It's Not Luck (18 page)

No rush, in due time he will get it. Loudly, I say, “Correct. But, as it turns out, it takes some stages before we are able to connect to it. Bear with me, first we’ll have to go through the mechanism by which prices are determined.”

“You mean the struggle between supply and demand?” Brandon asks.

“Basically,” I confirm. “But let’s try to understand it a little bit better. The companies represent the supply side, and as we see, suppliers have a very precise perception of value of the product they supply—the value is supposed to be product cost plus reasonable margin. Naturally, they push for their perception of value to dictate the actual prices.”

“Wait a minute,” Jim says, “you are talking about suppliers as if they are one entity. That’s not the case, suppliers fight amongst themselves.”

“Exactly the other entity that we have to consider.” I smile at Jim and point to the tree. “I haven’t neglected it—on the contrary. I grabbed what we talked about yesterday, that ‘Competition becomes more and more fierce,’ which leads to the conclusion, ‘Suppliers display a less and less uniform front.’ ”

“Thank you,” says Jim, “and now you have probably got, somewhere here, the demand side?”

“Here it is,” I point it out to him. “ ‘Market perception of value is in accordance with the benefits of having the product.’ ”

Before he has any chance to raise more questions I explain, “Rather than supply and demand, I prefer to show it as a clash between the companies’ perception of value for the product they offer and the market perception of value for the same product.”

“That’s interesting,” Brandon comments. “The two perceptions have nothing in common. The perception of value of the companies is based on the effort they had to put into the product, while the perception of value of the market is based on the benefits gained from using the product. No wonder the price is determined by arm wrestling; there is no agreed upon objective criteria.”

“Exactly,” I say. “And since we are now in a period when suppliers display a less and less uniform front, the unavoidable result is that,” and I read from the appropriate place in the tree, “ ‘Prices and quantities sold are determined more and more by the markets’ perception of value and less and less by the suppliers perception of value.’ ”

“Unavoidably,” Brandon agrees. “And that leads to,” he continues to read, “ ‘More than ever satisfying the market perception of value is key to success.’ Which, not surprisingly, is a lesson that all of us have learned in the last decade. The hard way, I might add.”

“First year course in economics,” Jim says cynically.

“No, it is not,” Brandon beats me by a hair’s breadth, “and stop being such a smart aleck. Don’t you realize what Alex wrote here? The pendulum is swinging to the market side, unrelated to the relation between supply and demand.”

“What do you mean?” Jim is surprised by Brandon’s fierce reaction.

“Let me explain,” I try to cool them down. “What we said is when competition becomes very fierce, like the situation when it’s also fueled by a technological race, when companies throw new products into the market every few months, in such cases prices will continue to go down, even when demand is higher than supply.”

“But that can’t be,” Jim protests.

“If it cannot be, then you must point out to us where we went astray; where exactly the mistake is in our logic.”

Jim bends over the table to reexamine our tree, but Brandon says to him, “Don’t bother. Alex is right. Look, for example, at the electronic wafer industry. Demand is much greater than supply. All the wafer plants everywhere are huge bottlenecks. The backlog, right now, is well over a year. Nevertheless prices continue to dive.”

“I guess you’re right. I’ll have to think it over. Brandon, if that’s the case, then in many relatively high-tech companies we are invested in, we shouldn’t expect that the recovery will lead to increases in their product prices. That is awful.”

“Jim, didn’t you suspect it? The recovery has been going on for almost a year now. Haven’t you started to scale down the profit forecast of those companies?”

“Not enough,” he admits.

“Can we continue?” I ask them. “We are about to connect to some more UDEs.”

It doesn’t help. Brandon continues to mutter, “First year economics . . . ” Jim is probably trying to reevaluate the future of some of his investments. Who said that practical results don’t come directly from the analysis stage?

Eventually I am able to continue to read. “If ‘Supplier perception of value is product cost plus reasonable margin,’ and ‘Prices and quantities sold are determined more and more by the markets’ perception of value and less and less by the suppliers’ perception of value,’ then, ‘In more and more cases the price that the market is willing to pay doesn’t leave enough margin,’ which is our UDE number three.”

“Simple, isn’t it?” Brandon teases Jim.

I don’t think that they’ll continue to smile after the next few derivatives. “Let’s view this branch,” I suggest. “If, as we said before, ‘Most managers believe that product cost is something real that quantifies the efforts absorbed by the product,’ then, ‘Most managers believe that selling below product cost leads (at least in the long run) to losses.’ ”

I examine them. They look at me. They look at each other thoughtfully. “Alex, don’t you believe it?” Brandon asks.

“If I don’t believe in product cost how can I believe it! I believe in the bottom line. But that’s beside the point. Do you agree with this derivative?”

“We believe that most managers believe in it,” Jim says. “As for us, for now, we would like to reserve our judgment.”

So far, so good, I think to myself, and calmly continue to read, “If ‘Most managers believe that selling below product cost leads (in the long run) to losses,’ then ‘Most companies are reluctant to accept orders with low margins and even go so far as dropping low-margin products.’ ”

“Alex,” Brandon says slowly, “are you telling us it is a mistake when we tell the management of our companies to strategically prune low-margin products?”

“It depends,” I keep a poker face. “When you ‘prune’ low-margin product you lose the money that you get from the clients who were buying that product. The question is do your resulting savings come to more than that amount.”

“We cut the variable cost, but we don’t always cut much of the fixed cost,” he admits.

“Brandon, stop fooling yourself,” Jim comes out strong. “Many times we don’t cut even the entire variable cost.”

