The Vicious Circle of Cross-Subsidization (Episode 17)
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Figures Don’t Lie – But...
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Figures don’t lie – but liars sure figure.” The antidote for business managers of all levels is to understand the relationships that figures represent.
The Vicious Circle of Cross-Subsidization
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Pierre Guillaume exposes how averages hide both opportunities and risks. He details how competitors leverage this obscurity to attack markets.
Optimal Profit Levels
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Alan Stratton tackles how to determine an optimal profit level for a business.
http://www.performancemanagementedge.com
==TRANSCRIPT==
Coming up on today’s episode of Performance Management Edge… We learn the risk of hidden cross-subsidies and how to calculate optimal profit levels for a business.
I’m Alan Stratton and this is the show that helps people like you to get an edge in business. This is the edge you need to get things done, to soar above the masses, and to make more money.
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It is said, “Figures don’t lie – but liars sure figure.” Cost analysis may not be everyone’s favorite work activity. But, anyone making profitability decisions absolutely must understand what figures and statistics represent. And the sooner they do, the better off the company will be. When we become too casual, is when we’ll find ourselves trapped in a situation that Pierre Guillaume will describe.
In this episode Pierre Guillaume explains how averaging may lead to a company’s demise and how excessive averaging may hide how one product is subsidizing another.
Take it away Pierre.
A little while ago, we talked about the tyranny of averages and how using a single figure to represent a non-homogeneous population could lead to some serious strategic blunders.
Remember how we discussed how using simplistic average cost in multiple market segments could result loss of profitable share?
Today, I’d like to explore this a bit further in a segment that I’ll call “The vicious circle of cross-subsidization”.
Imagine that your business has two separate segments with very different cost structures. For the sake of simplification, we’ll assume that these differences are limited in the cost-to-serve of these two segments. They sell the same mix of products to two very distinct customer bases: one buying in large quantities and requiring little hand-holding, the other segment by nature resulting in many small orders and shipments to customers requiring a lot of face-to-face interaction.
If you subscribe to the “one foot in boiling water, one foot on ice” theory of accounting, you will ignore the cost-to-serve variations resulting from the inherent differences between these two market segments and the necessary activities to be performed to successfully sell your products in these segments. You will measure profitability based on gross margin and set prices to achieve comparable margins in both segments.
In doing so, you will provide ample room for competitors to enter the first segment, having set prices at a level considerably higher than true cost. These competitors, understanding that they can undercut your prices while remaining profitable will end up gaining share from you. Conversely, in the high cost segment of the market, the excessively aggressive pricing you’ve set will lead customers to beat a path to your door, further shifting your account mix toward this higher cost segment.
This will result in lower overall profitability, leading you to raise prices to improve margin and maintain the same bottom line profit. This, in turn, will lead to further customer exodus in the low cost segment, further compounding the problem. Little by little, over time, you will be conceding the valleys of the market to your competitors and retreat to narrower and narrower hills, until the point of extinction.
This vicious effect of cross-subsidization, illustrated here by using a customer dimension, is also alive and well when thinking about product mix. Many companies have found than excessive averaging of costs lead to their having to retreat from the high-volume, low-cost segments of their markets to the much lower volume, higher cost segments, eroding the base of the business to the point where they could not survive. New entrants often attack first by focusing on these high-volume, low cost, and low complexity segments, not necessarily because their cost structure is more favorable than established players, but because they are more focused, less complex, and less likely to be subject to the vicious effect of averaged costs.
Cost averaging will mask inherent economies of scale advantages the established players have in the high-volume segment.
Either way, be it in the product of customer dimension, a solid understanding of cost differences is key to avoiding serious strategic mistakes that could lead to the downfall of the business.
Thank you Pierre. As companies launch new products, profitability serve markets, and then retire products, they often have to use profits from one established project to fund another. I maintain this is ok as long as they know what they are doing, how much the subsidy is costing them, and don’t blindly create the situations Pierre just described.
Let us hear your opinions. Pierre and I would love to hear your experience and comments with hidden product subsidies and bad averages. Scroll down the page at Performance Management Edge dot com to add your opinion.
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In this and future episodes we answer real life questions from viewers. For this episode, Bob Zobrist sent in this question:
“How would I calculate optimal profit levels with my business?”
Well Bob, I know you like to joke around but I’ll take your question seriously.
With all my heart and soul, I wish I had a simple answer for your question. The answer would be the business Holy Grail. I cannot count how many times I’ve been asked this question in one form or another.
An economist’s answer would be to determine your fixed and variable costs, then plot the results in a graph with revenue. Magically, the revenue and total cost lines cross at some point which the economist calls the break-even point. Your optimal solution then is as far away from that point as you can push your sales. Alas, I wish even this answer were as simple as it sounds. In my experience, companies struggle even to define what constitutes a fixed cost versus a variable cost. This answer also ignores the influence of differences in customer service and profitability among other things.
A mathematician would point out that the economist ignored critical constraints. He would tell you to create a linear programming model where you create an equation that expresses your optimal profit then feed it and all your constraints into a very fast computer. Then push the big green button to find your answer. This answer is attractive and, in fact, I’ve experimented with creating such a business model and solution. Alas, it still is extremely difficult to setup all the relationships.
Speaking of this complexity and interrelationships, I attended a lecture by a prominent academic who had once advocated advanced cost analysis but had since gotten religion. Now, to him, everything acted and reacted to a complex network of interrelationships and feedback loops. His conclusion was that it was impossible to define all these factors. So don’t even try to calculate anything. He was very persuasive in his arguments.
Actually, I agreed with him somewhat. I do appreciate that we operate in a complex network of inter-related causes and effects. However, I’m not going to give up in despair like my academic associate. Remember the pareto principle. There are significant factors and minor factors. As long as we accept that we cannot model to a 100% standard, we can use cost analysis and cost models to identify major relationships. Once we compare these to a revenue model, we can identify the most significant contributions to an optimal profit.
Our working model will include revenue, capacity, direct costs, processes, products, customers, resources. Our model is a learning model – Not that the model will learn by itself – rather we will learn and better understand our business and how it responds. Then as conditions change, we’ll have a better idea of how our results may change and what we should do to find our optimum.
So, Bob, no simple solution – but a valuable, rewarding process.
Now to our viewers. Maybe you agree, maybe you disagree. Do you side with the economist, the mathematician, the academic, or the business modeler? Whatever it is, let’s hear your viewpoint. Please share your view below this video at Performance Management Edge dot com.
In addition to comments, we also appreciate your questions like Bob’s. They help us customize this show to your current issues. Ask your question on the “Ask Us” tab at Performance Management Edge Dot Com or as a video on our YouTube channel.
In appreciation for your question, Bob, we’ll arrange a time for you to have a 30 minute telephone or Skype discussion on topics of their choice with one of our experts. And, we’ll send him a copy of “Future Ready: How To Master Business Forecasting” by Steve Morlidge and Steve Player.
Thank you to the Beyond Budgeting Round Table who furnished this book.
Remember: Business Management is more of an art than a science. Don’t wait for tomorrow to get started. Start today making these perspectives part of your business art.
On behalf our viewers, I thank our experts. Join with us on the next episode for more business insights.
And remember, Performance Pays Profits.
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