Chip Shortages and Pricing Considerations in the AV Industry

I was on the “inside” of Marketing and Product Development in the AV industry for several decades. The “What New Product Do We Introduce Next” and “What Price Should We Charge” are the biggest, most critical questions any company ever faces. Marketing is the department that answers those questions. Nothing happens until Marketing acts. Engineering, Manufacturing, Sales, Service, everyone waits until Marketing makes a decision.

Textbook marketing often refers to the “Four P’s of Marketing”:

1. Product
2. Price
3. Place
4. Promotion
   

The Product is the actual good or service being offered. Obviously it has to meet your customers’ requirements, be competitive with similar items (or services), be reliable, perform correctly, and so on. Your mousetrap had better be good at catching mice.

The Price is obvious—this is how much the company asks customers to pay. Whether it’s a television, life insurance, software or an airline ticket, Price is probably the first thing people look at after they decide that the Product itself meets their needs. A great price on a flight to Albuquerque NM doesn’t really mean much if you need to attend your brother’s wedding in Hartford CT. But if four airlines offer flights from your home in DC to Hartford, you’re going to compare every aspect of those four—including the price—very closely.

Place—This is the distribution channel where your product is available. If it’s hard goods, the choice may be between small independent “boutique” shops on one hand vs. mass-market big box stores on the other hand. It could be the company’s choice to go with a strictly on-line customer direct model vs. a physical retail model. Some companies do a combination of brick-and-mortar retailers and on-line sales. “Order on-line, pick up at the store” is a fairly common alternative these days. However it’s done, these are all examples of the Place P of marketing.

Promotion—This refers to how the company chooses to advertise and publicize their product or service. For AV products, the traditional way in the ‘old days’ was in print advertising in the enthusiast magazine, reinforced by local retailers’ ads and catalogs. As an example, a leading loudspeaker company in the 1970’s, Advent, ran a campaign of particularly “folksy,” down-to-earth magazine ads, very conversational and convincing. Their retailers, who were quite loyal to them, would then advertise the speakers in a similar fashion in the local newspapers, so the overall impression of Advent on their potential customers was quite strong and positive.

Advent Ads in High Fidelity magazine and in Retailer’s Catalog

These days, of course, none of that really exists anymore—there aren’t any specialty AV stores to speak of, the major enthusiast magazines are all gone (with the exception of Stereophile) and local newspapers are hardly a thriving medium any longer. Most AV advertising takes place online and there’s also a little through those catalogs that are still mailed out a few times a year, like Music Direct or Crutchfield.

Of the Four P’s, Price is the one that the company has the least control over. Many factors impact price. How companies deal with those impacts (what options they may have along the way) and what the long-term implications might be for the AV industry as a whole are worth looking at and discussing.

First, let’s look at how companies set pricing the on their products. Marketing will determine what the right price point is, though its own competitive research, feedback from its end customers, resale partners and from its own Sales organization based on their experiences in the field. We’ll set aside for the time being whether the company is doing a tactical “defensive” product in reaction to a competitor’s widget or whether they’re doing a strategic ground-breaking new product that no one has ever done before. Either way, the company has to set a target retail price. Let’s say the target price in this example is $300.00.

Bear with me here. This is a long explanation of how pricing works, but because you know a real AV “insider”—me!—you’re about to get the real pricing explanation that you’ll never hear anywhere else. Here it is:

How Manufacturers Set the Selling Price

This is a good time to discuss this, because it’s probably the least understood aspect of professional product design and development that there is.

Companies have a formula for determining the sell price of a product based on its raw cost of goods and other factors. Usually it starts the other way around: Marketing/Sales comes up with their desired sell price and applying the formula in reverse, this tells a company how much the raw cost can be.

Lots of factors go into the formula:

• The actual cost of the materials themselves—baskets, cones, magnets, ICs, heat sinks, plastic parts (and amortized cost of their tooling), crossover components, PC boards, metal or wood cabinets (depending on whether they’re components or speakers), grille frames, knobs, feet, terminals, RCA inputs, etc. Lots of parts make up these goods.

