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Wednesday 22 May 2002

Company Size and Profits

In this week’s New Yorker, there’s a story in the “Talk of the Town” section called “The Goldilocks Effect”, that points out that, generally, beyond a certain point, the larger a company gets, the more inefficient it gets.

It suggests that inefficiencies inherent in the structure of large corporations result in diminishing economies of scale, as different parts of the company pursue their own goals, communication between units gets more difficult, etc.

However, the story seems to miss an important and fairly obvious point.

JetBlue is different from other airlines. It doesn’t issue paper tickets. Its planes have leather seats and DirecTV. It serves no meals. It flies out of airports that the major airlines shun, like Long Beach. The most important difference of all, though, is that JetBlue is profitable. Since the beginning of last year, the airline industry has lost more than twelve billion dollars, while JetBlue has made millions. […]

Commerce Bank is different from other banks. Its branches stay open until 8 P.M.; its customers get lollipops and dog biscuits; employees wear red on Fridays. Commerce doesn’t raise money for loans by issuing commercial paper. Rather, it gets most of the money from ordinary depositors’ checking and savings accounts. It has never made a major acquisition. And, while many big banks are struggling, Commerce, which recently opened branches in Manhattan, is one of the fastest-growing banks in the country. Last year, it increased revenues by forty-one per cent and earnings by thirty-two per cent, while world bestriders like Bank of America and J. P. Morgan Chase saw revenues and earnings fall.

A few years ago, JetBlue and Commerce might have seemed like eccentric experiments, anachronisms left over from the days before companies were thought to need “global reach.” The unquestioned doctrine of the past half decade was that a company had to get bigger to get better. “I cannot overemphasize the importance of sheer size and scale in today’s environment,” Ken Lewis, NationsBank’s president, said in 1997, justifying his company’s $62-billion merger with BankAmerica. It was, after all, the heyday of the supersized Value Meal, the lane-hogging Suburban, and the Starbucks venti latte.

But the main difference between the venti latte and United Airlines is that the venti latte, for being larger, delivers more value to the customer. United Airlines does not.

Our coffees have grown because that’s what customers want. Our companies have grown because that’s what corporate executives want.

The purpose of a commercial enterprise is to make money. To do this, the enterprise sells a product or service for more money than it spends to manufacture the product, or to provide the service. The difference between the cost and the selling price is profit, if you’re the seller. If you’re the buyer, the difference between cost and price is (roughly speaking) added value.

You can increase your profit by lowering your costs or raising your prices. A lot of companies in the past few years seem to be doing both.

Profts can be inreased through cost-reduction by simply buying raw materials at lower prices. Better than that, though, is to eliminate entirely things that do not contribute their fair share to the customer’s perceived value. The current jargon for this is decontenting.

In some cases, this can be done with no impact at all on the customer’s value. Imagine that you’re in the business of selling Burpsi Cola from vending machines. Thing is, you only sell it in enromous cans that hold three liters each and that cost $0.50. You’re in a tight place: you’re losing money, and because your machines can only hold a few cans at a time, they’re generally sold out.

By switching to 355ml cans, you can increase your profits enormously, without impacting customer value much. True, the price of Burpsi Cola by volume will increase almost 1000%; but because few people can drink three liters of cola before it goes flat, they’re still getting about the same value they got out of the much larger cans.

In that admittedly extreme example, customer value will actually increase because they’ll be more likely to find a Burpsi machine that’s not actually sold out.

So: Southwest Airlines and JetBlue both did away with the rubber chicken a la king; in exchange, the customers get lower prices. That in itself doesn’t result in greater profits for the companies, but it does make their marketing task easier and cheaper. When you’re selling a roughly comparable product at a lower price, you don’t have to spend a lot of money explaining the advantage to people.

Commerce Bank simply refrains from the usual bank M.O. of customer-abuse. That’s a significant value to the customer right there.

The advantage that these companies have over their rivals is not that they’re small enough to turn on a dime, or that they have greater “efficiencies” or any of that. Their advantage is that they understand that their product is the thing they advertise and sell, that their customers are the people who buy it, and that their success depends on the satisfaction of those customers.

Companies like United Airlines, on the other hand, see their stock as their primary product, and their shareholders as their customers. CEOs tend to say “shareholder value” so often it’s like the quacking of a duck, but how often do you hear them talk about customer value? Very rarely; the customers — that whole messy process involving buying, manufacturing, selling, and customers is nothing but part of the process of churning out stock issues. You can see this change in focus writ large at some companies; they’ve changed their names to their ticker symbols. The company you know as United Airlines is actually called “UAL Corp.” American Airlines is “AMR Corp.” Southwestern Bell Telephone Company is “SBC”. The company formerly known as Detroit Edison is “DTE Energy”. Hospital Corporation of America is just “HCA”. T.J. Maxx is “The TJX Companies, Inc.” And there are more.

