Welcome to another installment of my Understanding the Consumer Products Industry series, where I'm leveling the informational playing field between consumers and the companies that sell us stuff. Today we return to the subject of price drivers.
Recall the three key drivers of prices in the world of retail:
1) Barriers to competition
2) Input costs
3) Current inventory levels
We've already talked about barriers to competition. Today we'll cover input costs, and we'll draw a few compelling conclusions about the modern consumer products industry that, with any luck, will help you get far more value for your money.
If you think about it, there's an entire stack of costs involved in getting a basic item like a box of Oreos into the hands of a consumer. There are ingredient costs, processing costs, packaging and transport costs, marketing and advertising costs, and so on. All else equal, if a company wants to make money on the goods it sells, then the retail cost of Oreos must be the sum of all the various costs in that cost stack, plus a profit margin.
Therefore, the more you can tilt your purchases away from products with large cost stacks, the more value you'll get for your consumer spending dollars.
Of course, long-time CK readers (especially those who have read my essay Stacked Costs and Second-Order Foods) will consider this a borderline obvious conclusion. In today's post, however, I'm going to use that conclusion as a starting point, because it helps us arrive at an important insight.
But before I can get to that insight, let me ask a question: What is, by far, the single biggest cost in the cost stack of most consumer products?
It's advertising and marketing.
In fact, almost all major consumer products companies use a laughably simple, three-step business model centered around advertising:
1) Spend lots of money blasting consumers with repeated advertising and branding messages,
2) When those consumers shuffle mindlessly and zombie-like to the store to buy those products, charge them a premium price.
3) Then, take those premium-price proceeds straight to the bank.
Some of the most successful and long-lived companies in modern economic history (Proctor & Gamble, Colgate-Palmolive, Clorox, General Mills, Kellogg, Pepsi, Coca-Cola, Unilever Corp., etc.) use this business model.
The bottom line? This business model works--and it works extremely well.
Here's another example of how well it works: During my career on Wall Street, I watched the profitability metrics of the world's best technology companies fluctuate massively (and sometimes horrifically) with business and technology cycles. But companies like Pepsi and Proctor? They earn operating profits in the 18-22% range consistently, regardless. Recession, depression, boom, bust--it didn't matter. They earn these profits like clockwork.
(Two quick tangential comments here: 1) for those readers who tuned out at the words "operating margins," please just take my word for it, 18-22% margins are really juicy, especially if they're recession-resistant; and 2) for those readers with a predilection for the stock market, understand that this also explains why consumer products stocks are awesome to own during an economic slowdown).
Handwringing Is Not Permitted
Now, I refuse to let this discussion devolve into a "companies are evil" handwringathon. Companies aren't evil. They merely sell us what we consent to buy, and this advertising-based business model works for one reason and one reason only: because we as consumers make it work.
If you think this unattractive market arrangement is purely the fault of greedy fat-cat companies, then you must also assume humans have no alternatives for the expensive, branded products they buy (which in almost all cases they clearly do), and that they also have little free will to seek out and seize those alternatives. Despite the semi-facetious title of this post, most human beings are not zombies.
(That being said, if you happen to be in line at your local grocery store, and you hear someone behind you moan "braaaiiinnnns!" you should probably run. That could be a real zombie.)
Okay. Here's my point. Now that we're totally familiar with this simplistic business model, we know everything. We know that consumer products companies are going to play a predictable role in the marketplace--they are going to run lots of ads and spend lots of money on branding, and they're going to sell us products at prices high enough to earn them generous profits, even after taking into account all the money spent on advertising and branding.
We also know that we as consumers are the most important piece of this puzzle. Why? Because we can respond by doing one of two things:
1) We can complete the cycle by responding passively to advertising and then paying extra for products offering dubious value,
2) We can break the cycle.
And that's why in this post I'm advocating an entirely new philosophy of consumption: When you see products advertised, don't act out in standard zombie behavior and passively ingest the message of the ad. Instead, develop the instinctive reaction to avoid those products. In short, make it so those ads make you not want to buy.
When you see an ad on national TV or hear a product jingle played on the radio, think of the enormous cost of that ad. Think of yourself paying for that ad (which, if you think about it, is exactly what you do if you buy that product).
When you see a product or company sponsoring a major sporting event, or buying naming rights for a stadium, think how much that sponsorship deal costs. Then, imagine that money coming directly out of your wallet when you buy that company's products.
Before long, you'll start to see heavily advertised products as destroyers of consumer value. You'll have no problem instinctively avoiding them, and instead you'll instinctively seek out lower-priced and equally useful substitutes. Further, you can apply this thinking to all the products you buy, including clothes, entertainment, and even big-ticket items like vacations, cars, furniture and appliances. You don't have to limit these ideas to your grocery or drug store.
How many consumer items do you buy that are heavily advertised? Are you receiving appropriate value in return? Ask yourself these questions and you will extract far more value for every dollar you spend.
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