Wednesday, November 15, 2006

economics of a computer store (why they don't stock what you want)

In some mailing list discussions recently some people demonstrated a lack of knowledge of the economics of a shop. Having run a shop for a few years (an Internet Cafe) I have some practical knowledge of this. I will focus on small businesses in this article, but the same economic principles apply to large corporations too.

When running a shop the main problem you have is in managing stock. There are two ways of getting stock, one is to have wholesalers give it to you for a period in which you can try to sell it and you pay for it when it's sold, this is probably quite rare (I don't know of an example of it being done - and probably no retailer wants to talk about it in case they lose it). Often retailers consider themselves to be privileged if they are permitted to pay for hardware one month after they receive it! The more common way of getting stock is simply to buy it and hope you can sell it in a reasonable period of time (often the wholesaler will offer to buy the stock back at a 10% discount if you can't sell it).

To buy stock you need money, this can come from money that has accrued in the business account (if things are going really well) or from a mortgage taken out by the business owner if things aren't going so well. For small businesses things usually don't go so well so the money used to buy stock is borrowed at an interest rate of about 7% or 8% (I'm using numbers based on the current economic conditions in Australia, different numbers apply to different countries and different times but the same principles apply). The ideal situation is when there is money in the company bank account to cover the purchase of all stock, this means that the cost of owning stock is that you miss out on the 5.5% interest that the money will get in a term deposit.

Almost all stock has a use-by date of some form. Some items have a very short expiry (EG milk used to make hot chocolate in an Internet cafe, some have a moderate expiry date (computer systems become almost unsellable in about 18 months and lose value steadily month after month), but in the computer industry nothing has a long expiry date.

Let's assume for the sake of discussion that you want to run a small computer store that is open to passing trade (this means that you must have stock for an immediate sale). Let's assume that all items of computer hardware lose half their value over the period of 20 months at a steady rate of 2.5% of the original price per month (I think that most computer hardware loses value faster than that, but it's just an assumption to illustrate the point).

The next major issue is the profit margin on each sale. If you can make a 20% profit on a sale then an item that has lost 10% of it's value while gathering dust in your store will still be profitable. However the profit margins on computer sales are very small due to having a small number of major manufacturers (Intel, AMD, nVidia, ATI, Seagate, and WD) that have almost cartel positions in their markets and there being little to differentiate the stores apart from price. I have been told that 3% profit is typical for retail computer hardware sales by the small companies nowadays! Now if the stock will lose 2.5% of it's value per month, you pay 0.5% interest per month and you make a 3% profit then if an item remains in stock for a month then you lose money. So on average (by value) you need to have stock spending significantly less than a month in your store. Cheap items such as low-quality cases and PSUs can stay in stock for a while. More expensive items such as new CPUs and the motherboards to house them must be moved quickly.

What's the first thing that you do to reduce stock? You can keep stocks low, but there is a limit to how low you can go without losing sales. The next thing to do is to not stock items that customers won't often buy or items where there is a similar item that you can stock as a substitute. The classic example of this is hard drives, a customer will want a certain capacity for a certain price - if their preferred brand is not in stock they will almost always take a different brand if it has the same capacity at the same price. Stores often advertise prices on multiple brands of hard drive in each capacity, but often only try to keep one brand in stock.

Of course this is a problem for the more fussy buyer. If you want to buy two identical parts from the same store on different days you might discover that they don't have the stock on the second day and that they instead offer you something equivalent. Not only do retailers have issues with managing their investment in stock but wholesalers have the same problem. So if a retailer runs out of WD drives and discovers that their preferred wholesaler has also run out of WD drives then they just buy a different brand - most customers don't care anyway.

There are some companies I deal with that have a business model based on services. One of them sells hardware to customers at cost, but charges them for the time spend assembling them, transporting them, etc. The potential for a 3% profit on the hardware isn't worth persuing, they prefer to just charge for work and also save themselves the sales effort. Another company I know operates almost exclusively on the basis of ordering parts when customers request them (but still make a small profit margin on the sales), this means that the customer can be invoiced as soon as the hardware arrives. The down-side to this is that wholesalers have the same stock issues and they sometimes have excessive delays before the wholesaler can deliver the hardware.

Dell is the real winner out of this. As they operate by mail-order they don't need to have the stock immediately available, they have a few days to deliver it which gets them time to arrange the supply. They can also have a central warehouse per region which reduces the stock requirements again. A 3% profit on items that rapidly decrease in value makes it almost impossible to sustain a small business. But an organization such as Dell can sustain a successful business at that level.

Of course the down-side for the end-user is that Dell doesn't want to have too many models as that just makes it more complex for the sales channel. Also they have deals with major suppliers which presumably give them deep discounts in exchange for not selling rival products (this is why some brands of parts are conspicuously absent from Dell systems).

10 years ago there used to be a small computer store in every shopping area. Now in Australia there are a few large stores (which often only have a small section devoted to computers) and mail-order. There seems to be much less choice in computer hardware than there was, but it is much cheaper.

PS I've attached a picture of day 39 of the beard.


Justin said...

Ten years ago, newegg was just starting out. I don't know if Australia has a similar system of if you know about it already, but basically newegg is the Amazon of computer parts. They've basically merged warehousing with online retail and skip on the costs of building stores and retail channels. And because their system has a national, if not international, reach, managing inventory becomes something more predictable and less like a random walk.

I haven't bought computer components from a local store in a long time; the selection is poor, the prices are comparable at best, and the hours incompatible with a student's schedule.

That said, if I ever buy another PC case or motherboard, it'll be somewhere where I can see it first. Microcenter (a fairly large and successful PC hardware "big box" store) is one such place.

Peter said...

Dell has it even better than you're letting on. They set up their manufacturing plants such that their suppliers back up trailers of parts to loading docks, but don't unload them. When you order yourself a new machine, they charge you for it, then tell a forklift operator to fetch the appropriate bits from the truck. Only once the part crosses the threshold of the truck door does an RFID sensor tell the supplier to send Dell an invoice.

In other words, Dell pays for its inventory something like 2 days after it's sold it, by foisting the warehousing costs onto its suppliers.

I don't have a point, I suppose, other that it's handy to be big. I just thought it was kind of cool.

Tom said...

Damn. If I don't shave for a month, all I get is some fuzz and three semi-long hairs. You're manly man, Russel. Well done.

Shannon Szukala said...

I agree with you running computer stock is hard. I found it easy to run down to best buy for cheap hard drives.

etbe said...

Peter, I had suspected that Dell would do something similar but had no evidence.

If I was in charge of Dell I'd be asking suppliers to deliver the gear and give me a few months to pay so that the money can earn interest!

I expect that if someone from Dell called Intel and AMD reps into a meeting and said "for the next two years all our CPUs will come from one company, please make your best offer" then they would get some really good deals.

Sun announced that they get the fastest Opteron CPUs before anyone else - presumably for promising not to ship machines that use Intel CPUs.

Gary said...

Don't forget when figuring out the cost of sales to include the lost opportunity cost - i.e if the money you have tied up in stock was free for you to use, what other things could you have done with it? The other thing to consider is to ask if you had taken all the money you used to run the business, and invested it in the bank, would you make more money? In a strict not-at-all-real-world of accountants, they will count your 'profit' as the difference between what you would have made investing the money, and what the business generated.

etbe said...

Gary, you are absolutely correct. I count the opportunity cost as being bank interest for a small business as the owner is usually too busy with one business to be able to branch out into other things with success. But you are correct that in some situations the opportunity cost may be greater.

Very few small businesses survive for more than two years, and of those few the number that are profitable when considering the opportunity cost of the capital is even smaller.