The business plan: need and want

Evidence supporting the idea

I spoke with going concern independent bike stores in the region. I learned that some IBS very much want the opportunity to compete with the prices found by the consumer online, but they don’t always get the chance; consumers automatically assume that the online retailer has the better prices and they never bother to check with the IBS to see if they can beat the price. Other IBS do not want any e-commerce on their website because it means they will have to set the prices they have in the store with the prices found on the Internet. I also learned that the IBS does well in terms of gross margins (the difference between the selling price of a bicycle and the price for which the IBS purchased it), but struggles with high operating expenses (labor and rent) and storage and display space for bicycles.  I learned that manufacturers require the IBS to order a certain number of frames in the fall so that the manufacturer can more accurately identify how many bikes they need to make; some manufacturers will allow the IBS to order a smaller amount, but it depends on the manufacturer. All the IBS note the expense and risk of ordering bicycles in the preseason. One IBS pointed out that despite the popularity for testing and fitting services, the IBS still must sell bicycles to remain viable. I learned that despite the efforts of the IBS to encourage the consumer to buy their bicycles or obtain their fitting and testing services in the fall or winter, most consumers are still “I need it now” consumers and make their buying decisions according to the weather.  

The business plan: need and want

Unbundling everything

The arrival of digital music in the form of iTunes turned the music industry on its head: it allowed the consumer to unbundle an album of music and obtain an individual song rather than accepting what the music industry and the artist believed to be a good song. The technology allowed the customer to choose and the result was lower prices for music. Meanwhile, the arrival of the e-book is having a similar disruptive effect: it is moving the publishing industry towards an agency model where agents (such as Amazon or Apple) collect a percentage of the selling price of each e-book downloaded by the consumer. It is overturning the vastly inefficient and marginally profitable model that has existed for years and it is also causing prices of books to fall. Once again it is the consumer who benefits. There is a great article in the New Yorker Magazine titled Publish or Perish that is all about this.

Although a bicycle is not an electronic form of entertainment, it can nevertheless be unbundled. One can obtain the frame, the parts and the wheels separately and then assemble them. However, this is not practicable because most consumers are not skilled bicycle mechanics. Consequently, manufacturers use the existing push model where they build up frames with components and wheels of their choosing at the factory and sell them wholesale to independent bike stores who then try to sell them to consumers. This model suits the largest segment of the market that wants to buy a bicycle and ride it out the door; however, it is not for the consumer who wants more choice and is willing to wait to get the bicycle a certain way. It is also wildly inefficient and expensive. Existing manufacturers are nevertheless hooked on this model because they have invested so much in it.

I met with Tim Brewer at Peak Performance soon after the store went out of business in late 2009. Mr. Brewer explained that consumers would come into the store and demand the prices that they saw from online retailers. Additionally, consumers would try out a bicycle to get the right size and then buy it online. These customers would return to the store later with the exact same bicycle and sheepishly ask for repair services. Some consumers apologized outright because they were violating the “contract” between the IBS and a consumer which tacitly promises discounts and preferential service if the consumer buys  a bicycle from the IBS. Indeed, the urge to put these consumers at the bottom of the list was strong.

Mr. Brewer realized the significance of this trend and was planning on moving operations towards the showroom model where consumers try out sample bicycles and gear and then order the correct sizes, packages and colors etc from computers set up in the store. However, the financial crisis hit and demand for high end bicycles (Cervelo, Felt) vanished overnight. Mr. Brewer did not have the resources to buy more bicycles for 2010 and refused to buy from the manufacturers. This did not go over well with manufacturers who at the time were up to their eyeballs in bicycles and desperate to push them into the retail network; local representatives were asking Mr. Brewer to buy dozens of high end bicycles for 2010 in the midst of a serious economic downturn. There were other factors explaining the closure (such as the small size of the Portland market, high promotion expenses, etc.) but at this point the manufacturers were ready to drop Peak Performance and bring their brands to the competition. 

