Tuesday, August 5, 2008

An economic parable - Part 1

Let's say that I own a pickle factory in Grand Rapids, Michigan. I make good pickles, and I've developed a real following. No one in Grand Rapids would think of having a serious event without my pickles; they might buy a Vlasic for a casual barbecue if the price is right, but the Andro pickle is the only one people will go out of their way to get.

I could sell my pickles and make a solid living forever. Competitors might arise, come up with a clever advertising campaign, take away some of my business for a while, but I'm focused, I know my Grand Rapidians, and I always seem to get that business back.

But I am not the only owner of my company. My dad, who founded the company, couldn't finance it all himself, so he got friends and acquaintances to chip in - I only own 30%. So, despite the fact that Andro Pickles has made money every year of its existence, it hasn't exactly been growth like the early days of Microsoft, and some of the investors are impatient. They think I'm mired in old ways of doing business, that we could be expanding and making more money and on and on.

Again, I'm pretty content with the way things are, I have a nice house and a comfortable life. My house could be bigger, and I could have enough to ensure the prosperity and ease of my grandchildren, but that's just not very important. I make my pickles, I sell my pickles, and I'm happy.

But what to do with those investors, especially as they start to suggest that maybe the board needs to install new management, MBAs who will maximize their return? OK, I'll get my own MBAs, a management consulting firm, and they'll give me some ideas. I'm secretly hoping that they'll give me a thick document which will essentially confirm that I'm already on the right track (I don't really understand how management consulting firms work, obviously). At worst, they'll suggest a few tweaks, but they'll keep the investors quiet and let me get back to my pickles.

Much to my surprise, but probably not yours, the consultants come back a few months later (and seven figures richer) with a set of recommendations that boil down to, expand your markets - and the market they've focused on is...Chicago.

Chicago is nearby, it's without a dominant pickle manufacturer, and it's a whole lot bigger. If I could eke out even a quarter of the market share I have in Grand Rapids, I would be making an incredible amount of money. The projections in the consultant's report are astounding, and quite seductive to my fellow investors (is it just coincidence that the consultant has a big business development practice in Chicago? - no time to ponder that now).

So the decision is made, we're off to Chicago, and riches await. At first, I figure, this can only be a boon to Grand Rapids. We'll ramp up production, offering more great pickle jobs to the people of this city that helped build my business, and we'll have a win-win.

But, it turns out, we can't do that. We charge a premium price for our pickles in Grand Rapids because we've built a reputation; having done so, we have been generous with our employees, with relatively high salaries and benefits. To get into the Chicago market, however, we're going to have to cut our prices dramatically, at least at first, so we'll have to take advantage of the lower pickle worker costs there (they have very few extant pickle workers, and so we can lowball them, and give few or no benefits).

Still, no problem. The Grand Rapids part of the business is humming along, same as before, and I can focus my efforts on the tough but potentially lucrative Chicago market. It's hard at first, takes the vast majority of my time and energy, but there are so many people there - I can't afford not to make this work.

And our brand spanking new pickle plant in Chicago, it's so efficient compared to the clunky old one in Grand Rapids. We see economies of scale, we see lower labor costs, we even can bargain suppliers down in their prices because we're doing do much business. Oh, the market share reality is lagging behind the projection; it's a little harder breaking into Chicago than we (the management consultants) anticipated, but, again, there are so many people.

Because we're not ramping up in Chicago quite as fast as planned, our profits are not quite what the investors anticipated. Obviously we're doing everything possible on the revenue side, so we need to cut costs.

One day, someone has the brightest idea of all. Let's close the old inefficient high-cost Grand Rapids plant, add a bit more production in the Chicago plant, and ship the pickles the 180 miles. Sure, they'll be a bunch of people in Grand Rapids who will be upset, it may even hurt our sales there. But, so what, Chicago is so big that one big sale to a supermarket chain will make that up in no time.

But look at what's really happening. If sales in Grand Rapids fall far enough, and we have hastened that by getting rid of some pretty well-paying jobs (Grand Rapidians no longer have the extra money for premium pickles), the market stops making sense for us altogether. That's especially true if we see even a small jump in the cost of transporting those pickles back; we have a high-cost item with declining market share, and the numbers really don't work for us to care about that tiny market, not when we have the whole vast Chicago area in which to sell pickles.

What we've done, of course, through perfectly logical and sound business practices, is to put all our eggs in the Chicago basket. If we don't ever quite make it there, we'll have no business at all. We're out, or virtually out, of the Grand Rapids market, and, since the demand for pickles is still pretty much where it was, other pickle makers will come in - there is no turning back for us.

This parable has become a fairly obvious metaphor, but I'll have more to say about it as a business model in Part 2.

No comments:

Clicky Web Analytics