What it means
Every differentiated product is on a journey towards becoming a commodity. Competitors copy the useful features, standards emerge, buyers get more informed, and what was once a reason to pay more becomes an expectation.
Mobile phone cameras, cloud storage and website hosting all travelled this path within a decade. The financial signature is unmistakable.
Unit volumes may hold up perfectly well while gross margin percentage falls year after year, because price is dropping faster than cost. Businesses that watch only revenue can miss the erosion entirely until margin is too thin to fund the sales force or the development team.
Several forces accelerate it. Price comparison and online marketplaces make alternatives visible in seconds, technical standards let customers switch suppliers without rebuilding anything, patents expire, and low-cost entrants arrive with a structurally cheaper cost base.
Once buyers start writing procurement specifications, commoditization is usually well advanced. The strategic responses fall into three families.
A business can compete on cost and accept thin margins on high volume, it can re-differentiate by wrapping the product in service, data, integration or brand, or it can move up or down the value chain into an adjacent activity that has not yet commoditised. Doing nothing is the only reliably bad option.
The nuance is that commoditization is not automatically bad for everyone. It expands markets, lowers prices for customers and rewards operators who are genuinely efficient at scale.
It is only destructive for businesses whose entire cost structure was built around a premium that no longer exists.
In practice
Real-world examples.
Example
A web hosting provider that charged $40 a month in 2012 finds equivalent capacity selling for $6 a month, as automation and scale drive costs down across every supplier. It survives by moving into managed security and compliance services where expertise still commands a premium.
Example
A contract manufacturer of plastic housings watches its price per part fall 18% over four years as buyers run reverse auctions across five suppliers. It responds by investing in design-for-manufacture consulting, so customers involve it before the specification is written.
Example
A recruitment agency loses its fee premium as clients adopt applicant tracking systems and post directly to job boards. It repositions around executive search, where the value lies in networks and assessment rather than in access to candidates.
Formula
Calculation
Gross Margin per Unit = Selling Price - Unit Cost
Gross Margin % = Gross Margin per Unit / Selling Price
Volume Required to Hold Gross Profit = Original Gross Profit / New Gross Margin per Unit
A hardware manufacturer sells a networking device for $200. Unit cost is $110 and it ships 50,000 units a year.
Gross Margin per Unit = $200 - $110 = $90
Gross Margin % = $90 / $200 = 0.45, or 45%
Gross Profit = 50,000 x $90 = $4,500,000
Three competitors launch near-identical devices and the market price settles at $140. Unit cost is unchanged at $110.
New Gross Margin per Unit = $140 - $110 = $30
New Gross Margin % = $30 / $140 = 0.214, or 21.4%
Gross Profit at same volume = 50,000 x $30 = $1,500,000
To restore $4,500,000 of gross profit at the new margin, the company would need $4,500,000 / $30 = 150,000 units, three times its current volume. That is why cutting cost or adding differentiated value is usually more realistic than chasing volume.Case study
Seen in the real world.
Kestrelink Systems is an illustrative, fictional maker of industrial networking hardware. For six years it sold a flagship device at $200 against a $110 unit cost, shipping 50,000 units and generating $4,500,000 of gross profit that comfortably funded a 40-person engineering team.
Three overseas competitors then launched close copies. Within eighteen months the market price had fallen to $140, and although Kestrelink still shipped 50,000 units, gross profit collapsed to $1,500,000. The board's first instinct was to chase volume, until the finance director showed that holding gross profit would require 150,000 units, three times the company's entire installed base growth over the previous decade.
Kestrelink instead bundled the hardware with a subscription monitoring platform at $9 per device per month. Hardware stayed a $140 commodity, but 30,000 subscribed devices added $3,240,000 of annual recurring revenue at a much higher margin. The fictional illustration is that when the product commoditises, the profit often has to move to whatever sits around it.
Watch out
Common mistakes.
- Assuming rising revenue means the business is healthy. Volume can grow while gross margin percentage falls, and gross profit in dollars is the figure that funds everything else.
- Responding to commoditization with a price cut alone. Matching a lower-cost competitor on price without matching their cost base simply accelerates the margin decline.
- Believing a strong brand makes a product immune. Brand slows commoditization but rarely stops it once the underlying product is genuinely interchangeable.
Questions
People also ask.
How can a business tell commoditization is happening?
Watch for falling gross margin percentage, customers running competitive tenders, shorter sales cycles decided on price, and features being requested as standard rather than as upgrades.
Is commoditization always negative?
Not for customers or for efficient large-scale operators, but it is damaging for businesses whose cost structure assumes a premium price.
What is the most durable defence?
Building value customers cannot easily source elsewhere, such as integration into their workflow, proprietary data, service depth or genuine switching costs.
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