Background research on the market

This is some research I did earlier this year on the idea of an advisory service for online consumers of bicycles and bicycle accessories. It didn't go anywhere, but some of the observations and the ideas are still relevant.

The Internet impact on consumer behavior

Tim Brewer of Peak Performance reports that consumers frequently went into his store, tried out or inspected gear and then either demanded prices they saw on the Internet from on-line retailers or simply left the store to purchase the same products on-line. Peak Performance went out of business in November 2009. 


Consumers shop on line in 2009
Consumers are increasingly comfortable making their purchases on line. On-line retail sales grew 4% to $24.8b from the beginning of November to 18 December 2009. Meanwhile, on-line retail sales on Cyber Monday, the first Monday after the Thanksgiving holiday increased 5% y-y to $887m in 2009 and represents a record level of spending.

The Internet  changes habits and preferences.

 For example, consumers are increasingly browsing for their purchases online rather than in stores and in some cases they are ordering their purchases online and then picking them up at physical locations. Consequently, retailers recognize that filling huge spaces with merchandise is inefficient and costly. Some large retailers are making their locations into more “enticing destinations” by setting up “experienced-based” areas that create showcases and allow consumers to test merchandise. One only needs to visit an Apple store to get a feel for the showcase model.

The traditional bike market

The traditional independent bicycle store (IBS) carries an inventory of about four brands of bicycle that it believes is suitable for their market. The bike store carries an inventory of essential accessories such as helmets, gloves, tires, etc. and they employ two or three mechanics who do bicycle assembly and repair. The bike store actively promotes its expert and friendly maintenance and support services. The tacit understanding or “contract” is that a bicycle purchased from the bike store will have the full benefit of this support and service in addition to some privileges.

Consumers respond to this message. Consumers want maintenance and support services and they take comfort in knowing that the local bike store is committed and able to do so. Consumers also respond to the idea of receiving privileged services from the bike store in exchange for purchasing the bicycle and other gear. Bike stores formalize this understanding by establishing, sponsoring or affiliating themselves with bike clubs and encouraging new and existing customers to join. Members of these clubs receive typically receive discounts on accessories and express maintenance services.

The problem is that the Internet has opened up new options for the consumer. There are now a variety of highly advanced online bike stores that offer wide variety, customization, convenience and competitive pricing. Consumers want the selection, pricing and convenience of online bike stores, but they also want the support of local bike stores. 

Consumers fear that if they purchase from online bike stores, they will not receive the same kind of service and support from local bike stores when their bike needs service or if there is a warranty problem. Indeed, many consumers report feeling guilty about not supporting their local bike store and ultimately make purchases from them even if the prices are higher or the product is not exactly what they are looking for. These consumers are trading price and selection for loyalty and security.

Additionally, making online purchases can be time consuming and bewildering. Consumers report the following: they do not know which online retailer they should buy from; they do not know what they should buy; they do not have the time or the desire to do the research themselves; they want to talk to someone face to face; and they want to see and test the products first.

The business plan: need and want

Solving the problem 

The company solves these problems by providing only frames rather than a completely built up bicycle to its network of IBS agents. This allows the consumer to use the Internet to research, choose and negotiate the prices of components and wheelsets with the IBS and it gives the IBS the opportunity to recommend and order the components and wheels, build the bicycle and service it in the future. The consumer is obtaining the price, selection and convenience of the Internet and the service and support of the IBS; the IBS is competing with online retailers on the basis of personal and value-added service and managing its inventory more efficiently.

The business plan: need and want

What is a simple formulation of the business

The company is a bicycle brand that combines the selection, convenience and price of the Internet with the community, service and support of the independent bike store. It is the next generation bicycle company.

What evidence is there of a market need or want?