In some cases, these companies have diversified beyond a single city, or a single chain of stores, and so perhaps a new name was indeed in order. Even those choices, though, are telling. These companies don’t want to be identified with air travel or communications services or retailing or hospitals: they want to be identified with what they see as their primary business, the sale of equities.

This is insane.

The value of a company’s shares is important, and shareholders are important participants in a company’s activities. But the shares are not the product. Let’s repeat that: The. Shares. Are. Not. The. Product. The share price increases, and dividends are paid, on the basis of the company’s profit. Those profits come from selling goods and services for more than the company paid for them. Those profits come from the people who buy the company’s product.

Companies that have forgotten this, and who don’t relearn it, will die. Imagine a mom-and-pop grocery store where Pop comes out on the sidewalk every few days and tells all who will listen that his goal in the management of the store is to maximize his profit. While he makes these speeches, Mom is inside raising all the prices and queering all the scales, to ensure the steady growth of shareholder value.

You wouldn’t continue to patronize such a store for long; but somehow the cadre of CEOs seems to think that such tactics work on a larger scale. Shareholders of UAL, US Airways, Bank of America and many others are learning, the hard way, that they don’t.

Posted by tino at 16:38 22.05.02
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I think contributing to this problem is stock options being used for compensation for senior executives, compensation tied to short term results and the relatively short lifetime at a given company for said executives. Al of these factors contribute to managing for right now in order tomaximize your current compensation package and options….and screw the future since you won’t be around.

Posted by: Paul M Johnson at May 22, 2002 09:28 PM

In a WSJ article from Monday, Ford and GM are acknowleging the decontenting for 2003 models. If you subscribe, you can read it here: http://online.wsj.com/article/0,,SB1021583836871233920,00.html?mod=COLUMN

As usual, they are assuming no one will notice, but the author asserts that it doesn’t matter what they take out, consumers are more educated, and they won’t care what’s missing, if they perceive the car as looking “cheap.” It’s not as if base GM and Ford models have luxurious interiors.

Oh, and ABS has been changed to an “option” instead of standard on some models. I bet people will notice that.

Posted by: Nicole at May 23, 2002 08:47 AM

That WSJ article talks about smart ‘de-contenting’, though. The specific example they give is removing map pockets from car seats, after studies showed that people weren’t even sure whether their own cars had them or not. “De-contenting” means removing value that customers don’t, well, value. Making things visibly cheaper and noticeably worse isn’t de-contenting, it’s just bad marketing.

Posted by: Tino at May 23, 2002 12:36 PM

I actually missed the New Yorker piece, but have some thoughts about points you bring up.

Basically, your argument boils down to the following:

  • Companies exist to make money.

  • Shares are not the product.

  • The problem is many companies try to make money by maximizing shareholder value.

  • Companies should instead make money by maximizing customer value.

  • My argument boils down to the following:

  • Publicly traded companies exist to make money for their owners.

  • Ownership of a company is based on the issuing of shares.

  • Shareholders want to maximize their profits.

  • If we accept argument #1, management must maximize shareholder value above all.

  • Increasing customer value is a means to raise your price, which may lead to higher margins.

  • Maximize margins = maximize profitability = maximized shareholder value

  • I think the sticking point is the difference between maximizing customer value and increasing customer value. Companies do not want to maximize customer value, they want to maximize shareholder value by maximizing long term profits&#185. They can maximize their profits by increasing the customer value of their product or service and charging a higher price. This difference may seem semantic, but it’s not.

    When we’re speaking strictly in terms of cash, the buyer and seller are sitting on opposite sides of the value maximization equation. You cannot simultaneously maximize a customer’s value without subtracting from the company’s profits, which ultimately affects shareholder value.

    The dotcom graveyard is littered with companies that maximized customer value over shareholder value. Take Napster for example. They certainly delivered maximum customer value.

    Finally, I’d argue the example you gave against maximizing shareholder value is flawed:

    “Imagine a mom-and-pop grocery store where Pop comes out on the sidewalk every few days and tells all who will listen that his goal in the management of the store is to maximize his profit. While he makes these speeches, Mom is inside raising all the prices and queering all the scales, to ensure the steady growth of shareholder value. You wouldn’t continue to patronize such a store for long.”

    If Mom is blindly raising prices and queering the scales, the store is increasing profits on a short term basis only, but damaging the business long term. Increasing share price for a day isn’t the same thing as increasing shareholder value. Just ask the Enron, Tyco, Adelphia, etc. shareholders who got left holding the bag.

    &#185Share price = net present value of all future dividends.

    Posted by: Eric Canale at June 10, 2002 01:19 AM