Why Competing on Price is Bad - For Everyone!

Why Competing on Price is Bad - For Everyone! If you’ve been hiding under a rock for the last couple of months, the news of the Tesco horsemeat scandal may have passed you by. If not, then you’re aware that a large number of FMCG retailers have been suffering supply chain issues where horsemeat has been found in beef products. Although this is a complex issue, a simple explanation is that FMCG retailers, in an effort to protect and enhance their profit margins (which are typically low), have been squeezing prices paid to their suppliers, which pressured their suppliers to cut their own costs. As a result, they sourced their meat from cheaper suppliers in the supply network, and somewhere along the line a load of cheap horsemeat got sold as beef. This got me thinking about costs in the recruitment industry. A recruitment agency is a supplier to its clients, and as a supplier, price is often a major factor. Clients want to reduce their costs wherever possible, particularly in the current economic climate. To do this they may engage agencies willing to work to lower fees, forcing other agencies to match if they want to gain business. The similarities to the horsemeat issue are striking: could recruitment have its own horsemeat crisis in the works? Cost Analysis To illustrate my point, I’m going to do some basic cost analysis â€" for any readers with an economic/accounting background this will seem simplistic, but hopefully it will be of value. Cost analysis suggests that broadly there are three types of business costs: fixed costs, variable costs and semi-fixed costs. Fixed costs remain the same regardless of the output of the business, e.g. rent â€" an office that costs £10,000 a year to rent will cost that regardless of whether the business’ turnover is £10,000 or £100,000. Variable costs vary according to level of output. If the cost of material to make a product is £5 per unit, then the variable costs are £5 x number of units produced. Semi-fixed costs have a fixed element and a variable element. A phone line is a great example; annual line rental may be £200, and then each call costs a certain amount per minute. The more calls that are made, the higher the variable aspect, but the line rental cost is constant regardless of us age. There are many complex factors involved in cost analysis (e.g. economies of scale), but for the sake of simplicity I will disregard those for now. Imagine a recruitment consultancy with 5 employees, which only works permanent roles. Its main fixed costs are salaries, office rental (including all utilities), software costs (a database, office software licenses etc.), line rental, and assorted administration costs (e.g. insurance and accounting). Its main variable costs are commission payments, job-advertising costs (such as job posting), and phone calls. Each employee has a basic salary of £20,000, office rental is £10,000 a year, software costs are £5,000 a year, line rental is £1,000 a year and administration costs are £4,000 a year. That gives us fixed costs of £120,000 a year. Next, lets assume that each employee averages £1,000 in commission a month, job advertising averages at £500 a month, and around £500 worth of phone calls are made every month. That gives us variable costs of £60,000 in commission, £6,000 in advertising and £6,000 in phone calls £72,000 a year. As a result, we have total costs of £192,00 0 a year. In total, the business turned over £250,000, with an average placement fee of £5,000. With a single-product business like recruitment, theres a useful tool we can use to work out how much ‘product’ (in this case, placements) the business needs to sell in order to break even â€" the Break Even Point (BEP). The concept behind this is very simple; if a business comprises of both fixed and variable costs, then there is a point at which the business turnover will cover all fixed costs and all variable costs needed to achieve that level of output. To calculate the BEP, the formula is fixed costs / (sales revenue per unit â€" variable costs per unit). The fixed costs for the year are £120,000. The sales revenue per unit is £5,000. The variable costs per unit can be worked out by finding the variable cost margin, which is variable costs / sales revenue. As revenue was £250,000, and variable costs were £92,000, then the variable costs margin was 36.8%. Therefore, the variable cost for each placement was £1,840 (36.8% of £5,000). Thus, the BEP is £120,000 / ( £5,000 £1840) = 38 placements per year. We can prove this: 38 placements would give us £190,000 in revenue. If each placement generates £1,840 of variable costs, then 38 placements will generate £69,920 in variable costs. As fixed costs remain the same regardless of volume, £120,000 + £69,920 gives us total costs of £189,920 to generate £190,000 in revenue (slight discrepancy due to rounding required placements to a whole number). Now, let’s imagine that for the following year all those variables remain the same, with the sole exception that, due to increased competition in fees, the average placement fee was £3,000. In this case the BEP is different: the variable cost for each placement would be £1,104 (36.8% of £3,000). Therefore the BEP is £120,000 / (3000 â€" £1,104) = 64 placements! This means that our agency has to make 64 placements just to break even, when previously it made a profit of £58,000 with only 50 placements. Ramifications What are the ramifications for this? Well, we know what happened when Tesco started putting the squeeze on its suppliers. Although the above example does simplify matters, it highlights the problems of competing on price. In order to turnover £250,000 our agency had to make 84 placements, as opposed to 50. The risks here are clear; to operate at that higher volume, corners will be cut. Recruiters will spend less time qualifying each candidate, there will be an increase in tactics such as spray-and-pray, and the clients will get less commitment from their agencies. This is the ‘horsemeat’ that I worry about. In forcing agencies to compete on price, clients will inevitably see less value â€" less ‘beef’ â€" being delivered. Agencies already tend to have a bad rap, a lot of which is undeserved. In a purely cost-driven environment however, agency horror stories will become the norm, rather than the exception. We all know that quality costs more, which is why premium brands are more expensive than value brands. However, this cost is for a reason; no quality brand has been affected by the horsemeat scandal. The bottom line is that clients who treat their agencies as value-adding partners, who are willing to pay them at market rate or above and who work consultatively with them can be assured a regular flow of juicy, quality steak. Those who see agencies as liabilities and costs, who work with the cheapest bidder and dont build relationships with their suppliers, are at risk of horsemeat in their supply.