• Transportation/freight from overseas or local vendors (either raw materials, completed subassemblies or finished goods)

• Labor (assembly/manufacturing, QC, warehouse handling, etc.) All of that takes a certain number of hours x an average hourly pay rate. Every product is assigned a certain labor/handling cost.

• Company overhead once those materials or goods come into the building in the US. Remember, you have to pay the rent (or mortgage), electricity, heat, taxes, phone, internet, buy computers and coffee and clean the carpets, pay administrative/executive salaries/insurance/benefits, pay the office’s petty expenses, etc. Every product or material brought in is assigned a percentage “overage” to cover this. Let’s say it’s 20%. So if an IC or a tweeter that is purchased from an outside vendor has a cost of $20, it is costed at $24 to cover its share of the U.S. operation’s overhead. A wooden speaker cabinet from the local cabinet vendor that costs $50 is costed at $60 ($50 + 20%), etc.

• Dealer margin requirements (TVs and electronic components like receivers are generally around 35-40% on retail “list price” (a unit with a $1000 list price has a Dealer Cost of $650); “home” speakers are typically 50% on retail ($400 list, $200 Dealer Cost); custom in-wall/in-ceiling speakers are typically 60% on retail. $400 list, $160 Dealer Cost)

• Sales commissions (reps, distributors, factory-direct salespeople, etc.)

• Freight out (if the company “pre-pays” the freight on orders to the dealer, this has to be accounted for)

• Fast-pay discounts (if a company’s payment terms to its dealers are 3% 30, net 31, then most dealers will end up taking the discount)

• Bad debt allowance (some dealers go out of business and never pay, some individual customers will default, etc.)

• Advertising allowance (Most manufacturers accrue a 3-5% advertising allowance for their dealers.)

• Warranty repair allowance (this actually is required by law to be kept in a separate escrow account, unless the company can prove its warranty expenditures are less than x% annually)

And so on. All of this is loaded into a formula and therefore a raw cost of goods of, say, $37 will yield a projected sell price for a stand-alone box speaker of $225 ea. That same $37 raw cost would be a sell price of perhaps $260 for an in-wall speaker product.

So you can see that the Cost of Goods to Retail Price “ratio” is easily 5:1 or 6:1. This is not a “rip off.” It’s simply what a company needs to stay in business, pay the rent and electric bill, pay the receptionist, replace a blown tweeter under warranty, etc.

But when an outsider says, “They should have used the Seas tweeter instead of the Peerless, or Solen caps instead of common electrolytics,” if those raw materials cost differences were just $15, then your $225 ea. speaker is now $300 ea.—and very likely, unsaleable and uncompetitive. If the company is forced to “eat” the cost increase in order to stay at $225 and they sell 10,000 speakers that year x the $15 upcharge each, well, there goes $150,000 out the window. Maybe now you can’t advertise 48 times a year on, hypothetically, Marketwatch.com at $3000/ad. Maybe you can’t give your prized engineer and your VP Sales their well-deserved (and expected) raises. Maybe you can’t pay your best supplier on time and they cut—or suspend— your credit line. This is how it works.

The very sharp mind of a well-known company president once said to me that the best product decisions were made by answering one simple question: Will you sell one more or one less product because of using the more expensive part? Fancy internal wiring, expensive “boutique” capacitors, cast vs. stamped baskets, etc., all these should be evaluated on that basis, in his view. Resist giving away “invisible gifts,” as he called them.

Sometimes you do need the better stuff, and Marketing needs to make the appropriate big deal out of it in their advertising, on their web site and in their literature. But very often, 95% of the performance is achieved with less expensive parts that allow the company to stay in business, pay its people and pay its bills, all while delivering a product that sounds really good at a price people can afford.

If you need fancy caps to sell the product into its market (including getting good reviews, if that’s critical to the product’s success), then by all means, do it. But far too often, the fancy-shamcy part isn’t needed, and when the company makes a foolish decision and includes it anyway, they hurt themselves for no reason and perhaps even go out of business—which helps no one.

