Sunday, March 9, 2008


According to Tim Ferris, author of "The 4-Hour Workweek", thanks to overseas (aka. sweat shop) outsourcing (my adjective, not his), the profit margins for a typical direct sale product are > 50%. In addition, up front investment costs are minimal (as low as $1,000 - $2,000) and all other costs are variable (based on number of units sold), which makes the model infinitely scalable. For a successful product, that makes the potential return on investment practically infinite, while the downside risk is minimal. As good as that all sounds, one look at the numbers explains who gets paid according to this new model, and who does not:

From page 186: Splitting the Pie: Outsourcer Economics

Revenue (per unit sale price): $92.25


Product Manufacturing: $10
Call Center: $3.32
Shipping: $5.80
Fulfillment: $2.35
Credit Card Fees: $8.14 (includes returns, bad credit etc.)
Royalties: $2.40

Total Expenses: $32.01

Profit: $60.94

NOTE: this does not include advertising costs, which vary depending on the method used. In the Pay-per-click internet model, advertising costs would also be variable.

Key observations about this model:

1) Net profit is phenomenal at 66%

2) The cost of the product itself is only $10. This includes all of the raw materials to manufacture, the cost of labour, all plant-related fixed costs and the manufacturer's profit.

3) Even if Labour is 50% of the $10 (i.e. $5), the cost of labour could double and still not materially impact the final NET profit margin. However, due to hyper (read: destructive) competition among overseas manufacturer's, neither the labourer nor the outsource manufacturer has any pricing power to raise the $10 price.

4) The numbers above explain how S&P 500 profits have increased by double digit percentages each of the past several years. Traditionally, the only way to increase profit margins was to increase productivity (output per employee), either by improved technology/automation or more efficient processes. A big chunk of that $60 profit used to go into the pocket of American workers. Under the outsource model the American 'Consumer' still pays the same final price and the entire increase in margin accrues to the owner.

Since it's abundantly clear who DOES get paid in this model, let's consider who doesn't get paid in this model:

1) The foreign worker making 50 cents per hour, 70 hours per week

2) The American manufacturing worker who now wears an orange bib and makes $8/hour at Home Depot (oh right, he just lost that job too thanks to the declining housing market...)

3) The environment, since there is no room in this model for any type of sustainable environmental practices

The last takeaway I would make is that of all of the costs above, the only piece that isn't already at rock bottom is the profit margin itself. There are many optimists saying that the stock market can't fall, because P/E ratios are at reasonable levels; however, as the above model shows, the market is priced off of historically inflated and unsustainable profit margins. As the economy slows, the first thing that will come down (indeed, the only thing with room to come down) are these generous profit margins - fortunately (or unfortunately, depending on how you look at it) there is a very long way to fall...