Introduction
This article analyzes profitable commodity strategy during various market trends. Centering the commodity landscape by extension centers branded strategy. It is possible to promote a brand without fundamental understanding of markets. It is impossible to do so in commodities. Conversely, a fundamental understanding of commodities married to even mediocre brand strategy can produce healthy returns on a branded product.
Definition of competitive markets
What is the essence of a thing? ~Aristotle
Commodity markets are the purest example of a market. Briefly, the most commonly acknowledged characteristics of a true or free market are:
- Transactions are voluntary.
- Governments act as arbitrator and referee only, ensuring against coercion.
- Products are homogeneous.
- Prices are governed by supply and demand.
- Market information is available to all participants.
- Profits on capital reach zero in the long run.
Logicians will note that not all of these characteristics are needed to ensure a competitive market; some of them are mathematical results of others. We shall review them and their implications below all the same.
These characteristics form the keys to success in a commodity market. They form its essence, and understanding them produces the keys to profit from them. Indeed, all methods of profits derive from these characteristics. There are no others.
“How can that be true?” you might ask.
The answer is simple, but drives every successful strategy: there is no such thing as a perfectly competitive market in equilibrium and the long run never arrives.
Voluntary markets
First, take the proper stance.
Coercion skews markets. Coercion changes markets into something else. The inherent value of a free market is not just its moral imperative of choice and self-determination. It is that choice inevitably drives innovation and efficiency in an effort to thrive.
Working in markets represents an opportunity to express oneself, whether singing a song or growing number 10 wheat. It is first and foremost an exercise in actualization, with constant opportunity to choose paths in both development and ethics. It is a journey of self-discovery more than a race to completion. This stance or perspective provides a healthier, more constructive center from which to operate, allowing relief from caustic team atmospheres that often accompany competition, and which are detrimental to performance.
When I first entered the commodity room at a large wholesaler, it was as quiet as a church. This was utterly alien to my experience; a visit to the Chicago commodity exchange or any cattle auction will tell you that buying and selling commodities is anything but unemotional.
Winning teams are engaged. Winning teams are emotionally invested. Winning teams feel they are part of a team. Several years later we won contracts on 5 automobile plants in a row. Do you think anyone in the building heard the roars?
Government as arbitrator
The noble keeper of the peace also chooses winners.
Governments at every level are far beyond arbitration of markets; regardless of one’s political view, they are firmly entrenched in subsidizing preferred actors in the marketplace.
The typical citizen is not aware of the extent of these distributions. Governments skew the market by providing organizations tax relief, barriers to competitor entry by regulation, monopoly grants, pricing powers, or outright subsidy. Google recently received a grant in the Carolinas of $1M per employee. Every automobile plant built in the last 10 years has received hundreds of millions of subsidies, including Mercedes, BMW, and Toyota. GM and Chrysler received a more formal subsidy, although they had to give up ownership to get it.
Any industry analysis or product strategy must begin with a thorough understanding of government involvement at all levels. Chances are very high that your competitor is receiving government aid in some manner, and product strategies have much less chance of success if they do not take these subsidies into account along with a fundamental understanding of how government intervention changes the nature of your market.
It is also important to understand supplier and customer subsidy. It helps understand their motives and profitability, and provides avenues for approaches and strategy. In at least some circumstances, it provides pricing power information.
But awareness and reaction plans are not enough. Virtually every organization requires a strategy for each level of government. They are out there and active in your market. Develop an insulation or subsidy plan, or be left behind. They are in the business of picking winners and losers with tax dollars. Participate in that process, or struggle.
For the rest of this paper, we’ll assume a free market in order to clarify the other characteristics.
Products are homogeneous
There ain’t no business like show business. Differentiate product and services.
Not all steers are alike. Photo from Library of Congress on Flickr
The assumption of commodity homogeneity is a theoretical one. In reality, products are different. Pipes are made in different plants with varying degrees of quality despite specifications. They wear differently, rust differently, and bear loads differently.
Cattle are not homogeneous. They vary widely in their yield, meat-to-fat ratio and weight. Wheat varies in quality. Every product is different.
And here is the first key. Products obtain different prices because they are different. Selling a basket of commodities requires an assessment of the alternatives, and then a choice of differentiation. One might choose quality over lower cost and market dependability. Perhaps a stabilizing nutrient appeals to a small niche where competition is not fierce but volume is still adequate.
Whatever the strategy, its first kernel is differentiation. Differentiation provides advantage. Advantage allows price separation from the market average. Price separation is profit.