The consumer wants the best of both worlds: the selection, price and convenience of the Internet and the the support, service and community of the independent bike store. The consumer wants the advantages of buying bicycles and equipment on line, but does not want to alienate or isolate their local independent bicycle store. In most cases, the consumer wants to support their local IBS. However, the consumer cannot justify paying IBS prices for some items when the same items are available from an online retailer for less (the consumer ends up subsidizing the local IBS, which can lead to complacency). The consumer wants the comfort of knowing that the local IBS is going to service their bicycle when it needs servicing. The consumer does not want to feel obligated to buy bicycles from the local IBS when there is unlimited selection on the Internet; and the consumer most certainly does not want to feel guilty when bringing in a new bicycle purchased on line to the local IBS, who might even sell the same brand of bicycle, for repairs or servicing.

The IBS wants a recurring relationship with the consumer. This traditionally means selling a bicycle to the same consumer every other year or selling a bicycle to a consumer’s family members or friends. The IBS also wants the opportunity to compete with online retailers. The IBS develops its consumer relationships and competes with online retailers by providing a more personalized, accessible and value-added service and by providing discounts that match the prices of online retailers. The IBS is not always given the opportunity to compete with on line retailers by the consumer; the consumer doesn't always ask. Meanwhile, The IBS needs to maintain good cash flow and manageable operating expenses; this is difficult to do when the IBS is required to order a full inventory of bicycles (and accessories) each year, rent a place large enough to store and display them and hire staff to assemble and service them. Seasonality does not make it easier. The limited selection of the IBS is a function of an unwillingness or inability to invest in inventory. Indeed, of all the items that hang on the wall at an IBS, only a few actually sell regularly; the rest are stocked because of discount incentives, vendor requirements or a desire to create the impression of “full selection”. This approach ties up capital in inventory and is an inefficient use of resources.

Analysis of hypothetical transaction

Frameset	Wholesale	Shipping	Total cost	Mark up	Retail	Profit
FWT MCR-01 2011	700	-	700	200%	2,100	1,400

This transaction is based on the 2011 version of the MCR-01. This frame weighs about 1,100 grams for a 53 cm frame. Features include internal cabling for brakes and shifters; braze on front derailleur, BB 30 bottom bracket, integrated seat post, painted finish and logo. There are also options for the front fork. To obtain a wholesale price of $700 implies a large order of more than 30 framesets. Integrated seat post frames are slightly more expensive to ship and a paint finish increases the cost of the frame. The mark up of 200% puts the retail price at $2,100 per frameset. This is 30% below the retail price of a 2010 Fuji SST and Cervelo S2. Profit per frameset is estimated to be $1,400 per frameset, before commission paid to the IBS (if the sale originates with the IBS). 

Components	Wholesale	Shipping	Total cost	Mark up	Retail	Profit
Components	1,200	20	1,220	45%	1,769	549
Saddle	80	10	90	50%	135	45
Stem	60	5	65	50%	98	33
Handlebars	100	10	110	40%	154	44
Pedals	180	5	185	35%	250	65
Tubular tires - pair	80	5	85	50%	128	43
Carbon tubular wheel set	870	50	920	50%	1,380	460
Total	2,570	105	2,675	46%	3,913	1,238
Retail price of bike					6,013	2,638

The company does not build up bikes; it is the job of the IBS to work with their customer to determine the customer’s choices for components and wheels. This gives the customer choice and avoids the situation where the customer pays twice for component upgrades (once for the existing parts in the bike when it comes in and again for the upgrade). It creates the opportunity for the IBS to develop the relationship with the customer; it also gives the IBS the opportunity to make money on components, provide discounts or use up any inventory of parts and wheels that are lying around the shop from previous years. It gives the IBS more flexibility and an opportunity to promote its expertise.

The example above estimates the wholesale cost of all components and wheels to be about $2,570. This would cover the cost of a high quality package: SRAM Red group, a light stem and some good pedals, a standard racing saddle and handlebar, a good quality pair of carbon tubular wheels and some standard tubular tires. Factoring in the shipping costs that the IBS would have to pay brings the total wholesale cost to $2,675 for the IBS. The IBS marks up these items on average about 46% (The mark up for items less than $1,000 is typically higher and can be anywhere between 40-50%. Items that cost more than $1,000 wholesale can be marked up anywhere between 30-40%. It is up to the IBS to decide.) The mark up covers the labor for putting the bike together, overhead and materials. The price that the consumer pays after the mark up for components and wheels is about $3,900. The consumer pays $2,100 for the frameset. Total price of the bicycle is about $6,000. 

