Goodwill Margin
John Mackey, Founder and CEO of Whole Foods: “Amazon allowed Whole Foods to think long term again. We needed to cut our prices but when you’re a public company if you’re selling something for a dollar and you say ‘you know what, we need to sell this for 90 cents’, and you start selling it for 90 cents, in the short run you just cut your sales 10 percent because you’re just not selling any more of it. Over the long-term people will realize ‘man I can get a good deal for 90 cents, I used to pay a buck for it’ and they start to shop with you more and your sales will go up. But when you’re a public company and the market is very short term oriented, you pay a heavy price in the short term for reducing your prices, and Amazon is willing to think long term and let Whole Foods do that.
Joe Rogan: ’Cause Jeff Bezos got that long money son.
From The Joe Rogan Experience, episode 1569.
In the ruthless business world, it seems that to get more, one must take more. Nothing is given. And yet history is awash with examples of companies benefiting most as customers and employees get an increasingly better deal. Henry Ford built an automotive juggernaut by slashing the price of his famed Model T while increasing his workers’ pay. In this essay, we explore why that is. Why giving can sometimes be worth a lot more than taking. We will start by describing a conventional confrontational mindset before developing an alternative framework based on the intangible value of goodwill. We then explore how to intuitively quantify goodwill and finish by looking at the industries most suited to this framework.
Porter and the Extraction Framework
Traditional business thinking relates ‘attractiveness’ or profitability with the strength of one’s bargaining position. When faced with poor alternatives, customers put up with high prices and suppliers with low prices. The former generates high revenues while the latter minimizes costs, together maximizing profits. Porter’s Five Forces is the exemplar business school framework summarizing this idea. It is named after the five groups exerting competitive forces on businesses: buyers, substitutes, suppliers, new entrants and competitors. Profitability, Porter explains, results from experiencing weak competition. The most attractive business is therefore that which extracts most of industry profits by exerting the greatest competitive pressures. Let’s call it the ‘Extraction Framework’.
Take Coca-Cola, a typical attractive business under this framework. The drink has weak rivals, as evidenced by waiters systematically asking “Is Pepsi OK?” when one orders a Coke. Substitute soft drinks like Fanta or Sprite exist but are often also owned by the Coca-Cola Company and priced similarly. In the age of targeted Internet advertising some new entrants have done well, but mostly locally. Without extensive distribution, they struggle to reach a global audience. This leaves them vulnerable to being acquired, often by the Coca-Cola Company. Suppliers of sugar or aluminum are interchangeable and compete on price. As for retailers, they can ill afford to refuse stocking such a popular brand. Costco, a discount retailer, stopped selling Coca-Cola in November 2009 following a pricing disagreement. Less than a month later, Coca-Cola was back on its shelves.
To measure attractiveness, we should compare the competitive pressures exerted by and on a business. Since the goal is charging as high a price and paying as low a cost as possible, we can look to the profit left after expenses are paid as a percentage of revenues, or net profit margin. Imagine a widget maker bargaining from a position of strength with its customers and supplier. By either charging customers more or paying less for parts it increases its own profit margin at the expense of others. Driving too hard a bargain therefore eventually becomes counterproductive.
Apple’s App Store is a topical high-margin business historically charging 30% on in-app transactions and subscriptions. Access to the loyal hundreds of millions of iPhone users worldwide is attractive enough to app developers that they willingly part with nearly a third of their revenue. Most app developers that is. For some, paying 30% is not an option. In the words of Spotify:
“If we pay this tax, it would force us to artificially inflate the price of our premium membership well above the price of Apple Music. And to keep our price competitive for our customers, that isn’t something we can do.”
To avoid paying Apple, Spotify chose to only sell subscriptions through its website. Amazon has followed suit with Kindle books, which must be purchased through a browser. For these Apple ‘suppliers’, 30% was simply too high. Apple’s hand is strong, but not infinitely so. Pricing was pushed far enough that both Spotify and Amazon chose to degrade their users’ experience rather than pay Apple’s ‘tax’. In response to growing push-back, Apple eventually conceded to charging 15% to small developers.
An implicit assumption made by the Extraction Framework is that there is a fixed and finite profit pool to share among participants in a business ecosystem. One’s gain is another’s loss. By lowering the price charged to customers, the seller loses a potential gain. By paying their suppliers more, costs increase and profits decrease. As a result, one only gives from a position of weakness since it yields no benefits. But what if that assumption did not always hold? What if by giving, one could get more in return?
