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Businesses Serving the Poor Need to Get Over Their Unease About Profit

by Erik Simanis, Managing Director of Market Creation Strategies (6/21/12)
Erik Simanis, Managing Director of Market Creation Strategies

High margins and very strong profitability are necessities for businesses serving D and E consumers.



If you’ve ever had anything to do with business initiatives among the world’s poor – the so-­‐ called bottom of the economic pyramid – you’ve no doubt heard the advice that enterprises in this space need to aim for low prices, low profit margins, and high sales volumes.

 

It’s more than just conventional wisdom. It’s practically the law of the land. It was laid down by C.K. Prahalad and his colleagues more than a decade ago in a series of articles and books, and it has stuck in the minds of businesspeople, policy makers, and nonprofits despite results that can only be described as dismal.

 

Take just two ventures – P&G’s water-­‐purification powder Pur and the Du Pont soy-­‐protein subsidiary Solae. At a price equivalent to 10 U.S. cents for a sachet that could purify 10 liters, Pur achieved penetration rates of 5% to 10% in its test markets – strong by almost any yardstick – but in 2005 the company gave up on Pur as a business, because the numbers simply hadn’t worked. Solae charged less than 25 cents for a range of packaged protein-­‐fortified snack foods and a packet of soy-­‐protein isolate—the latter providing about half of an average woman’s daily protein needs. Despite strong demand for the snack foods, sales couldn’t cover expenses. Solae closed the pilot.

 

Given its flaws, I’ve often wondered why the low-­‐price, low-­‐margin philosophy has persisted. Prahalad’s brilliance and persuasiveness certainly had something to do with it. But even more so, I believe that deep down, managers and executives feel that getting by on razor-­‐thin margins is the morally correct way to do business among the poor. The idea that a billion-­‐dollar corporation would intentionally aim for high prices and fat margins on the backs of the world’s poorest sounds callous and cutthroat. And their intuition isn’t baseless: As the bottom-­‐of-­‐the-­‐pyramid concept shifted into the public eye and attracted the criticism of the development sector, the standards for judging the impact of a venture aiming to serve low-­‐income consumers seem to have gotten a lot tougher. The term “selling to the poor” has become almost a pejorative. Serious discussion about driving profitability and generating competitive returns has been pushed into the recesses of the company, out of the public eye, and it has been replaced with platitudes of “doing well by doing good.”  

 

But the reality is that high margins and very strong profitability are necessities for businesses serving what I prefer to call D and E consumers, those in the bottom two layers of the economic pyramid. Business cost structures in low-­‐income markets are daunting: Operational expenses such as distribution frequently dwarf the costs that companies face in developed markets, while customer acquisition and retention often demand unusually intense – and costly – levels of consumer engagement. And getting to scale takes a lot longer.

 

Companies and those that criticize their efforts are not doing D and E consumers any favors by clinging to the low-­‐margin philosophy, which is unable to generate economic returns that are competitive with alternative uses of a company’s capital—the true benchmark of business success. Precious few of the ventures that failed to generate such profit levels have survived, leaving low-­‐income consumers without access to products and services that could have improved their lives and stimulated economic activity in poor areas.

 

A few initiatives have hung on through the good will of companies’ sustainability and corporate social responsibility departments. But their size will remain small and their impact limited, because investment will be based on what the companies can afford to donate, not on what the ventures actually need for rapid expansion. And make no mistake: Scaling up a business to affect the lives of tens of millions of people requires a level of capital and resources that far outstrips CSR department budgets and capabilities.

 

The microfinance industry is a rare D and E success story. Microfinance banks, which provide desperately needed loans to low-­‐income consumers, draw mainstream investors because of their attractive returns. The result has been explosive growth. In India, for example, the industry grew at an average annual rate of 105% between 2005 and 2010, receiving approximately $200 million in private equity investment during the last 18 months of the period.

 

But take one look into these companies’ balance sheets and you’ll see the secret to the industry’s success: The average net income margin (NIM) – the industry’s equivalent to gross margins – is around 30%. Compare that to the 7%-­‐10% NIM that is the norm for traditional banks serving wealthier consumers. Mexico-­‐based Compartamos, a microfinance bank that sold 35% of the company for $450 million in 2007, generates a NIM of around 60%.

 

The moral of the story is clear: A business-­‐led movement that serves the needs of significant numbers of D and E consumers will materialize only when companies crack the profitability code and demonstrate an investment-­‐worthy opportunity to shareholders. Until then, high-­‐level debates and discussion about enhancing the development impacts of D and E businesses are not only premature, they are also a costly distraction from the task at hand.

 

Getting to profitability will require a laser focus on basic business tenets, which include matching business models to the constraints of the commercial environment. And in D and E markets, the environment demands a very high contribution per transaction. It’s an approach has allowed the microfinance industry to flourish and transform the lives of millions of people across the developing world.

 

So for those companies that truly believe in the value of their products and are committed to bringing integrity, professionalism, and world-­‐class standards of operation to D and E markets, it’s time to get over that unease and to get into the game. Selling to the poor can make a difference in your companies’ bottom lines—and, in so doing, to the lives of your new customers and the communities in which you operate.

This article was originally posted on www.hbr.org on June 13, 2012.

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