Frameset retail price	6,013
IBS
Revenue
Components	3,913
Frameset commission	420
Total	4,333
Cost of goods	2,675
Gross profit	1,658
Margin (%)	38

The IBS generates about $3,900 in revenue from the sale of components and wheels. If the IBS convinced the consumer to purchase the frameset (if the IBS places the order on behalf of the consumer), the IBS is paid a commission which is 20% of the retail price of the frameset (0r $420). Adding the commission, the IBS generates about $4,330 in revenue. Gross profit on the transaction is $1,658 per frameset or a margin of 38%. This is better than the gross margin on selling a completely built up bike (estimated at around 33% by the National Bike Retailers Association). Also, the IBS never takes delivery of a frame that it is not sure it can sell, thus its cash flow improves and its inventory risk is lower.

Company
Revenue	2,100
Less: commission	420
Net revenue	1,680
Cost of goods	700
Gross profit	980
Margin (%)	58

The company generates $2,100 in gross revenue on the transaction. After factoring in a commission of 20%($420), net revenue is $1,680 pre frameset. Gross profit on the transaction is $980 per frameset or a margin of 58%. If the transaction originates with the consumer (where the consumer orders the frame directly from the company and has it sent to the nearest IBS that is an agent of the brand), there is no commission paid to the IBS. Net revenue is $2,100 and gross profit on the transaction is $1,400 (gross margin increases to 67%). The company is sharing the profits with the IBS, but is also rewarded for taking on inventory risk.

The Company Role

The company focuses on selling high quality framesets using the principles of frugal innovation. This means among other things developing a network of suppliers so that the company can react quickly to changes in market demand; developing new frameset designs that are simple, cost effective yet different in a preferred way; developing a network of independent bikes stores (IBS) to become agents of the brand; and executing marketing plans that support and expand the brand’s position in the market. It also means supporting a warranty program, a crash replacement program and ultimately a used frameset disposal service.

Rather than investing large sums of capital in building and owning a mold, the company will use open molds and tube to tube technology to develop framesets that are strong, stiff and light but also distinctive and thus exclusive. This is much less capital intensive and frugal. For example, a manufacturer can use an open mold frame but add some variation in the top tube, down tube or seat tube (a bend or a faring of some sort) that gives the frame a different look. 

Ultimately, the company will have its mold with a variety of small manufacturers. This will allow the company to make small orders and allow the factory to derive economies of scale. This will improve flexibility: if one factory cannot match the order, it will go to the next one.  If the frame design is simple (a single color, minimum paint job, basic tube design) it will be easy for a manufacturer to ramp up production so that orders can be executed “on-demand”. 

Super Sized Cycles: onshore or offshore?

This is an interesting story from the New York Times about  Super Sized Cycles in Vermont. This company is trying to decide whether or not it should produce its bikes in Asia or in the US. It has a lot of good comments from readers who have experience on the matter. Some say produce overseas and others say find domestic suppliers.  

Mass production techniques

Mass production techniques applied in new ways: The benefits of economies of scale are traditionally derived by the manufacturer. The manufacturer obtains the orders and then produces a huge number of bicycles in a single run; the bikes are built up in Asia and shipped out and that is it for the year. The IBS takes delivery of the bikes he ordered (and paid for a few months earlier), tightens a few bolts and then goes about trying to sell them.

The company’s business model uses smaller manufacturers that can derive economies of scale from smaller production runs and who can do more than one production run in a year. The business model also allows the customer to order a frame directly from the company and have it shipped to the nearest IBS who is an agent for the brand; the model also allows the IBS to order a frame on behalf of a customer.  These features create the potential for significantly higher volumes and gives the IBS the opportunity to develop processes that generate economies of scale. 

