In this post, I would like to introduce a familiar business model (for most value investors) that can help most investors in their analysis of companies. It is also a model that entrepreneurs should seriously adopt when they want to start their own businesses. It is a very basic model that can help generate good recurring income and is probably a sign that the company will be in the business for a long, long time and not those fly-by-night bubble tea shops where you see them today but not tomorrow.
This business model is known as the razor-and-blade model. Well for the uninitiated, this is the model where you sell the low profit margin razor at a cheap price and then earn back the money by selling the blades at a high margin.
Though mundane as it may sound, this model has proven itself time and again that it can generate stable cashflow and earn a good margin. Unfortunately, as the guru used to say, it’s hard to teach a new dog old tricks. So a lot of businesses don’t employ this model.
This model plays on the human mindset by enticing people to buy something, usually having the impression that it should be expensive at a low price. Then after “locking-in” the customer, the co. sells him consumable products at a higher margin. However, our ape-evolved minds cannot relate that instantly and we still think we are getting a good deal.
For example, we buy a mobile phone at S$199 thinking that it’s quite value-for-money given a lot of sophisticated stuff goes inside this cool piece of plastic and electronics (So the phone is the razor here). However, we then need to buy the blades (talk-time) that cost us $30-50 a month! And worse still, we are lock-in for 2 years! So is it really value-for-money if you think of the whole package? Hmmm…
Sounds like it’s a bit unscrupulous? Feel like you are being treated unfairly? But hey, that’s life, folks. Become a shareholder of the company then and screw the management during AGM! That’s why I own Singtel! Haha!
Anyways, besides the telcos, today we see various businesses employing this simple model, including our favourite Ipod (selling you the Ipod/razor, then the songs/blades), Canon printers, Playstation and Nintendo games, anti-virus softwares etc. But at the macro level, not a hell lot of businesses are doing this. Well of course, sometimes the nature of the business does not allow the adoption of the model, like the retail business. Which also implies that maybe that’s why retail businesses cannot earn a hell lot of money. Sadly when Singaporeans say they want to be entrepreneurs, most people think of retail businesses like restaurants, bubble tea (*gosh*) and clothings etc. My guess is only 1 in 20 retail shops will actually "succeed" ie earn as much as a full-time job after adjusting for time and effort put in.
The razor-and-blade model also manifests itself in different versions but the crux remains at its ability to generate recurring income stream. This is best exemplify by Dell, which recently announced that it wants to provide IT services to its clients instead of simply selling them the box (ie the PC lah). So in this case, the PC is the razor and the servicing contract is the blade. So Michael Dell really got some Liao one ok? Don’t pray pray!
Maintenance contract is actually a very good razor because it usually last for 2-3 yrs and hence securing the stable cashflow from the client for that time period, like the telcos (btw telcos is short-form for telecommunications companies like Singtel, Starhub hor). And with minimum extra capex or cash outflow, you actually get this money rolling in.
So next time when you see a business with a razor-and-blade model, remember to give it some credit bcos chances are it will still be earning money even when the crunch comes, unlike a lot of other businesses which will probably go into red. Especially those hot sectors nowadays, like RE related construction where majority of co.s involved don’t really have a business moat and are rising simply bcos it’s high tide now.
This business model is known as the razor-and-blade model. Well for the uninitiated, this is the model where you sell the low profit margin razor at a cheap price and then earn back the money by selling the blades at a high margin.
Though mundane as it may sound, this model has proven itself time and again that it can generate stable cashflow and earn a good margin. Unfortunately, as the guru used to say, it’s hard to teach a new dog old tricks. So a lot of businesses don’t employ this model.
This model plays on the human mindset by enticing people to buy something, usually having the impression that it should be expensive at a low price. Then after “locking-in” the customer, the co. sells him consumable products at a higher margin. However, our ape-evolved minds cannot relate that instantly and we still think we are getting a good deal.
For example, we buy a mobile phone at S$199 thinking that it’s quite value-for-money given a lot of sophisticated stuff goes inside this cool piece of plastic and electronics (So the phone is the razor here). However, we then need to buy the blades (talk-time) that cost us $30-50 a month! And worse still, we are lock-in for 2 years! So is it really value-for-money if you think of the whole package? Hmmm…
Sounds like it’s a bit unscrupulous? Feel like you are being treated unfairly? But hey, that’s life, folks. Become a shareholder of the company then and screw the management during AGM! That’s why I own Singtel! Haha!
