ice cream), we opened a retail lobster stand.

The fundamental economic guide to any successful business is: buy low, sell high, where the delta between is your gross margin:

For the lobster business, our focus in on the retail side. This works well as it creates a symbiotic relationship. Fishermen (and women) like to fish. They do not like to sell to individual buyers who have custom needs, pay with checks, or worse, cannot find their checkbook at the time of delivery. Nor do they want to deal with said customers after rising with the sun and fishing all day. Conversely, lobster retail is fixed hours, credit card payments and you don’t smell like bait at the end of your day; a win-win. We buy direct and sell at competitive retail prices, on average $6.50 buy, and $9.99/lb sell.

Value is a very important component of the equation. Value makes the space for margin when selling to a customer. Value, or the perceived value, of an item in the eyes of the customers is a link to “willingness to pay”. In general, the greater the value, the greater the willingness to pay, and thus the greater price that one can charge.

In the lobster business, the convenience value of being to pick up 12 lobster at a moment’s notice, pay for it with a credit card, and drive back to your summer cottage to cook them is greater than the convenience of fishing for the lobster yourself. It is may also be more convenient than hunting down fishermen and seeing if they will sell you lobster.

The Price of $9.99/lb. is works in this scenario because there is Value added to the transaction. It is because of this value that we are able to sell our lobster for $9.99/lb.

The remaining components of the introduction of the buy low sell high relates to the dynamic nature the system. Levers are dynamic in nature, always changing, trying to tip the balance one way or another. A rising cost without a corresponding price increase with compress margins, while a declining cost with a fixed price will increase them. Externally, market forces like inflation, vendor changes, commodities markets impact cost. Value changes include changes in perception or in the quality, or competition, among others. Price becomes a corrective lever to balance the changes and maintain stable margins.

Expanding this further, a profitable business is one where the sum of all costs is less than the sum of all revenue, thus yielding a positive margin (aka profit).

In a static market, the four variables (cost, value, price and margin) will reach an equilibrium. The market develops a known volume and thus a known revenue stream, resulting in fixed profit. While this “autopilot” stasis beneficial to a business, it is also a fantasy. Maintaining a status quo in the face of market forces, direct and indirect competition, and the human desire to improve means the variables, require constant tweaking.

In the broad market, participants are all tweaking their variables constantly. The ability to improve ones current state requires a change of input to yield a change of output, commonly these are incentives. Incentives modify behavior of individuals and the market. They are a tool which can modify the cost or price of a product, manipulate the perceived value, and result in a change of margin and profit. Incentives, particularly negotiated incentives are fundamental component of the global B2B economy. In the context of this article, incentives are split between pricing incentives and rebate incentives.

Before diving deeper into the role of incentives, it is important to take a look at the role of Value in the calculations. Value has a cost, described here as the Cost of Value. This not the cost of purchase, but rather the costs associated with adding value to what is being sold, such that the new purchaser under can buy it. In the lobster business, the cost of value is the storage tank, the electricity which powers it, the cost of water chemistry management, scales, marketing, the website and any labor associated with management and selling the lobsters, just to name a few items.

For wholesale products and distribution, there are broader number of cost of value categories, including but not limited to, transportation, storage, picking, routing, insurance, shrink, and any labor associated with the management, marketing, finance or sales of the product. This list differs across industry by category and by value. Additionally, the cost optimization of any of those categories, to improve profit, is outside the scope of this article. There are many methods (Lean, Six-Sigma, Kaizen), consulting practices, and technology (hardware and software) available on these subjects. In the scenarios which follow, the cost of value is assumed to be fixed.

Distribution has relatively low margins. In the following scenario, the total value and associated margin is set to 15%. Within the 15% there are two aggregated components: the cost of value at 11% and the resulting Net Margin (Gross profit) of 4%.

Modification of Sale Price or the Cost Price with have a direct impact on the net margin, assuming no change to the Cost of Value. Assumptions: Selling Price of $100, Cost Price of 85$, Value & Gross Margin is $15, of which $11 is the Cost of Value and thus Gross Margin / Gross Profit is $4. For this first example, no change of volume will occur when the Cost Price or Sale Price is modified. Price sensitivity = zero.

The power of pricing as it relates to profit: If the Sale Price is increased by one dollar, or 1%, the impact to the Gross Margin would be a 25%. ($4 base, plus one dollar becomes $5 of Gross Margin; $4* 1.25 = $5).
On the cost side, similar logic applies. A $1 cost reduction or ~1.2%, would result in the same 25% profit improvement ($4* 1.25 = $5).
When combined, the impact of $2 change of cost and price, of out of a $100 ($101) product, could yield a 50% profit improvement from 4% to 6%.

Price Sensitivity ≠ Zero

While it is fun to imagine a 50% profit improvement by creating $2 of additional margin, the fact of the matter is, products have price sensitivity. Additionally, if everyone in a supply chain or demand chain followed this approach at the same time, the result might resulting in inflation with a corresponding recession. These last two economic scenarios would have an impact to volume and thus to overall profits. Steering free of macro-economics, the focus here will remain at the micro level.

Diving deeper into the Anatomy of Profit requires acknowledging the role of negotiation for prices, both cost and sale and for conditional incentives or conditional pricing which will further change the mathematics of profit. Negotiation of conditions is not necessarily a clandestine, back room, discussion to eliminate competition, instead it represents the modification of micro-economic conditions to achieve a positive result.

The role of rebates:

In order to improve profit or increase revenue, companies frequently seek reduction in price, when buying, or an increase in price when selling. While it is self-evident that these two forces counter each other, there is a g great deal of nuance to what happens when two or more parties negotiate for better terms.