Internet Direct Companies

But wait, you say. Now we have all these “Internet Direct” audio companies that cut out the so-called middle man and avoid all those costs like rep commissions, dealer mark-up requirements and the like. Surely, those companies are not working on a 6:1 Sell Price to COGS ratio.
 
Well, yes they are. Pretty darned close.

First, these Internet Direct companies are usually smaller than the big national brands, so they’re buying their parts and finished goods in smaller quantities, which means higher prices. Often, much higher.

Secondly, they aren’t shipping 2000 speakers or AV processors in an economically efficient manner to a retailer’s central warehouse. Instead, they’re shipping one set at a time to every individual customer. It’s not just the higher shipping costs either. Instead of one sales order, one invoice, one warehouse pick, and one trucking appointment being generated for a 2000-unit order, now you’ve got 2000 sales orders, 2000 invoices, 2000 warehouse picks and 2000 trucking appointments. Internet Direct companies usually have much more liberal return policies also, as an incentive to get people to take a chance on their products. Goods sold through conventional retailers don’t come back as often because customers can see, touch, feel, and hear the product before purchasing it (less unpleasant surprises) and they can ask the store questions if they’re puzzled a bit either at the store or when they get it home. The operational and administrative costs for Internet Direct can be far, far higher, and those expenses must be built into a product’s cost structure if the company plans to stay in business, service its customers, and—hopefully—make a profit.
 
And last, the advertising costs are far higher too, because without a store to advertise and display the product, the only way people will ever know about you is if you advertise, advertise, advertise.

Bottom line: the cost structure for Internet Direct product is nowhere near as "much lower" than Brick & Mortar as people might think.

Ok, now you have an idea of how retail pricing is determined for consumer AV products. You can see that while some of the cost components and decisions are under the company’s control, many—too many—are not. That’s where we are now with this IC shortage.

The IC Shortage

The current IC shortage in the manufacturing marketplace is wreaking havoc with pricing and product availability. All industries are affected. Personally (it’s all about me in the end, right?), I’m bummed. We just recently swapped around furniture and equipment between two rooms and one of the rooms has a Panasonic 55-inch TV, some really excellent BA VR-M50 bookshelf monitors and a BA PV-1000 800-watt sub. The room is wired for surround speakers, but none are connected. The existing 2.1-channel system is connected to the TV and Verizon HD cable box, however, so I can kick in the “good sound” when the program warrants it. Then it struck me that if I replace the 2-channel integrated amp that’s currently powering the system with a 5.1 receiver, I can easily have a nice theater system in this room. I have a BA Micro 90C center channel speaker—new in the box, never used—that’s an ideal tonal match to the VR-M50’s (same company, same voicing philosophy, even the exact same tweeter). I can easily connect the surrounds since they’re already wired in the walls, which is normally the hard part.

Boston VR-M50’s and Panasonic TV—Potential Home Theater System

Excited about the prospect of my new system, especially since all the pieces are already in place, I peruse the Crutchfield.com site to look at home theater receivers, specifically Denon. I like their stuff and I think you get a lot of performance and features for not a lot of money. I look at the first model. It’s “out of stock.” I look at the next one. Same thing. And the next. Then it dawns on me: The chip shortage! Manufacturers and retailers alike are losing out on a lot of sales, for this calendar year anyway.

Denon AVR-S750H—$550 75 wpc Home Theater Receiver—Out of Stock

The ubiquitous and all-important IC chip

Like the automotive, phone, laptop and TV segments, AV receivers aren’t exactly “gift” items, so a missed sale in November will probably not be a permanent loss. The demand for those items builds up (“pent up demand”) and the sales are generally fulfilled at some future date when the availability eases up. This is far truer in some areas (like cars or cell phones) than in other areas, depending on the must-have vs. like-to-have nature of the purchase.

