Commoditization

How Does Commoditization Work?

Commoditization is the process by which products or services that could be distinguished by their unique attributes (or brand) become commodities from the perspective of consumers in the market.

Once a product becomes commoditized, the competing offerings are practically indistinguishable from each other, contributing toward price-oriented competition.

In a market characterized by price-oriented competition, the industry constituents compete on the basis of price, contributing toward a “race to the bottom”.

Since the competition is based on pricing, the inevitable outcome is margin compression, where market participants earn less profits per sale (and thus, profit margins decline across the industry).

Competing on the basis of price is not a sustainable for most companies over the long run, with the exception being market leading incumbents.

Therefore, a market classified as commoditized favors established incumbents with significant market share, a diversified product mix, and established branding.

Given the high volume of product sales, low-cost producers benefit from economies of scale, which refers to the concept wherein the cost per unit reduces from increased production (or output).

In contrast, new entrants cannot afford to set prices at the market rate, as the profitability and upside potential in growth is limited.

Hence, early-stage startups strive to compete on product quality and features, contributing toward more pricing power—the optionality to raise prices—assuming the perceived value to the customer base warrants higher pricing.

From the perspective of incumbents with a market leading position, that sort of competitive dynamic serves as a barrier to entry that protects their long-term profits and market share, establishing an economic moat (i.e. sustainable competitive advantage).

What are the Characteristics of Product Commoditization?

If a product is deemed a commodity, the common characteristics are as follows:

Why Does Product Commoditization Occur?

Simply put, commoditization occurs in a market when consumers perceive a product to be substitutable.

In other words, opting to purchase a product from a particular company, rather than a competitor, has a marginal impact on the value retrieved (i.e. the quality of the products are practically indistinguishable).

The concept of product substitutability is the prime determinant of commoditization of goods and services.

Initially, the emergence of a new product offering by a company, where there is no direct competition, is a favorable competitive landscape, since the early entrant can set their prices to ensure sufficient profits are earned per conversion.

The early occupant creates a new market (or submarket)—formally termed the blue ocean strategy—in which the company must generate consumer demand for a new product offering, facilitating long-term, sustainable profitability if achieved.

The prioritization early on is the distribution of a differentiated product in terms of product quality and features, presenting the opportunity to open up a new market with no competition rather than competing in an crowded, uncontested market with existing incumbents.

However, the lack of competition is often short-lived, as companies ranging from startups to established, mature companies will inevitably recognize the market opportunity (and the potential to generate more profit via market expansion).

If a business competes in an saturated market space—or red ocean—the hurdle encountered at market entry is to necessity to outperform established incumbents in an effort to capture market share (and a portion of the existing demand).

In short, the more competition there is in a particular market, the less potential there is to generate strong profits on a consistent basis, considering the shrinking pool for customers that can be acquired (i.e. the revenue opportunity becomes more spread across a higher number of firms in the market).

Cut-throat competition, especially if there is a long-standing market leader with an established market position, causes growth and profitability to decline as a whole, an unfavorable attribute for all market participants, exceptions aside.

Commoditization in business is thus viewed as a warning sign, implying the market is not worth entering—or expanding into—considering the shrinking pool for attainable profits and revenue (i.e. limited upside potential with significant downside risk).

Over time as the market continues to mature, greater parity tends to form across product offerings, effectively reducing the differentiation between competing products and placing downward pressure on the prices at which products are sold by companies to maintain its current market share.

How Does Technology Impact Commoditization?

The main factor contributing toward more product substitutability stems from the increased transparency attributable to the pace at which technology has become an innate component of consumer purchasing behavior.

The transparency in pricing—or more specifically, the ease at which prices can be checked via digital means like mobile apps—provides customers with the option to conveniently compare products, making them more willing to switch between competing offerings.

If a company operates in a market characterized by competitive pricing (or competition-based pricing), the prices are set by the market. In order to compete in the market, the company must continuously monitor its competitors and the prices at which their competing products or services are sold for (and adjusting as deemed necessary).

By tracking and quickly adapting to changes in the business model of the market leader (and notable competitors), a smaller-sized company in the same, or adjacent, market can protect itself from incurring steep losses in customers.

The cost leadership strategy employed by incumbents that distribute products at scale presents a material risk to the long-term sustainability (and profit margins) of less established companies, where the outcome is often a strategic pivot into a different direction.

The medium by which the market rate at present and pricing strategies are tracked by consumers and companies are technology enabled platforms, such as online marketplaces and automation tools to find the cheapest price.

The fact that product commoditization became more common in the early 2000s is therefore not a coincidence, as less information asymmetry establishes a more competitive market.

What are the Indicators of Market Commoditization?

One of the primary indicators of impending commoditization in a market is the slowdown of product development, which can be recognized by a widespread reduction in spending toward research and development (R&D).

The decision by management to allocate less capital to R&D initiatives implies that the opportunities to improve the quality of a product are gradually declining, creating time for competitors to catch-up, which starts the cycle of industry-wide price-cutting.

Furthermore, an increase in price sensitivity among consumers in the market is a core driver of substitutability becoming more pronounced (and should be interpreted as a “red flag” that the pattern in purchasing decisions is trending toward lower priced offerings, not quality standards and product differentiation).

The presence of low switching costs often coincides with market commoditization, where the cost of purchasing from a different provider is negligible. Instead, consumers have shifted to place a greater emphasis on price (and convenience), in lieu of perceived product quality.

The secular shift in consumer spending behavior puts companies in an unfavorable position, in which the rise in buyer power forces market participants to compete more aggressively on price.

Consequently, companies must cut prices in an effort to attract customers, initiating a downward spiral that reduces prices throughout the market (and thereby, margin compression), creating an environment that is increasingly difficult for companies to maintain its historical, or target, profitability.

Once commoditization in a market intensifies, the pressure to navigate the competitive landscape is often ensued by industry consolidation, which refers to larger-sized companies acquiring smaller-sized competitors that are struggling to weather the storm and exhibiting poor operating performance.

Over time, the consolidation of commoditized industries leads to the formation of conglomerates that leverage their positioning as the market leader with substantial cash on hand to further expand their market presence and scale, including more diversification in their product mix.

Given the timing and recent underperformance, the acquirer can often purchase the target company at a steep discount (i.e. low purchase multiple).

In closing, the end result of commoditization in business is normally the consolidation of smaller-sized market participants, whereby only a handful of established, large-sized companies that operate at global scale remain.