When our team turned around a beef plant, one of the keys was to identify and purchase cattle that had higher yields (meat to total weight) since live cattle are sold by the pound. We wanted to buy meat, not bone and fat. We tracked producer statistics (breeding and nutrition greatly affect yields) and buyer statistics. We trained our buyers to improve their inspection of live cattle. Over time we significantly improved yield percentages without paying market premiums.
Services
It is well known that bundling services with commodities nurtures price differentiation and a unique ‘value proposition.’ Services must at least cover marginal cost and in the long run they should cover all their costs.
Less known is that effective customer segmentation distinguishes between customers who value the service offering and customers who will pay for it. It is surprisingly common for firms to give away their services to at least some of their customers. Unless the practice serves some longer range strategy that will yield benefits, this is an invitation for mediocre performance at best.
If no customers are willing to pay for the service, then stop providing it. Let your competitors give away their labor.
In tough economic times, this rule is especially true. Continually search for and serve customers that appreciate and pay for your unique bundle of products and services. Continued difficulty finding such customers signals the bundle must be adjusted.
Leverage other products
Commodities by their nature tend to be inexpensive. It is in part a testament to innovation and technology. Both oil and steel are still cheaper by the pound than bottled water or potatoes. Take a moment to consider the import of that statement given the resources and capital both commodities require.
Their low price demands extra attention. Piggyback their delivery with higher priced goods in order to keep costs lower. Move them in large quantities. Optimize your supply chain.
Low cost retailers, T-shirt manufacturers, and anyone selling products that cost less than $5 per pound quickly find themselves interested in logistics or struggling to retain profitability. The larger the sales volume, the more attention logistic channels demand regardless of price. On the other hand, If volumes are low, there may not be much wiggle room.
Culture
High performance firms nurture a culture where all employees understand how the firm is situated in the market, what makes them special or unique, and where they make their profit. The culture then nurtures profitability as opposed to mediocre firms where profits leak from any number of holes throughout the day.
All employees have the capability of utilizing discernment and ethics to take care of the firm. But first they need to understand what it is worth and where that worth lies.
Supply and Demand
There is a tide to the affairs of men. Which, taken at the flood, leads on to fortune; ~Shakespeare
Supply
Sports teams expend incredible resources analyzing the strengths and weaknesses of their opponents. A good competitor does the same.
The global marketplace demands even more attention. Understand the manufacturing and delivery network from beginning to end, including supply and inventory networks, bottleneck points, shock scenarios, market share, and current trends. Without this understanding, inevitable shocks to the supply system will hurt the firm rather than provide opportunity to increase profits.
After a large hurricane, Wal-Mart noticed American flag sales were exploding. But there were only two domestic flag manufacturers; the rest had outsourced in Asia, their lead times measured in months. Wal-Mart purchased the whole productive capacity of the two domestic manufacturers and became the sole source of flags for a period of time while others scrambled.
When very inexpensive Chinese steel began encroaching into the West Coast, our steel team quickly identified it and shared with our customers the statistics of the steel, a number of high profile failures in Arizona and other states which we had tracked, and explained why our organization did not contract that steel despite its lower price. Sharing this information built a great deal of good will and reinforced trust with our customers. We also helped keep inferior steel out of the west coast at a time when many others just saw a series of random events.
Demand
Demand deserves the same attention as supply. Demand is not just a macro exercise. Understanding your customer and their motivations is absolutely key to selling products and even more important with commodities since differentiation is more difficult. If your customer segmentation does not yield a method of gauging demand, including forecasting major shocks, then the segmentation is not complete.
It is often a helpful exercise to analyze demand as a supply chain issue in addition to understanding the customer. It can inspire new delivery channels and location strategies which provide any combination of differentiation opportunities, lower cost, or unique service. Any of these strategies can affect prices and provide advantage.
As an example, retail clothing is most essentially a real estate industry. One of the major threats to Sears’ profitability in the last decades is that their stores are in the wrong place in hundreds of small and mid-sized cities around the nation. They were built decades ago and as the city aged, the population shifted leaving the store behind. Picture the Sears store in your city. Odds are that you rarely go there because it is either too far away or in a part of town you don’t want to visit. It is a wonder Sears has not moved aggressively to fix this problem, since it will surely eventually kill them regardless of what they have on their shelves.
Shocks to the system
Demand and supply shocks are inevitable, especially in commodities. Currently China builds the equivalent of Houston each month. Their usage along with India’s growth in infrastructure explains rising commodity prices in the last decade and almost ensures the same result in the next decade as the supply chain grows in chunks to meet increased demand. Commodities are integral to infrastructure.
