Many (or all) consumers complain in watch forums that watches are overpriced. Even watch enthusiasts complain that prices are higher than ever. If watch sales are down for the past 2 years, why don’t the watch companies simply lower their prices? Don’t the laws of supply and demand suggest that when sales are down, prices will fall as well? Here is why watch prices are unlikely to decrease anytime soon.
Watch Prices: Fixed Costs vs. Variable Costs
Think of this like a downward spiral. In 2012-2014, watch sales were growing by double-digits year over year. Swatch Group reported year-over-year growth in revenues of over 20% with profit margins exceeding 25% (technically, an operating margin but I will use the terms interchangeably for ease of reading – an operating margin integrates the cost of overhead). When a company is growing like this and the industry around it is growing equally as fast, it’s like an orchard; as long as the grower can get enough people and equipment to harvest all the fruit, they’ll make more and more profits. The industry naturally invested in factories, trained more watchmakers, invested in research and development to produce higher end luxury watches, and sought to produce enough to meet growing demand. The industry was growing – both the NUMBER of watches and the amount people willing to pay for them. Between 2006 and 2016, revenues grew by up to 20% and the number of watches sold went up by as much as 15-20% in some years. As any logical profit producing company would do, these companies built more production capability. Which business wouldn’t?
Most of these investments were fixed costs, meaning they have to pay the bill whether or not they sell a single watch. An example of fixed costs is the factory, the land, the salaried employee, employee benefits, some machines, some equipment. Variable costs are costs associated with production that you only have to pay if you make a watch. Examples of variable costs are the gold in the watch, the electricity to run the machine that makes the watch, the hourly employee that contributes to the process. Because the industry has high fixed costs, it has reduced operating margins (for simplicity’s sake, think profits) to 9% for Swatch and 16% for Richemont. Even 1 year ago (2015) Swatch has an operating margin of 18%. Revenues for Swatch are only down -11% this year, yet their profit margin has been cut in HALF! How do you have a -11% decrease in sales but drop profitability by half? The answer: High fixed costs.
Here is a simple example:
- Company X has $100 in FIXED costs. When they produce a watch, it costs them $10 in VARIABLE costs. If they produce 50 watches, their total cost of goods sold (COGS) is $100Fixed + 50*$10Variable = $600 Total COGS. Because they sold 50 watches, we divide 600 / 50 = $12 per watch. They sell these watches for a retail price of $15, so they make $3 profit (or 20%).
- Next year, they only sell 30 watches. They still have $100 in FIXED costs. The math is now $100Fixed + 30*$10Variable = $400, divided by 30 watches = $13.33 COGS per watch. The company can still only sell them for $15, so the profit is now $1.66 per watch (or 11%).
- Customers are no longer willing to pay $15 and demand a 10% drop in prices! Company X agrees and lowers prices 10% to $13.50. Now the profit margin on a watch is only $0.16 (or 1%).
How many more watches does Company X have to sell in volume to make up for lost profitability? 43 watches, or an increase of 13 more watches than the 30 they are selling right now. That’s almost a 150% increase in sales needed to offset the 10% drop in price! A 10% drop is unlikely to increase consumer demand by 150% — maybe, but not likely.
The Options for Lowering Watch Prices:
Swatch currently has a 9.4% operating margin. If they dropped prices 10% today, they’d be unprofitable unless the 10% price change was enough to incentive a significant increase in demand (it’s not as simple as the example above so don’t interpret this example as suggesting Swatch would need to boost demand by 150%). As a watch enthusiast who is not happy at the current prices, would you be any happier if the price dropped 10%? Or is it still too much? Price cuts are only possible if one of these two things were to happen:
- Increase demand for watches similar to the growth rates seen in 2012-2014 (15-20% year over year growth). This would allow enough watches to be sold to spread the fixed costs over a lot more watches which could allow prices decreases. Right now, the fixed costs are being spread across too few watches making a price cut very unlikely.
- Cut fixed costs. I read a forum last week where it was 30 people saying “just cut fixed costs”. Cutting fixed costs sounds simple in principle, but it is about as easy as telling the government to cut spending. Its easy until you actually have to go through the process of doing it. Most of the suggestions people make to cut costs are actually variable costs, not fixed costs. How do you quickly make your factory building cost less? Or lay off employees? These are extremely difficult topics, especially when dealing with local economies where laying off employees affects the whole community, maybe even the whole country.
- Current watchmaker unemployment is about 9-10%. What if it goes to 20%? Whole economies suffer when there are massive increases in unemployment. Additionally, labor laws make laying off workers expensive for employers.
- What about the factories? There isn’t a line of companies waiting to buy excess watch factories. If each company tried to shed 10% of their buildings and equipment, there would be a flood in the real estate market, making prices drop below current market rates hurting companies further as they would be forced to write down the value of those properties to current market rates.
- Consolidate brands. In my opinion, there are too many watch brands owned by the same companies. Many of these brands operate as independent companies with independent offices and factories. This increases fixed costs. An effort for cost-sharing or consolidation could be inevitable.
Then Why Can Microbrands Offer Cheaper Watch Prices?
Generally speaking, microbrands only offer cheaper prices because they aren’t really operating a company. Many microbrands are owned by a single operator who doesn’t produce watches as a full-time job. This cuts overhead costs significantly. While a watch company (such as Rolex) must operate a factory, pay a phone bill, cover employee benefits, and actually produce a watch, a micro brand doesn’t have any of these. A microbrand outsources production (usually) while not maintaining a company, rather just a brand that is run part-time by the owner. This significantly lowers costs.
Obviously, not all microbrands are not actual companies producing watches. Some micro brands are companies, make their own watches (or at least cases) and are very reputable. However, when you consider the micro brands that are actual companies (such as Niall, Vortic, and RGM), prices are much closer to those of major Swiss competitors than a Kickstarter project. Although, I would argue that the quality and service guarantee is also higher.
The Case of Bremont
Consider the new English watch company Bremont. They are new (as of 2007) and therefore cannot command the same premium as Rolex. If a watch company were able to survive with lower prices while being profitable, a new company like Bremont should be compelled by market forces to keep prices low. However, this has not happened and Bremont prices have gone up throughout the years to be equivalent to Omega and other established brands. The pessimist will say it’s because the company is greedy. However, if the company could sell more watches to gain market share and also make more money through the volume of sales, why wouldn’t they? Is it in Bremont’s interest to sell fewer watches and have less market share as a new company? On the contrary. Bremont would benefit by keeping prices low, selling more watches, getting their name out there, and gaining market share. So why haven’t they kept prices low? Because running a watch production company in the modern era is not cheap!
For these reasons, I don’t think we will see prices change anytime soon. The most probable outcome is we will see very small, modest decreases in prices to account for changes to exchange rates, or prices will not go up further, at least in the short term. However, we might even see small price increases. These might be very tempting due to decreasing profit margins. Second, I think some middle-brand companies will stop producing in Switzerland to reduce costs. This will be contrary to the new Swissness law requiring 60% of a watch be made in Switzerland, but some companies will likely stop caring if the label says Swiss Made if it’s a matter of survival. In addition to these moves will be one-time write-downs of some fixed costs to increase the prospects of future profitability. These could come in the forms of factories or pension obligations. These one-time write-downs would cost the company one time but would allow them to get rid of extra fixed costs in the future, increasing profitability. The luxury watch industry has survived in spite of market forces for hundreds of years. While the industry is due for a major restructuring, there have been recent moves by Richemont Group, Swatch Group, and LVMH indicating they are continuing to adapt in this quickly evolving market.