Chapter 21You Be the Consultant

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Review of Chapter 20

Do not purchase a customer or supplier merely because they are profitable. There must be a synergy that makes them more valuable to you than they are to their current owners. And do not overpay.

If there is unrealized profit at one stage of the vertical supply chain – as happens when there are regulations preventing a firm at one stage from raising price – vertical integration, tying, or bundling can give the integrated firm a way to evade regulation.

The double-markup problem occurs when complementary products compete with one another. Setting prices jointly eliminates the double-markup problem and is often a motive for vertical integration or maximum resale price contracts between a manufacturer and retailer.

Review of Chapter 20 (cont.)

Restrictions on intra-brand competition like minimum resale price maintenance or exclusive territories provide retailers with higher profit, which gives them incentives to provide demand-enhancing services to customers.

If there are two retail uses for a product, it may be profitable for a manufacturer to integrate downstream in order to practice price discrimination. Vertical integration stops arbitrage between the two products, which allows price discrimination.

Outsource an activity if the outsourcer can perform the activity better than you can.

Example: Excess Heart Valve Inventory When a surgeon operates to replace a

diseased valve, no one knows what size replacement valve the patient will need. To ensure that the right size is available, a Medical

Device Company must keep an entire range of valve sizes at a hospital.

Salespeople place and maintain an inventory of valves at hospitals in each region. Commission based on a percentage of revenue.

Example: Excess Heart Valve Inventory (cont.) Because the Medical Device Company does not get

paid until its valves are sold, it must bear the cost of holding inventory Calculated as the cost of capital (twelve percent) times the

wholesale cost of the valves placed at hospitals. The problem facing the Medical Device Company is

that the cost of holding inventory is high relative to the inventory costs of its competitors.

Discussion: Diagnose and offer solutions

Example: High Transportation Costs Large coal-burning electric power plant is located on a river

Every week, a dozen barges arrive loaded with coal to feed the power plant.

The Transportation Division of the parent utility company is responsible for transporting coal to the utility and pays barge company for doing so.

It is the responsibility of the Power Plant Division to unload the barge. The Power Plant Division is very slow in unloading barges, especially if

more than one barge needs to be unloaded at the same time or if a barge needs unloading on a weekend.

The Power Plant has only one crew of dockworkers, and they rarely work overtime or on weekends.

If it takes more than three days to unload a barge, the Transportation Division is charged for every day beyond three that it keeps a barge. Since very few barges are unloaded within three days, the

Transportation Division faces unusually high transportation costs. Discussion: Diagnose and offer solutions

Example: Overpaying for Acquired Hospitals Health care management company purchases Ambulatory

Surgical Hospitals, Of the twelve acquisitions made by the company in 2002, four of

them are unprofitable. Typically, the purchase price is negotiated to be some multiple of

operating cash flow, typically five to six times EBITDA. When the development team (those in charge of making

acquisitions) paid too much, it was found that they typically overestimated EBITA by a significant amount.

Operations was in charge of running the hospitals – compensated based on a percentage of the difference between actual EBITDA and budgeted EBITDA. When Development team overpaid, Operations was hurt.

Discussion: Diagnose and offer solutions

Example: Insurance Broker E&O’s Discussion: Company X is an insurance broker with a network of

more than 40 retail offices Local brokers have the decision rights to settle small E&O claims Brokers are compensated on the basis of revenue; Essentially asked to perform two tasks (higher sales and lower

E&O); but only rewarded for one. Centralized Legal Department does not get information about

cases until it is too late Company is experiencing an unusually high number of E&O

losses at the insurance brokerage. Analyze and propose solutions

What You Should Have Learned How to identify profitable decisions

Use the rational-actor paradigm to predict behavior. Use benefit-cost analysis to evaluate decisions. Use marginal analysis to make extent (how much) decisions. Compute break-even quantities to make investment decisions. Compute break-even price to make shut down decisions and pricing decisions. Set optimal prices and price discriminate. Predict industry-level changes using demand/supply analysis. Develop long-run strategies to increase firm value. Predict how your own actions influence those of others. Bargain effectively. Make decisions in uncertain environments. Solve the problems caused by moral hazard and adverse selection. Motivate employees to work in the best interests of the firm. Motivate divisions to work in the best interest of the parent company. Manage vertical relationships with upstream suppliers or downstream customers.

Now go forth and find unconsummated wealth-creating transactions, and devise ways to profitably consummate them