in Amazon, flywheel, Jeff Bezos, Nicholas Sleep, Nomad Investment Partnership, Scale Economics Shared

Margins, 2 Ways

“There are two ways to build a successful company. One is to work very, very hard to convince customers to pay high margins. The other is to work very very hard to be able to offer customers low margins. They both work. We’re firmly in the second camp. It’s difficult — you have to eliminate defects and be very efficient. But it’s also a point of view. We’d rather have a very large customer base and low margins than a small customer base and higher margins.”

Jeff Bezos quoted by Nick Sleep from Wired Magazine circa 2011 in Nomad Investment Partnership’s Letter to Partners

There’s a lot of heuristics used in our world and perhaps the best way is to go from first-principles but you cannot always do that or your brain would fry.

I do enjoy great heuristics, especially when it helps bring clarity to an otherwise highly complex world. I think that in “business”, it’s a bit easier to employ heuristics just because the outcomes are so chaotic anyways, you can be off by a country mile and still not be so wrong.

I digress.

In reading Sleep’s letters for the first time, I’m struck by the quote he pulled from Bezos on how he thinks about margins. We know Bezos, in running Amazon, had been famous for saying that: your margin is my opportunity.

It’s just a quote but let’s break it down anyway — just for fun.

Either Way, You Need to Work

In case, it’s not obvious, forming a business, building traction, managing people to see your vision and join it, keeping talent and customers is just scratching the surface.

But I love Bezos work ethic here: be it with high or low margins, you just need to work very very hard.

But notice his emphasis on what works hard at.

For high margin businesses, his contention is that businesses work hard at convincing customers to pay higher margins. There’s a negative connotation to that, but it also shows his dislike for that sort of business. It’s also being a bit harsh that somehow customers have the wool pulled over the eyes when transacting with your business. But still, maybe there is some truth to that.

Conversely, the hard work to keep margins low helps your customers. Notice he didn’t even talk about the specific good or service which I assume in both cases offer some value to customers. He really thinks the focus on the businesses he likes is that the hard work is put on just being able to offer customers lower margins and that that in and of itself brings value (or even more value) to customers. That’s telling and insightful.

Low Margins come from Continuous Improvement

And being able to offer something isn’t a guarantee that it’ll work. That can be pipe dream, but the best businesses that want to do that and commit to it, has also to commit to continuous improvement. In his words, eliminating defects and high throughput through efficiency gains day-in, day-out.

And it’s difficult.

That level of difficulty of maintaining low margins for the long haul means you need high quality on almost every part of your value chain. Nothing can be sweep under the carpet, no stone can be left unturned. That kind of behaviour needs to be imbued in the culture and that itself is harder to replicate than anything else.

It’s “a point of view”

That’s what business culture is at the base of it, a point of view. Doesn’t someone say culture is what you company does when the CEO or management isn’t looking?!

You don’t get high efficiency without culture. And you cannot get culture if you don’t believe that living with a lower margin business is respecting the customer. It’s not a truism that that is what you need to do in business affairs but that’s how Bezos built Amazon.

All this is to say that Sleep was well ahead of the curve on Amazon and Bezos. There are economic moats to be found everywhere but especially at the tail ends of the spectrum of the highest and lowest margins.

Higher margins are likely unsustainable over time due to market forces attacking your “moat”.

Lower margin businesses with a culture for offering lower prices for customers means that you can fend off your moat in two very important fronts:

  1. Less competition will chase you down because it looks like such hard work to start and maintain
  2. Once you do have the customers, it’s hard to unseat you because the value that is offered to customers is a direct result of your entire company’s maniacal focus and not just because of the perceived value of your offering alone.

Lastly, and this is entirely the work from Sleep on understanding first principles, that there is nothing better than to have this continuous, virtuous cycle of lower prices, getting more business, offering more value to the entire value chain and keep it repeating indefinitely. That’s scale economics shared.

Of course, in hindsight, everything looks like it was brilliant. And it still is.