However, the laws of Supply and Demand and Human Nature do make themselves felt very strongly and definitively in these circumstances. Remember that great comic character from the 80’s (or was it the 90”s? I forget), Father Guido Sarducci? He did a bit called, “The 5-Minute University.” When it came to economics, he said (in his exaggerated Italian accent): “Supply and demand-a. That’s it. That’s all of economics. Coppice?” He wasn’t too far off. When chips are scarce, the price goes up, because the chip makers will try to maximize their revenues with higher per-unit pricing even though their number sales are lower. This greatly affects the manufacturers’ final pricing, especially in products that utilize a lot of ICs. Remember that example from before—how just a $15 increase in the manufacturer’s cost of goods leads to a $75 increase in retail price? Just imagine if your IC cost per product goes up by even $20 or $25—you’re looking at a retail price increase of $100 or $125.

The human nature piece of the puzzle enters the picture when the chip suppliers realize that the manufacturers are desperate and will gladly pay a higher price just to get some supply. This is a constant in every business. If the supply is tight, vendors charge more, knowing that they will get it. Customers will pay more, desperate for whatever supply is available.

Plus….what very often happens in situations like these is that everyone, the supplier and manufacture alike, becomes accustomed to the new higher pricing. When the supply eases up, as it inevitably will, pricing never seems to fall back quite as quickly or quite as far as it did when it was on the rise. This is the “Up like a rocket, down like a feather” rule of product/commodity shortages at work.

Let’s say a bad hurricane knocks out several oil refineries in the Gulf and crude oil prices spike higher by $20/barrel, This sends gasoline pricing at the pump up by 75 or 80 cents per gallon within a matter of weeks. When all those refineries are back on line and they’re working at their normal full output, gasoline takes its sweet time returning to pre-hurricane levels, doesn’t it? Oftentimes, it never gets down to the original price. Consumers are so happy that the 75-cent/gallon increase has abated to “only” a 30-cent/gallon increase that they don’t complain. The entire supply chain knows this—not just the parent oil company, but the regional gasoline distributors and the actual retail gas stations as well. Consumers willingly pay the new 30-cent higher pricing, so there are no market forces at play to cause any further price drop. Therefore, gasoline pricing stays at that 30 cents/gallon higher level.

Humorous Aside—
Today’s chip shortage is not the first AV industry-wide shortage of a critical component. Not by a long shot. I remember in the early 1990’s—maybe ’92 or ’93—there was an industry-wide shortage of speaker magnets, of all things. In those days, many U.S. speaker companies still made their own drivers here in this country. I was at Boston Acoustics at the time and we made all our own stuff, save for the cheapie Tonegen ½” hard dome tweeter that went into our two least expensive bookshelf speakers. But we made everything else—every woofer, midrange and tweeter, right in Massachusetts. We had a big woofer (cone driver) assembly line and a proprietary computerized tweeter machine. We could hold our drivers to a ± 1 dB QC tolerance!  That was the way things were done in the U.S. speaker industry in the “ good old days.”

The magnet crunch occurred in the fall of that year and it was absolutely killing us and everyone else. I forget the underlying cause of the shortage, but one of the major magnet suppliers in Japan (Hitachi) finally had a huge shipment ready to go, somewhere around September. You figure a sea shipment was about 30 days from ship date to your door, so we’d have magnets in October, we’d run extra factory shifts and have our stock ready to go well in time for the holiday season.

Uh-oh. Not so fast. The Hitachi shipment ran into a very bad storm, complete with high winds and rough seas. The ship sank. SANK!! What are we going to do now? Wait for the next shipment a full month later? Fly magnets over to the factory? Can you imagine the expense of flying heavy magnets halfway across the world?

We ended up splitting the difference: We flew a bare-minimum number of magnets over for our most popular woofers and tweeters and we simply waited for the rest. Holiday sales that year were short, but not disastrously bad. We ate the air expense, and didn’t raise prices, because we figured (correctly) that the magnet shortage would right itself the following year.

