A regular reader asked me the other day to explain why I said I thought the margins of Whole Foods (WFM) are too high. Here goes:
what they are
Margins are ratios, usually some measure of profits (gross profit, operating profit, pre-tax profit…) divided by sales. (Yes, in cost accounting contribution margin is a plain old dollar amount, not a ratio. But it’s an exception. I have no idea why the misleading name.)
when high margins are bad
At first thought, it would seem that the higher the margins, the better off the seller is. Buy the item for $1, sell it for $2. That’s good. Raise your prices and sell it for $5, that’s better.
The financial press encourages this notion with articles that talk up high margins as a good thing.
At some point, however, other people will work out how much you’re making and start doing the same thing. They’ll typically go for market share by undercutting your prices. So now you’ve got a competitor who wasn’t there before and you’re facing a price war that will at the very least undercut your brand image.
Creating what analysts call a price umbrella below which competitors can price their products and be protected from you as a rival is one of the worst mistakes a firm can make.
In my experience, it’s infinitely better to build a market more slowly by yourself than to have to try to dislodge a new rival who has spent time–and probably a lot of money–to enter.
One potential exception: patented intellectual property (think: Intel or drug companies). Even in this case, however, there’s the danger that once-successful firms become lazy and fail to continue to innovate after initial success. The sad stories of IBM, or of Digital Equipment, or INTC for that matter, are cautionary tales.