Predictable Erosion of Frictional Costs
There are few certainties in business these days, but one of the trends to watch out for is the diminution of various types of service fees over time across a number of sectors. Any industry that can be disrupted by technology or market concentration efficiencies faces the challenge.
Think about the cost of one-day shipping a few short years ago versus the Amazon “free with Prime membership” model for certain areas and order sizes now. The value shipping brings to customers is not differentiated by factors other than reliability: if the order shows up on time on your doorstep, you don’t particularly care how friendly the driver was (someone you may rarely see) or what had to go on between shipping and receipt. You just care that the package showed up as scheduled, undamaged, and not left in the rain when it could be on the porch. In that situation, the low cost wins.
Or consider the highly competitive food delivery business, where it could well be best to think about growth by category rather than by provider. Do in-home diners like the various services available, and are they willing to pay a price for having food delivered? Absolutely. Do they care about who delivers their food? Not as much. In October of last year Grubhub posted on their website a shareholder letter in conjunction with their earnings release that in part was intended to explain recent trends they were seeing of newer diners not driving as much growth in usage as they expected. In their words: “…we believe online diners are becoming more promiscuous. For years, we saw in our data that a Grubhub diner was extremely loyal to our platform. However, our newer diners are increasingly coming to us already having ordered on a competing online platform, and our existing diners are increasingly ordering from multiple platforms.” It’s a lot like overnight shipping: does a customer really care whether the food comes from Grubhub, or Uber Eats or another provider? Or does the food just need to show up on time, fresh, with the order details correct?
Now, what’s the financial dynamic of those types of delivery services? Assuming the provider meets the “cost to play” minimal requirements of service, the point of competition becomes price. That’s never a good place to be from a competitive perspective.
In any business with that same dynamic, the margins will be competed away over time and fees will approach zero as a limit. Because there is still a cost involved to provide the service, the zero limit may or may not ever be reached. But to the extent prices come under pressure for the service itself, those costs must be absorbed in some ancillary way (the cost of the product being delivered increases, the service is paid for via another channel or the cost is embedded in some other way with an adjacent transaction). However the cost is ultimately covered, though, the user of the service has the power over price, not the provider, and the margins on the service itself are reduced.
Groupon is another example of a replicable service that’s been quite hard to differentiate. Same issue: if a consumer gets a location- or time-based coupon deal, does she really care about the source of that discount? Even with a first-mover advantage, Groupon has faced ongoing financial challenges because of the lack of delineated competitive advantage. Granted there is a powerful network effect that could come into play with any of these services, but increasingly there are multiple platforms that have the distribution and partnership heft to compete in more than one highly competitive space.
Think about financial services as another category. Years ago investors faced significant frictional costs when buying or selling stock. Most of the investment classics published decades ago spend significant pages bemoaning the damage done to investors by these costs and caution against frequent trading as a result (advice which is valuable in its own right, regardless of the trading costs involved). According to his research paper “A Century of Stock Market Liquidity and Trading Costs,” Charles M. Jones tells us that buying 100 shares of a $40 stock in the spring of 1970 would have meant a minimum commission of $34 +0.5% of the amount traded, or $54. The minimum commission tables changed over time, but the frictional costs were meaningful all across the board.
SEC deregulation in 1975 did away with fixed commission schedules, and the discount brokerage business was born. Fast-forward another 45 years or so, and those fees for the leading online brokerage firms have now gone to – you guessed it – ZERO. Same as our shipping and delivery examples: investors don’t care who fills their stock orders, just that those orders are filled correctly and in a timely fashion. Other than that, it all comes down to price. These changes don’t happen overnight. They don’t happen in a straight line. But frictional costs gradually disappear as disruptions and disintermediation occur.
There are other industries and sectors for which we might expect fees to go to zero or, at the most extreme, for entire business models to go away in the future. Will title companies, for example, continue to exist after blockchain technologies are fully implemented? Will custody banking continue in its current form? What about other intermediary-driven business models (certain types of insurance or real estate contracts)? What some of these businesses will face will be a need to differentiate beyond the transactional services they provide. Some will be able to; some will not.
What does this trend mean for other service industries and businesses? To the extent a service is a commodity – price competitive and deliverable in multiple ways by various vendors over diverse channels – associated pricing and margins will be slim. We’ve long thought about price pressures for commodity products, but commoditized services are equally at risk. If your customer has a broad choice of suppliers and does not value the differentiation you feel you are providing, how do you hold that customer?
Here are a few broad concepts that might be helpful as you reimagine your customer relationships. Consider the following:
Think about customer lifetime value. Can a loyalty program (think “frequent flier miles”) create a forward-looking incentive to lock-in customers now who might otherwise shop your services?
Is there a way to embed the least differentiated services you offer into a more differentiated product or service? Will a packaging strategy work for your business?
What about a convenience subscription model that removes time-of-transaction decision points for your customers: instead of the decision being made at the point of each purchase, is there an advantage to creating a single decision point by designing a monthly fee approach that is auto-billed regularly?
Whichever strategy you choose to pursue – and experimentation might be the way to discover which model is the best fit for your business – getting ahead of fee compression trends could save your profit margins, your sanity and the vibrancy of your business.
If you want to chat more about these ideas, email me at keith@riverfall.is.