JD and the Power of Production Cost Advantages in Retail (Daily Lesson – Jeff’s Asia Tech Class)

In this week’s lecture / podcast, I talked about how online retailers like early JD compete on different factors than marketplace platforms like Alibaba.

Specifically, I said:

  • Alibaba and marketplace platforms compete on:
    • Cost and / or difficulty of entry – including the chicken-and-egg problem and the cost of the logistics network.
    • Competitive advantages – including network effects (main one) and economies of scale in logistics, marketing and IT.
  • Early JD and online retailers compete on:
    • Cost and / or difficulty of entry – including the cost of the logistics network.
    • Competitive advantages – including supply cost advantages and economies of scale in logistics (mostly), marketing and IT

And this all goes under Learning Goal is #5: the Basics of JD.

But really the important take-away is that online and traditional retailers derive most of their power from Supply Cost Advantages over time. Their bargaining power with suppliers is really the important competitive advantage to understand.

Production Cost Advantages vs. Economies of Scale

If you are going to be cheaper than your competitor, you can do that one of two ways.

  • You can have economies of scale where you have an advantage in fixed costs like marketing, logistics, and R&D. If 15% of your cost structure is R&D and you are 3x bigger than your competitor in revenue, you are hugely outspending their 15% on R&D. Coca-Cola does this in marketing spend to pummel smaller cola companies. Huawei is grinding down Nokia and Ericsson in telco this way.
  • You can have an advantage in production costs. These are advantages in variable costs. If your competitor is half your size, their electricity bill is half the size of yours. No advantage for you. But if you have software IP, you can often do things cheaper than your competitor, regardless of size.

An advantage in variable costs is called a Production Cost Advantage, or sometimes a Manufacturing Cost Advantage. Some examples:

  • Saudi Aramco (the Saudi oil producer) is cheaper at refining and selling oil because it has its own oil reserves and doesn’t have to buy these inputs from the market at a higher price. It’s a production variable cost advantage regardless of how much they sell.
  • Microsoft is cheaper at building operating systems because it has a library of IP and technology it can draw on.
  • IBM is cheaper at doing IT consulting and services because it has accumulated knowledge of projects and lots of staff development. It has a learning cost advantage.

The Power of a Supply Cost Advantage in Retail

There are 5-6 important types of Production Cost Advantages. But the one that really matters in physical and online retail is being able to buy the goods that go on the shelves cheaper (and with better working capital terms) than your competitors. It’s a supply cost advantage based on bargaining power. For example:

  • WalMart can buy goods cheaper than smaller physical retailers.
  • JD can buy goods cheaper than smaller online retailers.
  • Big health insurance plans can buy medical services cheaper than smaller plans.

We call this Production Cost Advantage a Supply Cost Advantage or a Lower Cost of Inputs. It can be in labor costs, capital costs, energy costs, and supply costs. Most advantages in this area don’t last long. Moving factories to Vietnam gets you lower labor costs but competitors tend to match that quickly. Lower capital costs (hello Luckin Coffee) tend to disappear with capital cycles. But supply cost advantages based on bargaining power can persist. Some examples:

  • JD has big supply cost advantages because they serve all the Chinese consumers. This gives them bargaining power not only with suppliers in China but also internationally. Capturing Chinese consumers gives you a lot of power globally with merchants and brands. We are currently seeing them exert significant power in cross-border fashion and luxury to Chinese consumers.
  • Oxford Health, a now closed New York-focused health insurance plan, had lots of bargaining power. But only with New York physicians and hospitals. They had lots of New York consumers so they were good at negotiating with New York physicians for cheaper prices. But it was strictly a local advantage.

This sort of bargaining power with suppliers can come from market share. Or criticality. Or being a gatekeeper.

And this is really JD’s big lever as an online retailer (not a marketplace). It shows up as a 16% gross profit on goods sold, which is higher than their online and physical retail competitors. And they are using this cost advantage to keep their prices low (as opposed to pricing the same and taking it as profit). These lower prices get them more customers and market share, which further increases their bargaining power. It’s a virtuous cycle that I can call “profitless growth”.

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Final Point on Keeping it Simple in Retail

Recall in Podcast 6: Can Luckin, Mobike, Didi or WeWork Be Profitable?, I spoke about how you want to look at a business from the consumer and competitor viewpoints. And they are usually intertwined.

  • What does the consumer care about in most retail? The big factors are usually breadth of products, cost, acceptable quality and convenience / user experience. The big retailers like Walmart are all about offering tons of products at low prices – with easy to access. It basically means consumers have no reason to go anywhere else. Low cost and acceptable quality are the biggest factors in most retail. Specialty and luxury are different.
  • Can a well-funded, well-run competitor enter the space and take market share? Entering is actually not hard. You just open a store or a website. But the hard thing long-term is to match the cost of goods sold (and therefore price) of a Walmart of JD. And that comes mostly from bargaining power with suppliers.

JD has some other competitive strengths in online retail, such as economies of scale and user experience. But this is their biggest one. And this is what consumers care about most for most products. You want to keep it simple in most retail: big selection and low price.

That’s it. Have a great day – jeff

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I write and speak about digital China and Asia’s latest tech trends.

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