Commoditization: Is it inevitable?

When we think of commoditized products and services, we usually think of low margins, fights between undifferentiated companies for small and usually temporal increases in market share, and consolidations of weaker companies trying to get big enough to play in a ruthless market that is dominated by ruthless buyers playing one company against the other. Loads of fun.

Many of the industries that we deal with daily in our personal lives are basically commoditized. With all due respect to the following industries, they are fundamentally undifferentiated except maybe for geography and cool labeling: consumer banking (money is the ultimate commodity), gasoline, food markets, electricity, dry cleaners, most consumer electronics, everyday clothing, and insurance.

In fact, many of the industries that we deal with in our business lives have segments that are commoditized: screws, bolts, common steel, many MRO items, common hand tools, and transportation and shipping supplies. The list is surprisingly long.

Buyers of commoditized products see little functional difference among them. The dollar from bank A has the exact worth of the dollar from bank B. The only difference buyers see is price, or the cost of acquisition. This is true with consumers, and in too many cases it is also depressingly true with allegedly professional industrial buyers who should be looking at overall cost of ownership or utilization.

So what does this have to do with custom fabricators? Since the start of the first Industrial Revolution, these types of companies have been spectacularly differentiated by human skills (as well, of course, by geography). Companies could skillfully and economically make things that others couldn’t. And as long as there was sufficient demand for their skills, these companies commanded very respectable margins. The custom makers of anything were the last companies that one would call commoditized.

Have you noticed the use of past tense?

Bits and Bytes

As we all more or less know, the modern world is in the early stages of another massive change, the digital revolution. It’s only 40 years old, a comparative teenager, but its effects are already being felt in a major way. Look no farther than the new appendage humans have grown in the last 15 years or so, the mobile (now smart, and getting a lot smarter) phone. These appendages are linked together by a man-made nerve system, the Internet.

The first Industrial Revolution was powered by the steam engine, itself powered by the physics of thermodynamics. It was supercharged in the first 20 years of the 20th century by electricity, based on the physics of Maxwell and Faraday and the engineering of Edison and Tesla. That revolution lasted about 150 years.

The current revolution is powered by (Intel’s Gordon) Moore’s law. It’s actually not a physical law, but an observation and prediction, now 40 years old, that the computing power per unit size (and unit cost) of a semiconductor processor and memory will double every 18 to 24 months. It has been proven to be amazingly accurate. And despite predictions of its demise, it still is chugging along.

This revolution has profound implications for just about everything in our lives, including some we haven’t even thought about. It’s happening at lightning speed. Like the first Industrial Revolution, this one is a monster game-changer for industries, even fabricators.

Working with many companies in the custom metal processing field, I can’t help but notice a creeping commoditization of what was once a fairly well-differentiated segment of industry. The phenomenon is still in its immature stages, but it’s there, and I and others believe that it creates a clear and not-too-distant threat to the profitability, even viability, of the smaller company in this field. This includes those making less than $25 million or so in annual sales. For reference, the average custom fabricator makes around $7 million to $8 million in annual revenue.

In other words, the vast majority of companies in our field are threatened to varying extent by commoditization. Some, unfortunately, will be mortally threatened.

Technology and Commoditization

The telltale effect of commoditization is that there are more competitors for a given major job that can actually do the job. Assuming adequate overall capacity in the market, price essentially determines who gets the business.

This means that the only ways to protect or improve margins is to either reduce internal costs per unit faster than the price deteriorates (in a previous column I showed that to stay viable, fabricators must reduce these internally controlled per-unit costs by 3 to 5 percent per year), or wait for a big demand upturn that exceeds available capacity, which allows for price increases. This latter method is not known as a preferred strategy, obviously.

This environment exists because differentiation based on skills in making things is waning rapidly. The root cause is technology acceleration: Moore’s law as well as significant advances in materials science and engineering as well as computer science. It’s truly remarkable.

The manifestation of fundamental technology acceleration is in the machines we use to make things. The machine builders are responding very well to our demands for reductions in unit costs by consistently increasing throughput of their products and increasing the size of the work the machines can process. They are using beautifully designed mechanisms and structures to reduce our handling and setup times.

Much of this is a direct and indirect result of Moore’s law and sophisticated software engineering. Semiconductor and software technology allows us to do more with controllers and sensors, and allow us to design and model the machines much faster and more accurately.

The machine guys are great listeners. They hear you on productivity improvement, but they hear you on something else too: the lack of trained and skilled craftspeople in fabrication and machining in particular. The solution: Make the machines increasingly smarter. Make the machines so that a semiskilled and quickly trained operator can make quality parts. Then make them so that a totally unskilled person can do it—and one day, make them so that no person is required at all, even when making an extremely wide range of things with a similar range of order volumes.

This isn’t just a possibility; it’s a certainty. Already robots build other robots. What’s more, the “magical metalworking machines” will be widely affordable. Think of the implications. Basically, anybody with access to a relatively small amount of capital can become a credible competitor in many areas of metal fabricating and machining. That’s pretty much like setting up a dry cleaning shop. Ugh!

We Still Gotta Make a Buck

Believe me, I’m not being Dr. Gloom, and it’s not the musings of some crazy futurists. It’s real. And we feel it, whether or not we have really understood it yet. The real question is what to do.

I have witnessed the effect of Moore’s law after 30 years designing and running companies in tech-heavy industries. It got to be as accepted as the law of gravity. It was damn near as certain. It brought breathtaking change, but it also brought opportunity.

This technology acceleration was and is astounding in how it can change the fate of companies. The ones that came to accept it and actually consistently altered their business model and thinking usually did exceptionally well. The ones that didn’t crashed big-time. Look at Kodak (film) and Sylvania (vacuum tubes). Both could have been dominant in the new markets. They had the customers and distribution networks. But because of a lack of will, they basically surrendered the emerging camera and semiconductor markets.

Bits and bytes will obviously never replace steel and other materials in real life. But what will change is the relative value placed on making things, especially the things that fabricators and machine shops make. The reason, again, is that the scarce expert skills that were historically needed will not be as scarce in the future. And things that are not relatively scarce become relatively cheap—a commodity.

A few can win as a producer of commodities under certain conditions, but many can also win by changing their game. You must still make things, but you must also do things—the valuable, scarce “gray-matter” things that meet emerging customer needs. What are these “gray-matter” things? Stay tuned for future columns.