Ford and the Reinvestment Framework
In 1913, the first moving assembly line was built at the Highland Park Ford plant. Production of the Ford Model T more than doubled that same year. The workforce shared in Ford’s success earning a $2.25 average daily wage, which was attractive at the time. Despite this, Ford had to hire 53,000 people to maintain a 14,000 workforce that year. In other words, the average employee stayed for a little under 100 days before quitting. Such high employee turnover disrupted production and kept training costs high. In a counterintuitive move, Ford decided in 1914 to more than double employee pay to $5 per day.
At first glance, doubling pay when labor costs were already straining the business might not appear like a winning proposition. But that misses the intangible value Ford got in return from more motivated and loyal employees. In return for quality pay, employees responded with quality work. Turnover fell right down. In his autobiography, Ford explained:
“The payment of high wages fortunately contributes to the low costs because the men become steadily more efficient on account of being relieved of outside worries. The payment of five dollars a day for an eight-hour day was one of the finest cost-cutting moves we ever made, and the six-dollar day wage is cheaper than the five.”
A year later, new hires fell eightfold to 6,508. These were mostly to accommodate growing production volumes, which gets us to his second counterintuitive decision: selling the Model T ever cheaper. It can be hard to imagine now, but in the early 20th century the car was a rich man’s toy, not a tool of mass transportation. Many thought the car market would remain small. Success means selling a luxury product and making the largest profit per car as possible. Ford’s relentless focus on mass production at cheaper prices worried even his business partners:
“Some of the stockholders were seriously alarmed when our production reached one hundred cars a day. They wanted to do something to stop me from ruining the company, and when I replied to the effect that one hundred cars a day was only a trifle and that I hoped before long to make a thousand a day, they were inexpressibly shocked and I understand seriously contemplated court action.”
Once again, Ford believed he would get back in return for giving. In exchange for a lower revenue per car, he bet more would buy cars. How right he was. Here is the production and price of the first 15 years of the Ford Model T.
Instead of chasing immediate profits by squeezing customers and employees, Ford ran the opposite playbook. He gave where Porter’s Five Forces argued he should have taken. It worked because Ford did not in fact give profits away. He gave, expecting something in return. In other words, he preemptively reinvested would-be profits and reaped the rewards. By investing in his workforce, it became more motivated and productive. Higher wages eventually saved more money than cutting costs. Similarly, Ford viewed lower prices and their foregone revenues as an investment expanding the car market. He bet that volumes would far more than double in response to halving the price. He also believed that producing more cars would lower his cost of production both because of accumulated knowledge and economies of scale.
These two factors fed on each other. A lower price increased demand. Increased production to meet this demand lowered costs, allowing further reductions in price, and so on. The double whammy of expanding the market while reducing its unit costs eventually drove revenues and profits like few imagined possible. Simply put, Ford hoped to get a moderately thinner slice of an enormously larger pie. In fact, as the price was cut over fourfold in current equivalent dollars and twofold in nominal dollars between 1909 and 1923, volumes grew almost 190 times. As a result, revenues increased over 40 times in current equivalent dollars and over 80 times in nominal amounts.
To avoid confusing terms, we need to draw a clear distinction between two types of reinvestments Ford could have made. First, Ford could have maximized short-term profits from his initial factory, as under the Extraction Framework, and reinvested them to build more such factories. In other words, he could have sold more luxury cars. This would have worked for a while, until he had exhausted the niche market, as his business partners feared. However what Ford did was reinvest to build more but also better and cheaper cars. Unlike the former, this latter form is incompatible with the Extraction Framework, which explains why it took so many by surprise.
Instead of building more profit-maximizing factories, Ford used the scale of his latest factory and accumulated experience to lower the price of cars from all factories. This lowered the profit per car but was compensated for by more and increasingly efficient factories. Instead of simply investing to replicate physical or tangible assets, Ford invested to create intangible value. This form of reinvestment, which we will just call ‘reinvestment’ going forward, focused on long-term value at the expense of short-term profits. It is the core of the Reinvestment Framework. As Ford put it:
“A reasonable profit is right, but not too much. So it has been my policy to force the price of the car down as fast as production would permit, and give the benefits to users and labourers — with resulting surprisingly enormous benefits to ourselves.”
We can draw an additional distinction. Had Ford focused on selling more to the niche luxury car market, he would soon have received diminishing returns from his investments. New factories would have been built in decreasingly attractive locations, hiring decreasingly productive employees, and selling to decreasingly attractive customers. This would have both limited the scope for growth and it would have allowed competitors to catch up. Instead Ford’s early investments benefited from what Brian Arthur dubbed ‘increasing returns,’ or “the tendency for that which is ahead to get further ahead.”