For example, an IBS may find that customers are ordering the frame from the company’s website and having it sent to the IBS because the IBS is the nearest agent of the brand. Or perhaps the salesperson at the IBS has convinced a number of customers to buy the frame during the course of some promotional event. The result is that there is a high volume of frames coming in to the IBS. The IBS can then develop its own way of managing the work (develop a schedule, order components and wheels in advance or just in time, set a specific time etc) so that they obtain economies of scale. The significance is that the mechanics begin to develop expertise in building bicycles from the frameset to the finished product. They concentrate on this skill and they become better at it and processes are developed by the IBS to make the build up fast and efficient. Meanwhile, the sales person focuses on informing and assisting the customer with component and wheel selection. This strengthens the relationship with the customer. Ultimately, the company’s business model allows the IBS to increase volumes, lower operating expenses and improve cash flow. 

Austro-Daimler mock up with smaller lettering

Here is a mock up with slightly smaller lettering. The Austro-Daimler words fit on the white part of the tube and does not overlap on the blue part of the tube. This is better for this particular tube; the lettering is black and visible against the white frame. If the tube is a single color, there is more room to fit the lettering in a larger size and closer to the center of the tube.

The pull model

Pull model: The company delivers frames when the IBS agent places an order. This is the pull model and it is the opposite of the traditional “push” model where the manufacturer requires the IBS to buy an inventory of bicycles at the end of each year. The traditional model allows the manufacturer to “know” how many bikes it has to produce in the upcoming year; they find out by having a rep ask all their IBS in the fall how many bikes they are willing to buy for delivery in the spring. Once they know and have commitments to buy from the IBS, they can hit the print button at the factory and produce in a single run a huge number of bicycles; they derive economies of scale in this way.

If demand is stronger than expected, the IBS runs out of bikes and they lose customers to other brands or Internet retailers; if demand is weaker than expected, the IBS has an over supply of bicycles and ends up having a year end sale where the frames are discounted heavily. This is not good for the brand because it diminishes its value and the market begins to remember that a better savings can be had by waiting until the end of the year. This is why many brands will not allow a retailer to discount its bikes as part of a larger sale; they do not want the “premium” to be eroded. If they find out, they get upset.

The pull model is based on the demand in the market. The company carries a manageable inventory on shore and discloses it to its IBS; this allows the IBS to see how much inventory there is with the company and allows the IBS to be more proactive with its customers. The company manages an order book which allows the IBS to indicate whether or not it would like another frame in the future (much like a wish list function on a retail site). This becomes an indicator of future demand for the company and helps it determine the size of its next order. The company will have its mold in small factories so that small orders can still generate economies of scale.

The benefits of the pull model is that the IBS does not have to finance large amounts of inventory (improves cash flow) or rent large spaces to accommodate the inventory (lowers overhead expenses). The company does not have to pressure the IBS to buy inventory; the IBS also receives an agency fee on each sale which improves the IBS cash flow. The IBS is also in a position to originate a bicycle that suits the customers exact requirements (components, wheels, saddle, headsets, color maybe). This strengthens the relationship with the customer. 

The drawbacks of the pull model is that the company bears inventory risk; this could result in the company having to dump all the inventory on eBay, which would destroy the brand and the company.  The pull model also targets the smaller and more patient segment of the market rather than the much larger “buy it now”.  However, the more patient segment of the market is under served and less saturated than the “buy it now” market.  The pull model could result in mismatches between supply and demand resulting in permanent damage to the enterprise. The company could have orders in hand, but More Choice could simply be unable or unwilling to deliver the frames for whatever reason. If a situation like this were to persist for a few months (as it did with Williams Cycling earlier this year), it could be the end of the company.

Rising costs in China

Prices of carbon frames increase when prices of raw materials such as oil and chemicals increase.  Prices will increase again as the Chinese currency (the Remnbi) appreciates against the US dollar. Currently, the Remnbi is undervalued against the US dollar; China manages its currency using a trading band so that the country's exports to the US and other markets stay cheap. This arrangement is viewed as unsustainable.