Anyways, besides the telcos, today we see various businesses employing this simple model, including our favourite Ipod (selling you the Ipod/razor, then the songs/blades), Canon printers, Playstation and Nintendo games, anti-virus softwares etc. But at the macro level, not a hell lot of businesses are doing this. Well of course, sometimes the nature of the business does not allow the adoption of the model, like the retail business. Which also implies that maybe that’s why retail businesses cannot earn a hell lot of money. Sadly when Singaporeans say they want to be entrepreneurs, most people think of retail businesses like restaurants, bubble tea (*gosh*) and clothings etc. My guess is only 1 in 20 retail shops will actually "succeed" ie earn as much as a full-time job after adjusting for time and effort put in.
The razor-and-blade model also manifests itself in different versions but the crux remains at its ability to generate recurring income stream. This is best exemplify by Dell, which recently announced that it wants to provide IT services to its clients instead of simply selling them the box (ie the PC lah). So in this case, the PC is the razor and the servicing contract is the blade. So Michael Dell really got some Liao one ok? Don’t pray pray!
Maintenance contract is actually a very good razor because it usually last for 2-3 yrs and hence securing the stable cashflow from the client for that time period, like the telcos (btw telcos is short-form for telecommunications companies like Singtel, Starhub hor). And with minimum extra capex or cash outflow, you actually get this money rolling in.
So next time when you see a business with a razor-and-blade model, remember to give it some credit bcos chances are it will still be earning money even when the crunch comes, unlike a lot of other businesses which will probably go into red. Especially those hot sectors nowadays, like RE related construction where majority of co.s involved don’t really have a business moat and are rising simply bcos it’s high tide now.
I personally had the unpleasant experience a couple of years back of such a biz model. I bought a printer from Lexmark, thinking it was very cheap (think it was only $50!). But later then I realise the ink is very expensive and runs out very fast! I was super glad that the printer broke down some time later and vowed never to buy Lexmark again!
ReplyDeleteSo my point is that while the theory of razor/blade is theoritically sound, it's also on a case-by-case basis! Gillete worked because the razor they sold were sturdy and good. So it left good "after-taste" on consumers! Just my two cents...
In economics the razor is known as a loss leader. This doesn't work all the time, one has to compare the benefits gained to the costs of implementation.
ReplyDeleteThere are many interestingly forms of price discrimination (or pricing strategy). For example, telephone companies offer different types of plan so consumer practice self segmentation. Also, the one time charge and then subsequent charges on talk time can be said to be a two part tariff.
The purpose of pricing strategies is mostly for capturing consumer surplus. Indeed, the success of many large firms have been attributed to their ability to capture surpluses. (among other things)
There are many real life business strategies in Microeconomics textbooks supported by evidence and case studies. In fact, a lot of those are written by economists who has done extensive consulting work in the private sector.
Aspiring businessmen would do well to learn from them. After all, its free. :)
Thanks for the comments.
ReplyDeleteFishman, you are definitely right on that point. In fact, in the inkjet printer space, only 1 or 2 players are making money. That's bcos the razor is sold too cheaply.
Lexmark probably loses $100-200 for each printer sold.
The more they sell, the more red-ink! It will take a user to buy 20-30 cartridges for them to breakeven on 1 printer but the printer breaks down before that!
So I guess the key here is that the razor should be sold at a low profit, not at a loss.
Economist, perhaps you might want to elaborate what do you mean by capturing surpluses? Have not studied micro-economics.
Loss leaders like razors are actually sold at a loss. (Marginal revenue < marginal cost) The benefit of doing so could be invisible from an accounting point of view: for example, drug dealers give out drugs samples for free to create more consumers that bring in future profits.
ReplyDeleteAbout capturing consumer surpluses:
Consumer surplus can generally be described as the extra monetary benefit a consumer derive from buying a product. If you value a product at $10 and only paid $5 for it then your surplus is $5. Since the market only has one price while everyone of us value the product differently, consumer surplus generally exists. (a pack of cigarette is worth $0 to me while to a smoker it might be worth $5)
Hence the maximum revenue a firm can earn from a market is the maximum amount each and everyone consumer is willing to pay for it. As it is often not possible to know this figure, price discrimination mechanics have to be used to accomplish this.
Google's Adsense auction system is one of the best applications of microeconomic theories because it is effective at capturing almost 100% of advertisers' surplus.
Thanks Economist,
ReplyDeleteI like your blog too. Will put up a link in time.
I am definitely not a seasoned investor. Not when my track record still far less than 10 yrs. Even if it's 10 yrs, it is still not long enough to be statistically significant.
Nobody has a monopoly on knowledge. Let's learn from one another.