SELF TEST #19: Project the Direction of Future Prices and Margins
True or False: Even in a low-return, oversupplied industry, some new capacity will be added each year.
True. Capacity Creep, or "Learning Curve" additions to capacity, the kind that requires no capital investment, will add about 0.5% to 1.5% to the industry capacity every year. In addition, low-capital expansion (e.g., debottlenecking) offers high returns even in very Hostile industries.
Capacity could be added to an industry even if demand is flat. While the industry, in total, may not be growing, individual companies grow at differential rates as market share shifts. Even if demand is flat, an individual competitor may have to add capacity if he is gaining share.
True or False: The low-cost competitor sets the industry price level.
False. The lowest-cost capacity that is not producing sets the price level. In an industry in which demand is growing, this is the next unit of capacity (a shift, a line, a plant, a competitor) that the industry could add. In a shrinking industry, it is the last increment of capacity that exited the industry.
True or False: Demand growth can end Hostility, but may do so only temporarily.
True. Demand might end Hostility only until capacity greater than that demand comes on stream. This usually takes from 6 months to five years. After that, the industry could return to Hostile conditions.
False. Price volatility is low in a Hostile industry because Price differences, one of the primary causes of Volatility, are small and are uncommon among Peers. Competitors have learned to copy Price moves quickly to avoid losing share.
When should a company spend time and money to develop specific forecasts of future prices?
This effort is likely to be worthwhile only in industries with low marketing and sales expenses, where gross margins are at or below 10%. These are usually cyclical industries with high capital intensity. Industries with normal to high marketing and sales expenses should concentrate their analyses more on the likely expansion of competitors due to high prices and margins in the industry.
What combination of factors could lead to the following statement: Senior partners in Wall Street Law firms raised their hourly rates in 1987 from $300 to $350?
The most common cause of rising prices is demand increasing faster than the industry's existing capacity can supply it. Prices must rise to bring on new capacity or to discourage demand.
What is Price?
Price is the net cash equivalent a customer pays to a company for its product. In the economic sense, Price is the cost of the next increment of product availability, or industry capacity, that could be brought to the market.
When is Price likely to go up in a market?
The Price is likely to rise in a market when there is less availability of product, or capacity, than the industry needs. Price must rise to bring new capacity to the market.
When is Price likely to go down in a market?
Prices have an increased likelihood of falling in any market where product availability exceeds current demand. Usually, this occurs with new entrants, low cost competitor expansion or demand shrinkage.
What is Capacity Creep?
Capacity Creep is the natural addition of capacity to an existing facility due to the "Learning Curve" effect. Management learns to use the same assets and workforce to produce product more efficiently at the facility.
How much does Capacity Creep add to industry capacity every year?
Capacity Creep tends to add a very modest amount of capacity to an industry each year. The normal range is .5% to 1.5% increase in industry capacity every year due to Capacity Creep. The faster an industry grows, the more Capacity Creep adds to the annual capacity of the industry.
Why are high returns a potential problem for an industry?
While most industries would like high returns, the industries with high returns attract both new entrants and the expansion of competitors already in the market. If these expansions occur faster than demand grows, prices and margins in the industry will come under pressure.
What is the practical effect of a Price?
The practical effect of a Price is to regulate the amount of product available to customers in the market. If the price rises and increases margins, there will be more product availability. If the price falls and margins decline, there will be less product availability. The Price balances product availability, or industry capacity, with customer demand.
The industry is consolidating with many mergers and acquisitions. Will this reduce industry capacity?
The odds are this merger and acquisition wave will not reduce current industry capacity. Before the mergers and acquisitions, prices were high enough to keep all the operating facilities of the two merged companies running. Each facility is likely to continue operating as long as it can produce cash for its owners. On the other hand, these mergers and acquisitions may slow the rate of future capacity expansion. The larger merged company can absorb a larger increment of capacity addition without going into overcapacity.
Why should we bother to forecast future prices?
A company in a low marketing and sales expense industry is usually in a capital intensive industry. Creating new capacity in these industries takes a long time, usually several years. The forecast of future prices helps the Company prepare for changes it will need in its capacity to support its Core customers. If the Company sees capacity in excess of demand, it may want to delay investments in expanding its own capacity, or even plan for reductions in capacity. These, too, take time. On the other hand, in normal to high marketing expense industries, the forecast of future prices helps the Company plan pricing tactics. If the Company sees prices beginning to soften, it can plan to put more defensive tactics into its pricing in order to protect Core customer relationships. If the Company sees prices on the rise, it can follow the general trend of rising prices without worrying about competitor retaliation.
What forces tend to put prices and margins under pressure?
The forces that tend to put prices and margins under pressure are those that create capacity that is greater than demand. Naturally, this may happen if demand shrinks from a previous level to a new lower level. In this situation, capacity is greater than demand. In the more common case where demand continues to grow, there are three basic forces that cause capacity to grow faster than demand. The first of these forces is new entrants to a market. The second is rapid expansion by current competitors in the market, especially low-cost competitors. The third is high returns in the industry which tend to invite more competition in the industry than exists today. These high returns are also a special incentive for current competitors to expand rapidly in the market.
Return to Self Test #19