Distribution is all the rage these days. Some might say that it has always been the rage.
But I don't really like it when people borrow cookie-cutter platitudes from social media and recite them like parrots without nuance.
I also don't like it when people do great products and the sheer labor and intelligence that goes into making them at the expense of distribution which for most online businesses today, simply amounts to making the most noise and spraying and praying on Google and Facebook.
However, what's interesting to me is that at the same time, we are also seeing a lot of businesses go back to focusing on profitability.
Operating leverage is a concept that is key to understanding this tightrope walk between profitability, product innovation, and distribution.
Let's learn.
Simply put, In a business with high operating leverage, a significant portion of its costs are fixed, such as rent, salaries, or equipment.
This means that as the company generates more revenue, the fixed costs stay the same, leading to a greater portion of the new revenue translating into profit. High operating leverage can be a powerful advantage because, as the business scales, it doesn't need to invest as much in additional resources to generate more profit.
Consider, for instance, an airline that typically has to sell around 80% of its tickets just to break even. If the airline can sell more tickets, the majority of the additional ticket revenue will contribute to its profits, as the cost of operating the flight remains almost unchanged whether the plane is 80% full or 100% full. Consequently, if the airline can sell one more ticket for $500, its profit will increase by $500 (not quite, but you get the point).
This is high operating leverage: beyond the break-even point, the % increase in profits per % increase in sales is high.
On the other hand, a business with low operating leverage has a higher percentage of variable costs, such as raw materials or labor. In this case, as the business grows its revenues, its costs will increase proportionally, limiting the growth of its profits.
For example, picture a temporary staffing agency. The agency employs freelancers at a rate of $15 per hour and charges clients $20 per hour for their services. If the agency can increase its sales by $100, it will only make an additional $25 in profit (as it has to pay the freelancers $75 for five hours of labor).
In this scenario, the business has lower operating leverage as the variable costs of hiring freelancers scale up with the amount of business the agency gets. The % increase in profits per % increase in sales is low, as variable costs with every additional sale eat into profit margins.
Another example is retail stores like Reliance or Walmart. They typically have a low degree of operating leverage due to their relatively high variable costs. The majority of their costs come from purchasing inventory (perishable and non-perishable goods) that need to be replenished regularly, as well as labor costs associated with store associates, cashiers, and stockers. And while they do have fixed costs like rent, utilities, and salaries for full-time employees, their profit margins are often slim, and a significant portion of their expenses fluctuates with sales volume.
If you wish to understand the differences between fixed and variable costs in various industries, ChatGPT can help.
Here are examples of five industries along with their fixed and variable costs:
Manufacturing
Fixed costs: Factory rent, machinery depreciation, property taxes, and insurance.
Variable costs: Raw materials, direct labor, utilities used in production, and packaging.
Software Development
Fixed costs: Office rent, software licenses, salaries for full-time employees, and server costs.
Variable costs: Contractors or freelance developers, cloud-based services with usage-based pricing, and marketing expenses tied to customer acquisition.
Restaurants
Fixed costs: Rent, kitchen equipment depreciation, property taxes, insurance, and management salaries.
Variable costs: Food ingredients, hourly wages for waitstaff and kitchen staff, and utilities like gas and electricity.
Retail
Fixed costs: Store rent, display fixtures, salaries for store management, and insurance.
Variable costs: Inventory, sales commissions, shipping costs, and labor for sales associates.
Telecommunications
Fixed costs: Network infrastructure, office rent, salaries for engineers and support staff, and equipment depreciation.
Variable costs: Bandwidth usage, electricity, customer acquisition costs, and maintenance or repair costs related to network utilization.
So, what happens when a significant percentage of a business is made up of fixed costs vs. when it is made up of variable costs?
When a business has a high proportion of its operating expenses as fixed costs, it is in its best interests to maximize distribution. Because as revenues increase, a larger portion of each additional dollar of revenue contributes to profits since fixed costs remain constant. This can lead to higher profit margins and greater profitability as the business grows.
Think of a business like Salesforce that spends a significant chunk of its profits advertising, as compared to reinvesting it into product research and development.
Why?
Because Salesforce has a buffet of existing software products it has acquired over the years like Tableau, MuleSoft, ClickSoftware, Vlocity, Demandware, and most recently, the $27.7B acquisition of Slack. This is a kind of fixed cost the company bore at the start.
Now, to generate sufficient RoI on these fixed costs, it is only smart for Salesforce to invest heavily in increasing its sales — especially given the fact that the enterprise SaaS space benefits from high switching costs. This means that once a large organization onboards Salesforce, it is not easy for them to quickly switch to a competitor. But it is significantly easier for Salesforce to now upsell other products in its suite.
Conversely, when a business has high variable costs, i.e., low operating leverage, as revenues increase, profits may not grow as quickly because variable costs increase proportionally with revenue. This leads to more consistent profit margins, but lower overall profitability compared to businesses with high operating leverage.
This is why startups like Zomato and Swiggy will have a hard time getting to profitability.
They have high variable costs associated with every additional delivery they make. Cost of delivering scales linearly with increasing sales.