The instrument most frequently employed is via a Rebate, where the rebate reduces the net price of a product, good, or service, and where the delta price (quoted price vs net price) is paid at a later time.

In the diagram above, Supplier Rebates reduce the cost price when the entity is buying, and the Customer Rebates reduce the sell price when selling.

Product scenario:

Keeping with the examples above, of a 15% Gross margin and the 11% cost value, resulting in 4% net margin, the scenario will add a product level rebate with the intention of increasing sales. Product A assumes a cost price of $8.50 and a sale price of $10.00 the gross margin of the product is $1.50 or 15%. Cost of value is 11% or $1.10 and the resulting net margin is 4%, or $0.40.

To sweeten the selling deal, the seller offers a 9% rebate to customers for every Product A sold. This will impact the product with a $0.90 net price reduction resulting in a $9.10 net sales price, and what is now a negative profit margin of $0.50 or 5%. ($9.10 sale price - $8.50 cost – $1.10 cost of value = –$0.50). This is a loss. So, in order to remain profitable, there will need to be a change on the cost side as well.

To bring down the cost price, the seller requests (and receives) a 9% discount for Product A. The new net cost price, with the 9% rebate is $7.74. ($8.50 cost – 9% or $0.76 = $7.74).

The combination of both rebates return to positive profit. Now the gross margin is based on a sale price of $9.10 minus $7.74 which is $1.36. When the cost of value of $1.10 is subtracted, it results in a net profit margin of $0.26.

This is important: Buy providing a 9% Rebate to the customer and receiving a 9% rebate from the supplier, the net profit for Product A had dropped from $0.40 to $0.26, a 35% DECREASE in Profit.

Negotiating deals:

There are hundreds of books on the topic of negotiation, politics, leadership, finance, deal making, raising kids. . . In B2B, the negation for a better deal comes down to two primary components 1) the desired business outcomes, a mathematics problem, and 2) getting people to meet the conditions which yield said business outcome, a behavior problem.

In a supply chain, “better” deals result in multiple parties winning the math problem with the right behavior, “worse” deals result in no parties or only a single party winning the math problem, supported by behavior with may lead to the long-term decline in the relationship. The discussion on dealmaking in the context of math and behavior will continue to be a topic of deeper discussion. First, the basics in the context of rebates.

On the mathematics side, a customer rebate of 5% will yield a $9.50 net selling prices. ($10 - 5% = $9.50). A supplier rebate of 7% will yield a $7.91 purchase price ( $8.50 – 7% = $7.91). The gross margin with buying and selling rebates is now $1.59 ($9.50 - $7.91 = $1.59), up from 1.50 and the net net profit is now $0.49 (1.59 – 1.10 = $0.49) instead of $0.40. This is a 22% increase in profit.

Comparing the math:

A 9% and 9% rebates reduced the profit of the company by 35%, from 4% to 2.6% A 7% supplier rebate and a 5% sales rebate increased the profit $ by 22%, from 4% to 5.2%. The behavior side is a little more tricky. In the real world, business negotiations include a give to get. If you do X for me, I will do Y for you. This behavioral component of rebates is essential to the success of achieving the terms on which the rebate is paid.

To explore the behavioral components of a deal, a new business outcome is declared. The Manufacturer / Supplier, Distributor agree to grow a product’s sales volume (# of products sold) with a target of 10%. The Distributor also wants to grow their profit (margin % and dollars). The Customer agrees that 10% product volume is desired, along with additional profit (margin % and dollars) as well. In order to achieve this growth, all companies will need to change the behavior of their sales organizations and the value story they tell the end customer. Price will be very important. Negotiations begin with the Distributor-Customer relationship.

Customer state the requirement of a 5% price concession to achieve growth target. The distributor listens and offers back a 2% price concession, with behavioral incentives according to the following table:

In this scenario, the Distributor is offering additional rebates when volume growth is attained. This focuses the behavior on growth, while simultaneously providing the good will of a price concession. At 5% growth, the Customer will only receive a 2% price increase, however at 10% growth, both parties will achieve their goals, including the 5% discount. Additional incentives are provided for over achievement, up to 8% net sales price discount for 15% growth. While this may seem risky, the distributor will reduce the risks through negotiation with the Manufacturer, who is looking for that 10% growth.

Rather than negotiating the same deal with the Manufacturer, the Distributor is looking for leverage. In the table, the distributor accepts from risk for non-growth (the 2% price concession to the Customer), where if there is negative growth (<0%) there will be no incentive. However, they negotiate that any growth will yield a 2% rebate and more importantly, they negotiate an extra 2% at the point where the business goal is achieved. This is negotiated from a position of high confidence in the outcome, with the corresponding ability for all companies to achieve targets given market conditions. With these two negotiated agreements in place, the 7% cost price reduction and 5% sale price reduction can take place. Not only does this provide for greater profit margin (+22%), it also increases the volume 10%.

Looking at profit dollars, if the baseline volume was 100,000 units at $10.00 and $0.40 profit, the net margin dollars would be $40,000. The new profit would be based on higher volume, 110,000 units and $0.49 profit per unit, yielding $53,000. A combined 35% growth of net margin dollars along with three happy trading partners.

Finding leverage for profit:

For some companies the scenario described represents common everyday practice. With the power of AI, additional questions are being asked to determine how to optimize the mathematics of deals by guiding behavior and conditions to achieve desired results. Adding to the complexity of driving optimal results, current facts (pricing, rebates, other incentives) are hidden inside agreements where they are difficult to extract and analyze for behavioral results.

In the next section, the blog will explore multiple attributes, behavior modification, game theory and profitability utilizing technology.

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