Leg Zero: Porter´s model explained. Industry Rivalry. Economies of Scale and the Ratio of Fixed to Variable Costs. (Part VII)
Bonjour a tous!
Today we will continue with the industry rivalry force. As I mentioned previously, it will take me at least 6 weeks to cover the whole Porter´s Competitive Industry Analysis. Why? Because it is very important to understand each of the key determinants or factors for each Porter´s force. The degree of our understanding for each key determinant variable will give us a competitive advantage in our beautiful business strategy development.
Today is the turn of THE RATIO OF FIXED TO VARIABLE COSTS AND ECONOMIES OF SCALE.
The ratio of fixed to variable costs determines how far companies will slash prices in order to utilize spare capacity. Let´s remind us about some concepts here:
There are two types of costs available which you must always have in mind while launching your beautiful business:
1. Fixed Costs
2. Variable Costs
Fixed costs are the costs that occur on a regular basis including rent, administrative costs, depreciation, and employee´s wages, salaries, and benefits, and are independent of the level of activity (e.g. production). Usually, we can find other many fixed costs in companies such as infrastructures, equipment, warehouses, trucks, surveillance system, water bills, electricity bills, the internet, etc. Fixed costs are static and tend to be identical in all periods of activity.
Variable costs are directly connected to the activity such as raw materials, distribution services, marketing, temporary labor costs or leased employees needed to manufacture a product.
For example, High fixed cost businesses are highly dependent on high volume sales to make profits (e.g., airline industry). For example, if you have an airline with high fixed costs and low consumer demand, you will likely suffer losses. In consequence, the willingness of airlines to offer heavily discounted tickets on flights with low bookings reflects the fact that the variable costs associated with filling empty seats on a scheduled flight are close to zero.
“High fixed costs create pressure for all companies to fill capacity, thus leading to price cutting when there is excess capacity. High storage costs push companies to decrease prices to ensure sales. Also, high fixed costs, relative to variable costs, can increase industry rivalry. Why? Each time a firm sells a unit of a product, the revenues from the product go to cover the variable cost, fixed costs, and profit margin. In bad times, firms may be tempted to sell their products at a loss, so long as the prices cover their variable costs. The higher the fixed costs relative to variable costs, the lower that the firm can set its prices (below profitable prices) and still cover variable costs. This can reduce industry profits considerably. Effectively, the higher the fixed costs, relative to variable costs, the higher we can expect industry rivalry”.
ECONOMIES OF SCALE:
Often a large firm can produce a good at a lower unit cost if it has the economies of scale to do it. Let´s discover what is economies of scale through a “petit dejeuner” example: fruits preserve jam. I will compare two companies completely different which sell the same product.
The first company, Confiserie Lilamand, owned by Monsieur Pierre Lilamand and his wife Sophie, in Saint-Rémy-de-Provence; and the second company, J.M. Smuckers Company from Orrville, Ohio. The J.M. Smuckers Company (the giant international jams company), can produce a jar of fruits preserves for much less than the price of the Lilamand “Confiture de Fruits”, which produces much fewer jars a year than J.M. Smuckers. The core business of Confiserie Lilamand are the candied fruits, but the company has a business line: Jams!, Jams of excellent quality made with fruits from the French Provence.
Unlike Monsieur Lilamand, the Smuckers Corporation probably buys its glassware, sugar, strawberries, labels, and pectin wholesale, and gets quantity discounts. Given the size of J.M. Smuckers Company, also uses large, labor-saving equipment to cut costs. The J.M. Smuckers Company has 7140 employees and has grown through acquisitions to other businesses such as peanut butter, shortening and oils, ice cream toppings, sweetened condensed milk, healthy and natural foods and beverages; In comparison, Lilamand Confiseur has 20 employees, it is a family business with just 4 business lines: Candied fruits, calissons, syrups and beautiful and excellent quality jams and preserves.
When a firm can cut unit costs by expanding its size, or “scale,” we say that it is experiencing economies of scale. Which of both firms, Smuckers or Lilamand have higher economies of scale? Of course J.M. Smuckers.
J.M. Smuckers is able to sell a Smucker’s Strawberry Preserves, 18 oz size at US$2.84 (US$0.16 per ounce), meanwhile, Confiserie Lilamand sells it at 9 euros per 300 grams of jar jam (US$1.01 per ounce). As a result, one ounce of jam from Confiserie Lilamand is 6.3 times more expensive than Smucker’s jam.
Even though these two companies sell the same product, their structure, size and purpose are completely different, and I wouldn´t dare to include both of them in the same industry, neither in the same bucket of competitors. If I am hired by Lilamand company to help them with strategic corporate advisory, the industry sector for this specific company is gourmet preserves and specialty jams. Meanwhile, J.M. Smuckers Co. belongs to another group of competitors with the same size and diversified food processing scope, such as Conagra Brands Inc., Hormel Food Corporation, and Mondelez International.
How did I find the Confiserie Lilamand jams? Guess how? By using www.pinterest.com. I did a Pinterest search for french excellent quality jams, and I found a specialty jam photo from Confiserie Lilamand. I did click on the photo, and I was redirected to Monsieur and Madame Lilamand website. I found Lilamand website “look and feel” simple, clean and the pictures were appealing and bright. I thought, if Confiserie Lilamand produces candied fruits, I bet they have good quality preserves or specialty jams. Afterwards, I visited Confiserie Lilamand Facebook page. Even though Confiserie Lilamand core business is candied fruits or “fruits confits”, I choose Lilamand company for the purpose of today lesson because I wanted to show you an example in France, which is so similar to many businesses in the world. Artisan Businesses which started more than a century ago, wishing to grow and expand, based on “tradition, quality, and excellence” in a global marketplace. If Confiserie Lilamand wants to expand in the USA, their place is not the same rack where J.M. Smucker’s jam is situated in Walmart, but gourmet specialty stores such as Williams Sonoma, Dean & Deluca, Eataly, Southern Season or Formaggio Kitchen.
This is all for today, tomorrow we will continue with another key determinant factor of the industry rivalry force: Switching Costs.
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