Ideas in Progress

Wal-Mart is widely known for its low prices. It is also widely known in the business world for getting low prices by using its size and purchasing power to “strong arm” its suppliers into reducing the cost of their products. Some people think that Wal-Mart’s power and tough negotiating with manufacturers to reduce price may even be helping to keep inflation low. A simple, static view of this situation makes it seem like Wal-Mart is creating savings for its customers (and more business for itself) by forcing manufacturers to accept lower profit margins on their goods. In that zero-sum analysis Wal-Mart transfers wealth from manufacturers to their customers by their tough negotiating and low pricing policies. This obviously helps consumers by saving them money. This arrangement also helps Wal-Mart by increasing their customer base as more people shop there to save money. This arrangement would seem to be very bad for Wal-Mart’s suppliers. But I’m not sure of that. I think Wal-Mart may be doing a great service to their suppliers, and the entire manufacturing community.

This article at fastcompany.com discusses Wal-Mart and their tough negotiating tactics with their suppliers. It gives the example of Vlasic, who Wal-Mart pressured into selling them almost a quarter million gallon jars of pickles every week at a profit for Vlasic of around only one cent per jar! How could something like this be good for a supplier? Let’s ask my friend Henry, who knew more about reducing manufacturing costs than everyone at Harvard Business School put together. Henry said:

“One of the ways of discovering what a cost ought to be is to name a price so low as to force everybody in the place to the highest point of efficiency. The low price makes everybody dig for profits. We make more discoveries concerning manufacturing and selling under this forced method than any method of leisurely investigation.”

For all the complaints about how tough Wal-Mart is for demanding low costs from its suppliers, I can’t imagine that they are as tough as Henry was on his own company. After all, Henry surely knew more about his own company's products (which he did the original development work on) than Wal-Mart’s purchasing agent knew about pickles. Henry wouldn’t cut prices down to only a penny’s profit; he would cut below costs and trust in innovation and mass production to get costs back below his set prices again. The idea that if a company is forced to reduces prices on a product by a dollar, then it loses a million dollars on every million units it sells is wrong because it fails to look at dynamic factors like the effect of lower prices on sales, the effect of sales on economy of scale, and the effect of price pressure on increasing the rate of innovation. Again, Henry explains it better than I could:

“Reducing prices is taken by the short-sited to be the same as reducing the income of a business. It is very difficult to deal with that sort of a mind because it is so totally lacking in even the background knowledge of what business is. For instance, I was once asked, when contemplating a reduction of eighty dollars a car, whether on a production of five hundred thousand cars this would not reduce the income of the company by forty million dollars. Of course if one sold only five hundred thousand cars at the new price, the income would be reduced forty million dollars- which is an interesting mathematical calculation that has nothing whatsoever to do with business, because unless you reduce the price of an article the sales do not continuously increase and therefore the business has no stability…Old time business went on the doctrine that prices should always be kept up to the highest point at which people will buy. Really modern business has to take the opposite view. Bankers and lawyers can rarely appreciate this fact. They confuse inertia with stability…”

So I don’t doubt that Wal-Mart helps to reduce inflation. It doesn’t do this by taking money from manufactures, but rather by encouraging innovation the same way Henry did in his own industry. Wal-Mart’s constant pressure for lower prices forces their suppliers to make more discoveries about manufacturing than they ever would make through leisurely investigation. These reduced prices allow Wal-Mart to buy and sell in larger quantities. These larger quantities then produce their own savings through economy of scale and by capital improvements that could not have been justified with the previously smaller rates of production. While Henry may have been better at it with his own company than Wal-Mart is with their suppliers, Henry only had one business. Wal-Mart deals with a huge variety of products, and so the improving effects of its relentless pressure are spread over an amazing number of industries. There is no telling how many innovations in manufacturing have occurred because of Wal-Mart’s aggressive negotiating policies with its suppliers*. This is a tremendous service to the manufacturing community. The fact that Wal-Mart’s actions aren’t done deliberately to improve the state of manufacturing technology, as Henry did, doesn’t diminish the real effects of that policy.

The aforementioned fastcompany.com article includes these quotes:

“Many companies and their executives frankly admit that supplying Wal-Mart is like getting into the company version of basic training with an implacable Army drill sergeant. The process may be unpleasant. But there can be some positive results.”

“Getting ready for Wal-Mart has been like putting Levi on the Atkins diet. It has helped everything—customer focus, inventory management, speed to market.”

“’Wal-Mart won’t necessarily say you have to reconfigure your distribution system,’ says Carey. ‘But companies recognize they are not going to maintain margins with growth in their Wal-Mart business without doing it.’ The way to avoid being trapped in a spiral of growing business and shrinking profits, says Carey, is to innovate.

“John Mariotti is a veteran of the consumer-products world—he spent 9 years as president of Huffy Bicycle Co. and is now chairman of World Kitchen… He could not be clearer on his opinion about Wal-Mart. It’s a great company, and a great company to do business with. ‘Wal-Mart has done more good for America by several thousand orders of magnitude than they’ve done bad,’ Mariotti says. ‘They have raised the bar, and raised the bar for everyone.’”

Looking only at the theoretical, static, zero-sum depiction of Wal-Mart beating up on suppliers it is hard to understand these positive comments. But they make perfect sense in the dynamic world that business and manufacturing really inhabit. We no longer have Henry around to drive manufacturing costs down. Thank God we at least have Wal-Mart to not only revolutionize the productivity of retailing itself, but also to relentlessly motivate all their suppliers to increase the productivity of their own industries and to provide the large volume business to justify the investment needed to do so.


*Yes, one of the things this drive to reduce costs does is increase outsourcing, but this is not a post about mercantilism and its flaws. I’ll save the discussion on outsourcing for another day.