By the early 2000s, the tiny company known as PC’s Limited — originally started in Michael Dell’s dorm room — had been reincorporated as Dell Inc, and the company had prevailed against IBM and Compaq in the personal computer wars of the 80s and 90s. Dell was now a publicly traded company. Michael himself had stepped aside as company CEO for a brief period, from 2004 to 2007, about the same time the entire PC industry started sliding sideways. Dell writes of this period in his autobiography Play Nice But Win (all emphasis mine):
There is a concept that surfaces here and in several other places I have noticed. It is the idea that an undue focus on percentage margins can cause a business to make economically destructive decisions. For example, in Good to Great to Gone, Wurtzel explains Circuit City lose ground because it focused on high gross margins and did not stock CDs, computer games, and other high turnover items. It kept losing ground to Best Buy who was gaining market share, but had lower margins. What they did not realize was Best Buy had more sales per store, thus turnover, and could operate at lower margins and as Best Buy kept generating more sales per store, their rent costs were low as a percentage of sales and could afford better real estate. By the time Circuit City realized it, it was too late and Best Buy had a better ROIC (high margins and higher capital turnover) and thus lower costs and better market share. This ties to Michael Dell’s idea of balancing growth, profits, and share.
In Becoming Trader Joe, Joe Columbe talks about how he never focused on % margins, but rather dollar margins. He would sell at low margins is $ made sense since that’s how bills got paid. I need to flesh this out more, but its here.
After puzzling over this mystery for a long time, (Christensen) finally came up with the answer: it was owing to the way the managers had learned to measure success. Success was now measured not in numbers of dollars but in ratios. Whether it was return on net assets, or gross-margin percentage, or internal rate of return, all these measures had, in the past forty years, been enshrined into a near-religion (he liked to call it the Church of New Finance) by partners in hedge funds and venture-capital firms and finance professors in business schools. People had come to think that the most important thing was not how much profit you made in absolute terms but what percentage of profit you made on each dollar you put in. And that belief drove managers to shed high-volume but low-margin products from their balance sheets, even though nobody had ever come across a bank that accepted deposits in ratios. This was why he called it a church: it was an encompassing orthodoxy that made it impossible for believers to see that it might be wrong(emphasis added) .
Circuit City is from the mid to late 90’s and Columb is probably from the 1980’s. The basic idea is a overt focus on % margins causes you to make bad economic decisions. I can’t emphasize how great a read Good to Great to Gone is. The author uses habits of mind which points out precepts where a business succeeds or fails during inflection points. Essentially, he uses anecdoes as instantions of these habits of mind at the end of each chapter.
Also, an interesting aspect of capital allocation is that of opportuniy costs. Circuity City could have bought best buy for $30M, with strings attached. Given just the competitive harm, that could have been money well spent…
Sorry, not sorr, haha! To better contextualize my scatteredd thoughts:
From Becoming Trader Joe:
This is the question other retailers most often ask. Usually they ask, “What percentage margin did you aim for?” Which always launches me into my tirade about how you pay your bills with dollars, not percents. This seemed to be a concept that was pushed aside in the traditional supermarket environs. (Location 1935)
Thus, at the time, I was willing to make only 13 percent on a $20 bottle of champagne, because that was a $2.60 profit. For a $2.00 item, however, I wanted to make a much greater percentage. Actually, we persistently got rid of anything that sold for less than a dollar. We stopped selling individual cans of soda and beer, for example, as I didn’t want that kind of trade in the store.
Good to Great To Gone:
“We, like any successful discounter could not take margin [percentages] to the bank, only dollars. So selling a reasonable amount at a lower gross margin was generally better than making far fewer sales at a greater gross profit.”