The Limits of Frugality: Making Things Cheaper Is Not the Same as Making Them Profitably

Just as China is discovering the limits of low-wage production, so India is discovering the limits of low-cost products.

Both countries face a similar strategic conundrum; they have vast populations who offer scalable markets, but primarily at lower price points. China has chosen as a strategic imperative, to build its industries and export strength at the expense of its citizens' grander economic aspirations. And it is not afraid to enforce its will.

India has been a fractious democracy since its modern inception. It has chosen to protect local industries - and industrialists - but has also felt pressure to hew to a theoretical egalitarian construct even though the reality is that there is now more poverty in India than in China.

After two years of western recession, the two countries face somewhat different challenges. Both must move up the value curve in order to grow national wealth and competitive authority. China must turn to its internal market for future growth because its mercantilist strategy has contributed to the struggles of its customers. India must become more of a global competitor outside of tech services, which means dismantling its politically powerful protected domestic industries and bureauracies. Its strategy of producing lower quality but higher volume versions of western products is not delivering the profits it needs to fuel the growth required to support a huge population.

The larger issue for both countries is raising the income level of the population so that they can consume the country's own higher margin products without engendering a disastrous inflationary cycle. It is essentially the challenge of making scale more profitable. JL

The Economist reports:

THE MOST IMPORTANT event in Indian business in 2011 may have been an outburst on September 6th by Sunil Mittal, the boss of Bharti Airtel, the mobile-phone operator. India’s telecoms industry is admired the world over for the innovative way in which it has slashed prices and put phones into the hands of even the very poorest. Today there are some 600m active subscribers in India, many of them in the countryside. But Mr Mittal said the extra cost of servicing rural customers, and their low usage levels, had made things unprofitable. Prices are now expected to go up across the industry, after two decades of decline. India’s low-cost telecoms revolution has, it seems, reached its limit.

Indian firms have made much of their ability to serve the poor masses at the “bottom of the pyramid”. Along with cheap phones, other celebrated examples include one-rupee sachets of shampoo and clever schemes to get around the lack of bank accounts. This reflects raw commercial instinct, but also serves an ideological purpose by showing that capitalism in India is not just for the middle classes. It is politic for Indian bosses to talk up their ability to invent things that all can afford. Whether their firms profit as a result is less clear.
Mobile phones are not the only field where the limits of frugality are being reached. Tata Motors’ Nano, a $3,000 car, has been a flop so far. Some blame Tata’s marketing, but other carmakers say they cannot achieve such a low price without compromising on quality, and that customers are wary. In air travel, insurance, consumer finance and satellite TV, companies have cut prices to build their customer bases over the past five years but could not reduce costs enough to compensate, and compromised on quality. As in telecoms, this is likely to lead to price rises and the exit of the weakest firms.

Today perhaps 17% of India’s population has half of its spending power, according to the Asian Development Bank. Over time the growing urbanised middle class, who are getting richer fast, will become relatively more important for profits. Margins for these customers are likely to be higher because the cost of distributing products in cities is lower. The boss of one large consumer-goods firm says, in private, that today his company makes two-thirds of its money from the poor and lower middle classes, but adds it is “not enough” to focus on them since “the portion of upper middle class will become substantially more important”. He is tilting his products accordingly. Consumer-goods firms are often keen to move away from cheap products, where Chinese rivals pose the greatest threat.

One proxy for the difference in profitability between the urban rich and the rural poor is the price paid for mobile-telecoms spectrum. In the 2010 auctions for 3G telecoms licences, operators bid ten times more for a slice of the airwaves in affluent Delhi, with 18m people, than in east Uttar Pradesh, with 120m people. Similarly, India is about to auction off FM radio spectrum and the competition is expected to be fiercest for the big cities, says N. Subramanian, the chief financial officer of Radio Mirchi, a big player today.

That is not to say that selling to the poor masses, and inventing ways to cut prices in order to appeal to them, is not vital. It is, both from a moral standpoint and because India’s stability depends on it. But the big profits lie elsewhere.