Sophie the Giraffe and the Productivity Loop

August 3, 2012 — Leave a comment

sophie_stickerThis is the sixth post in a series about Amazon’s Feedback Loop, the mechanism most responsible for the company’s success. See also the previous posts, The Growth Levers in Retail: Price, Selection, ConvenienceUnlocking the Broad Middle (Hint: Price Is the Key)Sam Walton, Panties and Power LawsThe Productivity Loop (Walmart’s Feedback Loop); and Why Is Price the Ultimate Competitive Advantage? (Playing Games).

To demonstrate Walmart’s productivity loop, let’s use a hypothetical example. Let’s say Walmart begins selling Sophie the Giraffe teething toys, those over-priced French rubbery things so many moms insist on buying for their tykes (my wife included).  Boutique shops sell them for about $24. I’ll assume they buy the toys wholesale for $16 and slap on a 50 percent markup.  (These boutiques are aiming for the less price sensitive customers, those on the right-hand side of our consumer bell curve.)

Even though they sold through the previous order at $21, Walmart sticks with their30 percent markup. They sell the new batch of Sophies at $16.64 and advertise to all the young moms of the world that they have the best price. Moms can’t pass it up, and they sell out within days.Walmart starts off with a small order in which they pay the standard wholesale price and mark it up 30 percent. Their Sophie now costs about $21, a nice discount to the boutiques, and Walmart sells through the first lot pretty quickly. Seeing some customer demand for the toy, the Walmart merchant now goes back to the manufacturer, Vulli, and places an order for 100,000. They require a 20 percent discount – $12.80 per toy instead of $16 –  in return for the bulk purchase. As you wish, says Vulli, and fills the request.

Walmart now goes back to Vulli and asks for an order of one million Sophies, but it wants a 30 percent discount this time in exchange for the massive bulk purchase. Vulli complies, Walmart gets it for $11.20 per unit, marks it up (30 percent) to $14.56, and sells out again.

Walmart is churning the price part of the productivity loop, and boutique owners are pulling out their hair as they watch Walmart sell the giraffe for less than they can buy it wholesale. But even if they could buy it at the same price as Walmart, they couldn’t afford to mark it up only 30 percent. That wouldn’t provide enough gross profit to pay overhead expenses for high rent (convenient location), fancy in-store fixtures, marketing, and management salaries. Their expense structure ties them to the 50 percent markup. They need to charge the higher price; they must get that fat gross profit. They need it to pay their more expensive bills.

So Walmart wins the battle of Sophie the Giraffe on two fronts, both victories stemming from the productivity loop. First, its low price creates large demand, moving the product off shelves in high volumes. This high volume lets Walmart go back to Vulli, order more Sophies, and extract a discount that allows them to sell it even cheaper in the next cycle. Second, Walmart can afford to mark it up for 30 percent because it keeps the overhead low, which makes the sales price even cheaper and helps drive even higher volume sales.

Low price drives much higher volume. The higher volume allows Walmart to buy goods in bulk for a lower cost. And because Walmart has lower overhead, it can afford a lower markup on its merchandise, creating an even lower price and driving even higher volume.

Walmart churns this loop every day across hundreds of thousands of items, constantly widening the price gap and making it harder and harder for competition to catch up.

That’s the essence of the productivity loop, whether it’s practiced by Walmart or any other retailer.

I think it’s fair to assume that, at some point before starting Amazon, Jeff Bezos studied Walton’s success in some detail. He made himself intimately familiar with the model of the feedback loop. And he was ready to apply it in his company when he launched Amazon in 1995.

Next, we’ll (finally!) get back to Amazon and discuss its feedback loop.

Paul Dryden

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