But shocks always happen; both shortages and gluts. Develop plans and contracts that take advantage of them and the resulting price changes that accompany them.
When President Bush raised tariffs protecting domestic steel, our team was well situated when domestic manufacturers raised prices 25-40%. We had enough steel to fill tractor trailers end-to-end for more than 30 miles.
We spent the resulting profits building assets, rationalizing the supply chain, leveraging our way into new markets, and providing superior returns to our shareholders. Five years later our sales volume was five times larger.
Lastly, patience proves essential even with all the facts at hand. Most issues with commodities arise because firms are at either end of the spectrum; unaware and passive, or aware and too aggressive. A modest gain is better than none at all, and playing fast and loose with commodity speculation inevitably ends in failure. An understanding of markets allows profits without speculation.
Market information
Information is not knowledge. ~Einstein
This article is all about information. It is impossible to gather too much. But information is useless if it isn’t converted into knowledge and internalized by the organization. That requires active lenses and analyses that synthesize information to the advantage of the organization and customer alike.
Errors in information gathering occur all the time. Following are two of the most common, and they can spell the difference between vibrant action and stale inactivity.
Closed systems
Many organizations develop sophisticated closed systems that tell them comparatively little. Retail stores are a good example; a typical retail store spends technology dollars recording sales in real-time point-of-sale systems that cascade the information all the way through to the vendor. They accurately record movement and at their best measure marketing campaign ROI.
By now such systems are common. All are inherently flawed. Some simple mathematics yields their fatal flaw; left alone the system will eventually stock nothing. There is really no reason to add a sku or buttress existing sales. There are only reasons to take sku’s out as sales decline.
This is the inherent issue with closed systems. They need to be shocked externally to remain vibrant since left alone there is no outside information gauging the external market or lost sales. Therefore they will inevitably decline.
This flaw is the fundamental reason it is so important to introduce new products into the system; it provides a shock. It is common to view new product introductions as a method of combating existing product ‘aging’, when in reality declining sales are a fundamental characteristic of the closed system itself.
The cure to the flaw is to develop an open system of information gathering. That system takes into account all sales in the market (not just internal sales) in order to better describe and gauge the total market and its trends. The more detailed the information; customer segmentation, channels, geography, etc., the better its description.
Successful implementation of this market information implies a significant and profitable strategy. Can you see what it is? Consider the size of the market for the answer.
Information gathering structure
Utah copper mine circa 1917, from Library of Congress on Flickr
One of the secrets to actionable knowledge is the structure of information gathering in the first place. Market information is not hierarchical or linear. It is dispersed and like effective communication, flows in multiple directions.
Develop multi-pronged information systems by supplementing formal studies, customer feedback, local agent discussion, and external sources (some multi-national if that is appropriate) with internal sales. Like the data gathering itself, share the information in the same way. Have discussions throughout the firm about what it means and how it can profitably be used.
Our copper network, comprised of manufacturers, international contacts, local sales and rep agencies, managers and corporate office personnel ended up releasing periodic statements to the sales team. We held regional conference calls with our sales groups to better analyze information and develop actionable next steps.
We shared many of our market predictions with customers. Counseling your customer to delay their purchase because prices are likely to decline, or conversely, encouraging purchase in advance of price increases, develops trust and loyalty in a manner that dependable service can not replace.
The described structure internalizes information and utilizes it as productive, actionable knowledge in the market place. That is adaptive, autonomous competitive advantage.
Profits tend towards zero in the long run
Competitive markets demand declining profits in the long run because of the simple axiom that information and competitive advantage are impossible to retain forever. The strategies in this paper outline methods of avoiding head-on competition for that very reason.
In perfectly competitive markets, profits decline until capital enters and exits the market in virtually equal balance in inverse proportion to the ebb and tide of capital returns. This moment occurs at or just before marginal revenue equals marginal cost.
Happily, the long run rarely ever arrives. Demand grows as the world gets richer in fits and starts. New technologies change the fundamentals of the game. Markets continually change to adapt to a changing world.
Conclusion
The article above must be tailored to the size of your firm and ultimately the size of the market. Nevertheless, study the essence of markets. Their characteristics point out how to profitably operate within them. And never forget that ultimately the customer must value your unique or differentiated product and service offering, not just appreciate it.
If you can thrive in commodity markets, you can thrive in any market. There’s a reason commodity managers are more highly paid than branded managers; it’s a tougher job. Good luck.
References
Pictures courtesy of Library of Congress
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