This article in the  New York Times  Changes in China Could Raise Prices Worldwide suggests that labor costs in China are also set to increase (from a very low base) and might push up prices worldwide. Seventy percent of all bicycle equipment is imported from China and Taiwan. Given that bicycle manufacturers readily pass on all or most of their higher costs to the consumer, it reasonable to believe that bicycle equipment prices in the US will increase in the future.

This implies narrower profit margins for the manufacturer and the IBS. If prices are always passed on to the consumer, it means that demand will drop as consumers leave the sport.  The article underscores how the industry needs to use the principles of frugal innovation to drive growth. The existing model will be hard pressed to survive in a world of rising costs in China.

Scaling out production

Scaling out production: The company scales out production of framesets to More Choice, Inc. through the services of a procurement agent in Thailand. More Choice designs the frames and owns the mold; the procurement agent works on product development, arranging the order, executing it and making delivery; design work and web development and graphic design work is scaled out to services in Asia where costs are much lower; component and wheel set selection is scaled out to the consumer; component and wheelset procurement and final assembly is scaled out to independent bike stores. Ultimately, the company will scale out production to different manufacturers. A key part of the distribution strategy is to scale out to independent bike stores.

Austro-Daimler logo

The logo worked out well. It is clear, visible and simple. On a white background it would be even more striking.

Austro-Daimler gold lettering

Here is a mock up with gold lettering. The lettering is more visible against the white and blue down tube, but the contrast is not as good; if the tube were all white, the black lettering would be much better.  The next frame will be a solid color. The gold lettering might work if it had a black edging. This would be more costly to produce; most lettering now is one color. 

Scaling out distribution

The company scales out distribution by signing up independent bicycle shops (IBS) as “agents” of the brand. For example, an IBS reviews the company website, makes a few calls to the company for more information about warranty, returns, customer support etc; inspects a sample frame and then opens an account with the company.  There is no cost to the IBS for becoming an agent; there are no minimum order requirements; there are no floor space or product placement requirements. Becoming an agent of the brand is similar to  opening an account with eBay or Amazon. The significance of the agency model is that the IBS does not have to purchase a dozen or more fully built up bicycles of various sizes and keep them in the store (on the floor or in the basement) as inventory. This is expensive and risky for the IBS and an inefficient use of resources. The IBS can order frames as and when the customer demands one.

Instead, the IBS holds a few sizes for demonstration, inspection and sizing purposes only (this complements what has to be the company’s very comprehensive website). When the customer decides to buy a frame, the IBS places the order with the company and the frame is delivered to the IBS.  The IBS takes a percentage of the value of the order. The IBS then orders the components and wheels for the customer and builds up the bicycle. The IBS makes money on the component and wheel order, the mechanics stay busy and most importantly, the IBS retains the relationship with the customer. 

There are no restrictions on how many agents there can be in a given geographic location or market. Currently, manufacturers ensure that their dealers are more than a few miles apart; this means that dealers of Fast Frames Bikes will have a small monopoly on that brand in their local market. It also prevents unhealthy competition among dealers. You will rarely find two dealers of Fast Frame Bikes in the same neighborhood. 

The trouble with this arrangement is that a customer may like and want a Fast Frame bike but he may not want to buy it from the local dealer. For example, the local dealer of Fast Frame Bikes may charge slightly higher prices because they are located in an expensive neighborhood where the rent is high or incomes are high; they may have a reputation for poor service; they may have poor selection; their mechanics may be not very well trained; there are any number of reasons. The result is that these restrictive arrangements eliminate choice and ultimately drive the customer to the Internet.

The agency model reduces risk and cost for the IBS and allows the customer to choose which IBS he wants to work with. The IBS reduces its investment in inventory and overhead without losing the relationship with the customer and the customer gets the convenience and selection of the Internet with out losing the support and community of the IBS.  The finished product is better too: it is built up by a mechanic from scratch at the IBS rather than at a factory; it is build up with all of the components that the customer wants and with the wheels the customer already has or decides to buy.