Raw Speaker Magnets

AV Prices Usually Go Down

The AV industry is an interesting industry in that consumers have been “trained” over the decades to expect better and better performance for a lower and lower price. Unlike, say, cars or houses or restaurant meals or a gallon of milk, CE pricing has actually dropped, year after year. Cell phones are cheaper and offer incomparably more features and performance. You can buy a laptop today at Staples for $500 that has over 1000 times the computing power of the computers on Apollo 11 that went to the moon in 1969. Adjusted for inflation, a $500 Pioneer SX-727 37 wpc stereo receiver from 1972 would be over $3000 today. But instead, a 100 wpc 2-channel receiver today, like the Yamaha R-N303, is about $399. And that’s in 2021 dollars. In 1972 dollars, it would be about 60 bucks! For the $3000 that the SX-727 would be in today’s dollars, you are well into 7.1 or 9.2 territory, with over 125 watts per channel and multi-channel immersive surround processing power that not even 1969’s Star Trek could envision.

Yamaha R-N303 Stereo Receiver ($300 in 2021, $60 in 1972 Dollars!)

So, rising prices are not the way the AV industry usually goes. Customers expect stable pricing with better performance or lower pricing at the same performance level. The AV biz is governed by a version of Moore’s Law—Processing power will double every two years and pricing will be the same or lower.

But with the chip shortage, as graduates of the 5-Minute University and keen observers of the human condition are only too well aware, pricing in our humble industry is set to rise. In many cases it has already. Real, actual increases, without an accompanying increase in performance, and not lower when adjusted for inflation. Nope—instead, real, hard price increases.

The Real Danger from the Chip Shortage

Will customers balk? Will sales grind to a halt? Will “postponeable” purchases be permanently put off? Most consumers consider their iPhones and laptops to be essential items in their life. If the newest iPhone goes from $1000 to $1300, then the customer will simply stretch out their payment plan from 24 to 30 or 36 months. They may not upgrade as often or they’ll take a very manageable $200 hit when they trade it in and live with it. But they’ll still buy.

However….virtually no one in their right mind considers their next mid-range $700 home theater receiver to be “essential.” If that receiver goes to $1000 from $700, or worse yet, is simply not available, then a significant bloc of AV customers will likely just not buy a new piece of gear. No one needs a new home theater receiver. It’s strictly a luxury that’s pretty far down the list of life’s necessities. The very high end of the market probably won’t be affected much, if at all. The $4000 pre-pro customer will still buy at $4500 or $4800, but that’s only a very small slice of the AV market. But for garden-variety mid-line AV goods, a severe IC-caused availability crisis and price increase could be a damaging blow indeed to the long-term health of the bread-and-butter segment of the market.

Let me draw an analogy to something that happened in 2020 during the earliest, most frightening period of the Covid crisis. Most major-league sports simply canceled their 2020 schedules. Baseball, football, etc. just didn’t play a full schedule and didn’t have in-person attendance. People got used to not watching and attending those games, in a hurry. Many people actually found it to be a relief, to be free of the agonizing daily or weekly pressure of following the wins and losses of their team and schlepping out to the stadium. Many people—not all, to be sure, but many—came to realize that sports wasn’t so important after all: it did not put food on their table or educate their kids or pay their electric bill. It wasn’t essential. It was nice to be free from the pressure, the intrusion on their schedule. When the sports schedule came back to normal in 2021, a sizable chunk of the fan base never returned. NFL TV ratings—the lifeblood of the sport—are down significantly and probably won’t return to pre-Covid levels any time soon, if ever. Once Covid took football away from them, many fans realized they could live their lives quite nicely without it.

The non-availability of goods is the real danger of the chip shortage, not the price increases.

The midrange AV customer may very well come to realize that upgrading from a 2012-vintage Denon 5.1 receiver to a 2021 7.2 receiver or buying a new subwoofer is essentially meaningless in their life’s big picture. Sure, the chip shortage may cause a price increase in the near term (maybe even a semi-permanent price increase), but that’s only an annoyance; it’s not main the structural danger. The big threat is that the IC shortage—and the resulting product shortages it causes—may well lead consumers to realize that this entire category of AV purchases is not so important to them after all.

So what does that mean? This: They’ll simply spend their money on something else. People have to have cars. They think they have to have a new smartphone. But they don’t have to have a new piece of audio gear and if that realization sets in, then the AV segment of the consumer electronics industry is about to suffer a very damaging blow.

What do you think about this situation? Please comment in the related forum thread below.