The large upfront cost of building the first mass production line yielded a valuable economy of scale, unmatched at the time. Additionally, every car rolling off the line was an opportunity to learn and improve the manufacturing process. As a result, Model T unit costs tumbled as production soared. The more Ford grew, the more competitive it became. Supplier and partners responded by adapting to suit Ford’s specific needs, further entrenching their lead. The cycle would feed on itself by attracting evermore customers looking to own a car, or more specifically a Ford Model T. By 1920, Ford controlled over half the American automobile market and was three times larger than its nearest rival, General Motors.
Many questioned his approach however, because none of what happened was guaranteed. Who was to say profits were reinvested to generate greater bounty tomorrow? At the time, it would have been hard to distinguish between reinvesting and giving away profits. Especially since Ford reinvested to improve quality and expand the market, rather than simply do more of the same. We say a bird in the hand is worth two in the bush, but what if you can’t even see the bush? Fortunately, Ford was right. There was a bush and it bustled with birds. Beyond increasing production and lowering costs, every dollar of profit Ford parted with built an intangible value in the mind of his workers and customers: goodwill. Instead of being squeezed, Ford’s ‘partners’ in business shared in the bonanza. Ford knew the importance of this:
“Good-will is one of the few really important assets of life. A determined man can win almost anything that he goes after, but unless, in his getting, he gains good will he has not profited much.”
Although goodwill would be difficult if not impossible to measure in practice, a thought experiment can approximate what we mean. Goodwill is the difference between the maximum a consumer would be willing to pay and the price charged. One willing to pay $10,000 for a Model T but charged only $5000 gets $5000 of what economists call ‘consumer surplus’. Such surplus becomes goodwill if it benefits Ford down the line. Where the Extraction Framework looks to the profit margin as a sign of success, the ‘Reinvestment Framework’ looks to the ‘goodwill margin’, or the intangible asset as a percentage of the selling price created by charging less than the customer is willing to pay. Viewed this way, sacrificing one’s profit margin in exchange for goodwill margin makes sense. In Ford’s case, the trade-off was immensely profitable. The same logic applies to workers’ salaries. By paying workers above the minimum they would accept, and benefiting in return, Ford created goodwill.
In summary, Ford raised his employees’ wages, hurting his near-term margin and got higher quality workers in return. He consistently lowered the price of his Model T, shrinking his profit margin and expanding the goodwill margin shared with customers. In return, Ford benefited from loyal customers growing in numbers every day. This demand lowered unit costs, keeping Ford ahead of its competitors. From a financial perspective, while the profit per car went down, total revenues and profits soared. Instead of extracting as much as possible out of a small car market exclusively selling to the rich, Ford reinvested his profits and benefited from the emergence of a mass consumer market for cars.
When to reinvest
We have established that reinvesting means benefiting eventually. Without getting something in return, we are merely spending or giving. Only time will therefore tell which we are doing. That is why Ford would not have been able to increase wages indefinitely. At some point, he would have been ceding profits, getting nothing in return. Workers can only be so motivated and productive. Similarly, once every person becomes the proud owner of one or several automobiles, lowering prices might no longer increase volume.
For a business to benefit from reinvestments, it needs to receive higher revenues and profits in return. This is unlikely to be true for mature industries, both in the sense that the product or service cannot get significantly cheaper or better and that demand will not grow considerably. One such example would be the food industry. As productivity increased, the average American household more than halved its grocery expenditure as a share of income in the last 60 years. Whole Foods showed growth pockets can exist, but the overall industry is losing its share of the consumer’s wallet. It seems the Reinvestment Framework best applies therefore to immature industries working on nascent products or technologies.
Immature industries face great uncertainty. Their product might never work or demand never materialize. But at the same time, their uncertain future reveals a potential to transform into something else entirely. Just like railways in the latter half of the 19th century, cars in the beginning of the 20th, or computers after WW2, new industries emerge on the back of technologies turning the impossible into the trivial. As they do so, the opportunities for reinvestments are rife — for a while. Eventually, progress slows along with demand, so that the industry is mostly left with a static or even shrinking pie to share among its participants. These businesses, many with grand legacies, figure that if there is only so much to go around, they might as well take the lion’s share.
Fortunately, there has so far always been a new ‘something’ waiting in the wings. Along with a Carnegie, Rockefeller, Ford, Noyce, or Jobs to reinvest their profits and grow.
Sacha Meyers
