Profit Margins and Deadlines to Buy or Sell

One of the important things that determines whether a company is consistently profitable and earns high returns is how much pressure it has to sell its product quickly.

Each transaction in business involves a buyer and a seller.  If the seller has to sell his items by a deadline or quickly, with low marginal cost to selling the items, the seller will be forced to cut prices toward the end of his selling deadline.  This kills profit margins and creates a bargain-hunting concept among buyers.  Two examples are (1) a hotel or airline, which must sell plane tickets before the cutoff time for the flight or the nightly stay; and (2) a produce company, which must sell its bananas before they turn brown.

If the buyer has to purchase items by a deadline, and the seller is under no obligation to sell by such a deadline, the seller will tend to have higher profit margins and higher return on investment, especially when the seller's products are unique or differentiated from the competing brands.  Examples include a potato chip company such as Lays:  The buyer has to purchase chips before he has people over to his house. He is under a deadline. The seller does not have to sell his chips by a specific time because he can control the supply and the items will last for weeks on the shelf without going bad.  The seller is under no obligation to lower prices to get a quick sale, while the buyer is obligated to pay whatever sellers are charging when he needs the chips.  So the seller has more power in this transaction and will command higher profits and return on capital.

Generally, whether the buyer or seller gets the better deal depends on the time that each has to buy or sell the item and the supply and demand for the specific item in question.  These factors determine the seller's pricing power.

The concept of supply and demand as it relates to products that spoil is a fascinating concept.  Take, for example, a cable company.  The cable company in theory has a product that is constantly spoiling.  Every day that a customer does not sign up for the cable company's service is a day of lost revenue for the cable company.  But in most areas, there are only two or three cable companies available for customers to choose from.  Therefore, demand exceeds supply and the cable companies have pricing power, which will bring them long-term profits.  The same holds true with cell phone companies, which need valuable spectrum to be able to offer products to customers.  Alternatively, could you imagine the low profit margins that would exist if there were 20 or 30 cable companies in each market offering the same channels?  You would see extreme price wars among the companies, with customers being the only winners.

Sellers can differentiate their brands enough to overcome the negative pressures associated with selling deadlines so long as demand for the seller's product exceeds supply within the deadline time period.  The key is the ability to limit supply.  For example, the Four Seasons Hotel (should be) largely profitable despite the constant spoliation of its product because it has such a good reputation that the demand to stay in its hotel exceeds the average supply for most of its hotels on a given night.  That means it has pricing power and therefore high returns on capital.