“If the company doesn’t have a bottleneck,” Brandon slowly brings it together, “and we don’t cut all the costs that were part of the calculated product cost, then . . . . Alex, you are telling us that we have actively participated in jeopardizing our own companies, aren’t you?”

I maintain my poker face. It’s not easy.

“I need a drink,” Brandon says, and stands up.

“Make it a double,” Jim follows him.

I guess that they are more interested in the last conclusion than in the way I have connected it to UDE number 4. That’s fine with me. It won’t hurt them to do some soul searching. Some people claim that the way to hell is paved with good intentions. From what I’ve observed and deduced since I’ve learned to construct common sense, these people are wrong. By now, the way to hell must be blocked by good intentions.

They return with coffee, bringing me one also.

“What happened to the drinks?” I ask.

Jim pats his stomach, “It’s here.”

“There is still one thing I would like to show you,” I say.

“You have shown us enough,” Brandon promises me.

“No,” I object. “Remember, all of this stems from your demand that I show that one core problem is responsible for all the UDEs. We haven’t done it yet.”

“Yes, you have,” Brandon sighs. “You have shown how everything is tied so tightly together. It’s good enough.”

“Besides,” Jim raises his hand, ‘Judging from your eagerness, I suspect another bomb is waiting for us. I think that we’ve had enough for one day.”

“There is one link still missing,” I insist. “You haven’t seen how striving for local optima leads to the lack of innovative marketing ideas.”

“Yes, that’s important,” Jim agrees.

“Okay, Alex,” Brandon gives up. “We asked for it, we deserve to get it. Go ahead, show us.”

He got the point. Next time they will not be so hasty to suggest that I spend all morning constructing trees rather than leisurely buying gifts for my family.

I point to the area of the tree we haven’t covered yet and start reading, slowly. “If ‘Most managers believe that the product price should be equal to product cost plus reasonable margin,’ then ‘Most managers believe that there is essentially a single, fair price for a product.’ At the same time, do you agree that, ‘Different market sections might have different needs’?”

“Uh-oh. Here it comes,” Jim trumpets. “Of course, what a dichotomy.”

“No,” Brandon corrects him, “what an opportunity. Keep on Alex, this is interesting.”

I keep on, “If ‘Different market sections might have different needs,’ then ‘Different market sections might have different perceptions of value for even the same product.’ ”

“Of course,” says Jim. “Different perceptions, we can demand different prices.”

“Not so quickly,” I say. “Different perceptions don’t automatically translate into different prices. My conclusion at this stage is only that ‘To a large extent most managers ignore the market’s different perception of value for the same product.’ To answer your point, I have added another statement. ‘Actions to guarantee effective segmentation can be taken.’ But Jim, if a company neglects to find and institute these actions it must expect that two segments having different perceptions of value will both demand to pay the lower price.”

“If one section knows about the other,” he admits.

“Jim, at the end there are no secrets. At the end one will know about the other, and then what? You must take actions to guarantee that even if from the supplier point of view it is the same product, from the market’s point of view it is not.”

“Can you give us an example?”

“Sure. Look at the airplane we are about to board, eventually. Go to the tourist section and check the prices people have paid. Do you really believe you are going to see only one price?”

“No,” he smiles. “Not at all. It depends when they bought the ticket, where they bought it. It also depends if they bought their tickets as a group or as individuals.”

“Yes,” I agree. “It also depends on some strange things like the length of their stay. If you notice, none of it has any relation to the actual cost of flying a passenger across the Atlantic. They all will occupy the same space, in the same airplane, served by exactly the same crew. The airline took actions to segment the market, otherwise they wouldn’t have survived. Even though, I must admit, that when you look deeper into it you get the impression that they probably over-segmented. If you know their system intimately you can find some crazy deals. Do you want another example?”

“No,” says Brandon. “I think I can come up with many others. But tell me, what is your definition of segmentation?”

“Here it is,” I show him. “ ‘Two sections of the market are called segmented from each other if and only if changes in prices in one section do not cause any changes in the other section.”

Brandon reads it again. “So, you don’t mean just niches?”

“No,” I agree. “Niches are just part of my definition. I am talking about the fact that a company can take actions to effectively segment a market that right now looks uniform to them. Of course, provided that this market does contain sections with different needs.”

“Keep on,” Jim says.

“I must emphasize,” I continue to explain, “that these actions to guarantee segmentation are very important. Look what happens when we don’t do it, when we do have only a single price, no matter what it is. Do you agree with the following statement: ‘Imposing a single price enables customers who have a high perception of value to pay a low price.’?”

They agree.

I continue, “At the same time ‘Imposing a single price trims away customers for whom the price is too steep relative to their perception of value.’ ”

“What you are actually telling us,” Brandon concludes, “is that most companies don’t take advantage of the vast potential inherent in market segmentation.”

“Precisely.” They catch it much quicker than I was able to derive it. I suppose they have more experience than I do.

“Alex, what you are telling us is that due to lack of actions to segment we have UDE number ten?” Jim jumps to the next conclusion.

“Bravo!” I cannot hold back my admiration.

“What is UDE number ten?” Brandon asks.

I put my finger on the sheet and read, “ ‘Most new outlets and most new/improved products eat into the sales of existing outlets/products.’ And I’m not saying it lightly. I spent quite some time this morning going over some cases where it did happen in my companies. In each case, if in parallel with launching the new outlet, I had taken some specific actions to segment the market, I could have minimized the damage.”

“We’ll take your word for it,” Brandon says.

“Try to do better in the future,” Jim pats me on the back.