Competing with lower prices is stupid

The other week I said, “Cutting costs and only competing on price is a death spiral. Always has been, always will be.” I then got asked why a couple of times, so I thought I might expand on this point a bit.

I don’t want to give a lecture, but I thought it might be time to delve into a bit of business 101 first.

Costs generally come in two flavours; the first type is variable costs which can also be known as direct costs, cost of goods sold, cost of materials, etc. Variable costs are the $10 that you spend to acquire a light fitting that you sell for say $25.

The second type of costs are the fixed costs; also known as indirect costs or overheads. These are costs like the annual rental for the shop you sell the light fittings in. Of course, some costs are hybrids, having a fixed and variable component.

The key to sustainable profitability is understanding exactly what your costs are and how much of your variable and fixed costs to get allocated to each dollar of sale. Unfortunately, this is where things get tricky.

• The timing of variable costs may be out of sync with the sale

Take for example General Aviation. Every time you run the engine on a light aircraft, you not only use fuel, but create an engine maintenance liability. The engine may need to be serviced every 1,000 hours and overhauled every 10,000 hours. This is horrendously costly and must be factored in to the cost of running your business.

• The true costs may be hidden from you

Take the example of employing a computer service person. He may cost you $75,000 plus superannuation at $6,750. This makes a total of $81,750, a figure you thought you could be confident about. However, that employee is only going to work 48 weeks of the year as you have also offered them leave. This means you will need to buy in another resource to cover them, while they are away. Turns out that resource is going to cost you $10,000 for the four weeks. So your labour costs are actually $91,750 – or 22% higher than the salary offered, and we haven’t even discussed other costs such as payroll tax yet.

• It may be difficult to “apportion” fixed costs to every sale due to uncertainty about expected revenue

You can argue “but I don’t know if I will sell $400,000 or $500,000 of light fitting this year, so how can I apportion the shop rental when working out my costs?” The answer is of course to make an estimate or budget, and review it regularly. It’s probably better to estimate on the conservative side so that any variance is likely to be in your favour.

These three examples, and I’m sure there are more, highlight the key to sustainable profitability – “knowing your costs”. But they are not the key to being competitive and having a successful business. This is because you will always have competitors that don’t have this insight into their products and services. They will unwittingly sell below cost, and when the costs that they haven’t factored in eventually appear, their business will go under. Sometimes they will naively sell below cost deliberately to buy market share in the hope they can ramp up prices later. Unfortunately they don’t get to win then, because there will always be another fool ready to step into their shoes and compete below cost.

Over the last 20 or so years, I have worked in oil, electrical equipment, engineering, computing and marketing. In every industry I have seen multiple examples of firms competing with prices that are too low to sustain business over the longer-term. In every case when these businesses fail, they were immediately replaced with someone with the same strategy. There will always be people prepared to run unprofitable businesses, mostly because they don’t know they are doing it.

So it’s quite obvious to me that competing with “lower prices” is generally a stupid idea. The nice thing though is that there is a virtually unlimited number of other areas you can compete on, and you are only limited by your imagination. The first step is to find out what your customers actually value, because it’s always going to be more than lower prices.

Brendan Lewis is a serial technology entrepreneur having founded: Ideas Lighting, Carradale Media, Edion, Verve IT, The Churchill Club and Flinders Pacific. He has set up businesses for others in Romania, Indonesia, Hong Kong and Vietnam and is the sole Australian representative of the City of London for Foreign Direct Investment. Qualified in IT and Accounting, he has also spent time running an Advertising agency and as a Cavalry Officer with the Australian Army Reserve.