They need to pay delivery partners based on the number of orders they complete, and this cost increases with the volume of orders.
Additionally, they may incur expenses related to customer support, packaging materials, and discounts or promotions to attract customers. The high variable costs can limit the potential for increasing profit margins as the business grows, making it more challenging to achieve profitability.
So, if my startup has low operating leverage and high variable costs, how do I get to the break-even point and attain profitability faster?
There are a few ways:
Optimize variable costs by optimizing delivery routes, delivery personnel salaries, and seeking other forms of operational efficiency.
You can even focus on improving customer retention and lifetime value and try upselling and cross-selling them new products to increase your total sales.
Or you can try to dominate certain geographies to gain higher negotiating power. As your delivery startup grows and expands its network, it may be able to leverage its scale to negotiate better terms with suppliers, improve route optimization, and streamline operations, ultimately reducing variable costs and improving profitability.
But there's a limit to all these optimizations. Beyond a point, you have to increase pricing and boost sales at the same time, which is a hard nut to crack.
In any case, businesses with high variable costs cannot afford to spend a lot on distribution without focusing on improving the product for higher pricing power and retention in a competitive market. Because the returns they get on increased sales are not as high as a business that has high operating leverage.
And consider what happens when retention is low for a business with lower operating leverage.
Your Customer Acquisition Costs (CAC) go up in relation to the Lifetime Value (LTV) of the customer. You're getting new customers for a certain amount of money, but the purchases they make over their lifetime as a customer do not make up for the cost of acquiring them — simply because the profit margin per every new sale you make is low due to high variable costs and the fact that they did not stay a customer for long.
However, there are some benefits that low operating leverage businesses benefit from.
They can more easily scale up or down in response to changes in demand. When demand decreases, they can reduce their variable costs (e.g., by purchasing fewer raw materials, inventory, labor, etc.), making it easier to maintain profitability.
They consequently also are less exposed to the risk posed by fluctuations in demand, as they can more easily adjust their cost structure. This can make them more resilient during economic downturns.
In contrast, high fixed costs and operating leverage means are more vulnerable to fluctuations in demand. In economic downturns or periods of decreased demand, they may struggle to cover their fixed costs, leading to significant losses. Restaurants during Covid are a great example.
But at the same time, the high upfront investment in infrastructure means that during normal operation, the business can safely invest in marketing as more revenue majorly adds to profit. This is also why restaurants are incentivized to sign up on Swiggy and Zomato, even when they have to pay huge commissions. They're constrained by seating space and are simply spreading their fixed costs like the kitchen and labor over a larger set of customers who order food online.
This is also why large FMCG brands like Coca-Cola invest heavily in marketing.
Primarily, it's just due to the ultra-competitive nature of the FMCG space where more marketing is almost directly correlated with increased sales. But higher operating leverage and Coca-Cola's high fixed cost investment in its manufacturing and supply chain means more sales directly add to its profit margins.
Coca-Cola has substantial fixed costs, including investments in production facilities, distribution networks, advertising, and marketing. These costs do not change significantly with fluctuations in production or sales volume. In contrast, the company's variable costs, such as raw materials (sugar, packaging materials, etc.), are relatively lower compared to the fixed costs.
The high operating leverage means that as Coca-Cola's sales increase, its fixed costs remain relatively constant, allowing for a larger portion of the additional revenue to be translated into profit. Conversely, a decline in sales would lead to a more significant decrease in operating income, given the high proportion of fixed costs.
Thus, it is in Coca-Cola's best interests to spend a lot on distribution and advertising.
But the same cannot be said of all businesses, especially ones with lower operating leverage.
Having said all of this, operating leverage is only one big part of the puzzle.
The other parts of the puzzle you need to consider while contrasting great products with great distribution are:
1. Market Maturity: The more mature a market, the more it makes sense to focus on distribution and expand market share. But in a rapidly evolving market or an emerging industry, innovation through R&D can be vital to creating solid product differentiation and might not be as optional as influencers might make you believe.
2. Moats: If a business is in a highly competitive market with weak moats, it is actually better off focusing on building a great product that is able to retain customers. On the other hand, if a company has a clear competitive advantage or is operating in an industry with high switching costs, focusing on distribution can help maximize that advantage.
3. Growth Stage: If you wish to disrupt a market or launch in a market where incumbents already have a monopoly, prioritizing a highly differentiated product is a no-brainer to even capture the attention of early adopters. Early-stage companies often need to prioritize R&D to establish a strong product or service offering before focusing on distribution. As the business matures and its products become more established, the focus may shift to distribution and market expansion.
So, the next time you read a LinkedIn post or a tweet saying
"Mediocre product with great distribution beats great product with mediocre distribution,"
you know it is way more nuanced than that.
Especially for early-stage founders, my advice would be to focus on building a great product — a product that works — first — before chasing the low-hanging fruit of distribution.
You can build a profitable company even by serving a really small set of customers who absolutely love your product. The reverse — meh product with great distribution — isn't sustainable in the long term. In that case, you're only waiting for someone to come with a much superior product and disrupt you.
All the alpha now lies in doing the hard thing.
