In December, we commented on the relationship between designer goods and knockoffs. (Click here to read the commentary.) Our basic point was that the traditional relationship of counterfeits to authentic designer goods was probably beneficial for most brands. Seeing cheap, poor imitations of high-end products sitting on street corners enhanced their desirability to consumers who could afford the real thing. We noted however, that as many designers have been shifting the production of their authentic luxury items to China, the knockoffs have improved in quality to the point where experts may have trouble telling the difference.
This comment has generated some controversy – and opened a question we did not answer. That question was validated – in an offhand way – in a Wall Street Journal article today entitled As the Luxury Industry Goes Global, Knock-Off Merchants Follow by Alessandra Galloni. Galloni quotes Kris Buckner, president of Investigative Consultants, testifying before the U.S. Senate as saying, “A counterfeiter can sell counterfeit handbags and make as much money as someone selling cocaine.”
Why is selling counterfeits as profitable as selling cocaine? Because the margins for genuine luxury items are so astronomical that counterfeits made identically and sold for significantly less money can still be extremely profitable.
The question is – what is the right margin for designer goods? What paradigm can we construct to decide how to price luxury items?
This is not a simple question. Part of what a designer is selling, after all, is exclusivity. By lowering costs, luxury goods makers have made a sound business decision. But they are caught in a bind – if they lower price as their cost declines, they risk eroding the exclusivity of the brand. And in pure economic terms the price they are charging should not change because the item is just as valuable to the consumers who are buying it.
The problem is that classic calculations of brand value ignore the possible of near-perfect counterfeits. When the markup between the distributed cost of a product and the retail price to the consumer is one hundred times or more, there is huge incentive for counterfeits. By moving production to China, luxury goods manufacturers increased the incentive for counterfeiters by putting the production technology for their items in the same geography as their counterfeit production facilities. Getting a perfect knockoff became a labor issue (instead of having to reverse-engineer a Louis Vuitton bag, just hire away a line manager or an engineer from their plant) instead of a manufacturing challenge.
Knockoffs will always be cheaper because their distribution system is cheaper. The question is, how do you avoid creating a market for products that cannot be distinguished from your own? This is a serious issue. It is one thing to have consumers sporting around cheap designer back that anyone who owns the real thing can spot as a fake. It is quite another when almost no one can tell the difference.
Lots of evidence shows that consumers will pay more for an authentic brand they trust than an exact replica. A trip to any drug store shows that Tylenol sells for 2-3 times the cost of generic acetaminophen. This is true for most store brands versus national brands and has held constant over many years. We would suggest that luxury goods should not sell for more than 2 – 3 times the price of identically produced knock-offs. Remember that we are not talking about cheap imitations here – this rule would not mean that a Patek Phillipe should sell for twice the price of a rip-off with a $0.27 Chinese quartz movement inside. But it does apply to those Louis Vuitton bags that sell for hundreds of times their manufactured cost and ten times the price of identical knockoffs. There is also value in service, and consumers may pay an additional premium for being able to purchase luxury items in an exclusive environment. But if that premium is priced too high the end result will still be more identical counterfeit items – and erosion of the brand.
How, then, can luxury goods manufacturers possibly hope to maintain exclusivity? Our calculations would suggest that brands should dramatically lower prices. But as we noted earlier, lower prices are a problem in themselves as they deprive affluent consumers of exclusivity by allowing access to a much broader group of consumers.
The luxury goods industry seems to have forgotten that their valuable brands were grown not simply through better design but with better quality. At a time when machine manufacturing processes produced inferior results, luxury brands were handmade. They used sturdier fastenings, better materials and more expensive fabrics.
Now that technology has made this all a lot cheaper to deliver, luxury marketers must deliver more value to maintain their price points. The materials need to get more exclusive, the manufacturing process needs to be unique and the ‘feel’ must be different. U.S. currency is a great example of this. Treasury agents realize that their best defense against counterfeits is to make sure that ordinary consumers can tell the difference between real and fake dollar bills. So they guard the supply of paper that produce the dollar (so most fakes are caught because they ‘feel’ different). As that protection erodes they embed colored fibers and watermarks that are unique. Luxury goods manufactures need to similarly ensure that their goods look and feel different.
It is incredible to think that luxury goods manufacturers believe they can preserve their franchises through legal enforcement. The law will not protect them when their markups have gotten far out of line. Only by improving the quality and real luxury of these goods will they secure their franchises. The days when unique designs would sustain a business are long gone. Just stop into an H&M and you’ll see why.