Tom Spencer

Economies of scale

by Tom Spencer on March 1, 2009

in Economics

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1. Importance of economies of scale

In the early 20th century, by using assembly lines to mass produce the Model T Ford, Henry Ford became one of the richest and best-known men in the entire world.

Economies of scale provide a company with two main benefits:

  1. Increased market share: Lower per unit costs allow a company to reduce prices and increase market share. Economies of scale allow larger companies to be more competitive and to undercut smaller firms.
  2. Higher profit margins: If a company is able to maintain current prices, then lowering the average cost per unit will result in higher profit margins. For example, a drinks manufacturer which can produce 100,000 cans of soft drink at $0.50 each might expand production to 500,000 cans of soft drinks at a cost of $0.20 each. Assuming it can sell cans for $1 each in either situation its profit margin per can has increased from $0.50 to $0.80, which represents a 60% increase.

2. Relevance of economies of scale

There are many times when, for a firm to make a good strategy decision or for a government to engage in sound policy making, an understanding of ‘economies of scale’ is useful.

2.1 Barriers to entry

The existence of economies of scale in an industry creates barriers to entry. This is relevant if you are trying to determine the competitive intensity and attractiveness of an industry (see Porter’s 5 Forces analysis).

Where economies of scale exist, they represent a barrier which inhibit new firms from enter the industry. A large incumbent firm is in a better position to exploit economies of scale than a new entrant and, as such, may be able to force a new entrant out of the market by undercutting on price.

2.2 Natural monopoly

An industry is a natural monopoly if one firm can produce a desired output at a lower social cost than two or more firms. That is, a natural monopoly exhibits economies of scale in social costs.

In a natural monopoly, since it is always more efficient for one firm to expand than for a new firm to be established, the dominant firm often has significant market power. Therefore, it makes sense that a natural monopoly is usually highly regulated or publicly-owned. Examples of natural monopolies include railways, water, electricity, telecommunications, and postal services.

2.3 Free trade

Economies of scale provide a justification for free trade policies since some economies of scale may require a larger market than is possible within a particular country. For example, it is unlikely that Airbus, based in Toulouse, would be able to operate profitably if it could only sell aeroplanes within France.

3. Economies of scale explained

‘Economies of scale’ refers to the situation where the average cost of producing one unit of a good or service decreases as the quantity of output increases. One reason economies of scale are possible is that large overheads and other fixed costs can be spread over more units of output. Reduced average costs may result from increased output by an individual firm (internal economies of scale) or due to the growth in the size of the industry as a whole (external economies of scale). The situation where the average cost of production increases as output increases is known as diseconomies of scale.

Economies of scale 2

3.1 Internal economies of scale

Internal economies of scale are the cost savings that accrue to a firm as output increases. Seven (7) reasons that internal economies of scale may occur are:

  1. Lower input costs: A larger company will have more bargaining power with suppliers and will be able to negotiate lower prices for raw materials by bulk buying and through entering long term agreements.
  2. Efficient technology: A company that uses more efficient production technology will be able to produce higher output at a lower average cost.
  3. Research and development: Research and development is a large fixed cost for many firms. As a company increases output, R&D can be spread over a larger number of products.
  4. Access to finance: A large company will typically find it easier to borrow money, to access a larger range of financial instruments, and may also be able to borrow at lower interest rates.
  5. Marketing: Many marketing costs are fixed costs, such as the cost of advertising. A larger company is able to spread the cost of marketing over a larger number of products, thus reducing the average marketing cost per unit produced.
  6. Specialisation of labour: In a large company, managers and workers are able to specialise in particular tasks. Management specialisations include operations, marketing, human resources, and finance. Specialist managers are likely to be more effective and efficient in carrying out their roles because they will have a higher level of expertise and experience, and can obtain role specific training and qualifications.
  7. Learning by doing: Workers can improve their productivity by regularly repeating the same type of action. The increased productivity may be achieved through practice, self-perfection and the introduction of minor innovations.

3.2 External economies of scale

External economies of scale occur outside of a firm, within an industry, and arise when firms benefit from the way in which their industry is organised. Three (3) reasons that external economies of scale may occur are:

  1. Improved transport and communication links: As an industry becomes established and grows in a particular location, the government is likely to provide better transport and communication links to the region. This benefits firms as they will need to spend less money on transport and communication. Improved transport also allows firms to attract more customers, and recruit from a broader pool of employees.
  2. More focused training and education: As an industry becomes more dominant, universities will offer more courses suitable for a career in that industry. For example, the rise of the IT industry led to a proliferation of IT courses. Firms benefit from being able to recruit from a larger pool of appropriately skilled employees.
  3. Growth of support industries: If a network of suppliers or support industries becomes established and grows alongside the main industry then a firm will be able to purchase higher quality inputs at lower cost.

3.3 Diseconomies of scale

‘Diseconomies of scale’ refers to the situation where the average cost of production increases as output increases. As a firm benefits from economies of scale and grows in size it also becomes more complex to manage and run. Diseconomies may result as the increasing bureaucracy of a larger firm leads to inefficiency, as well as from problems of motivating a larger work force, greater barriers to innovation and entrepreneurial activity, and an increased principle-agent problem.

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Product Life Cycle model

by Tom Spencer on January 25, 2009

in Analysis framework

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1. Background

The idea of the Product Life Cycle was first developed in 1965 by Theodore Levitt in an article entitled “Exploit the Product Life Cycle” published in the Harvard Business Review on 1 November 1965.

2. Benefit of the Product Life Cycle model

For a business, having a growing and sustainable revenue stream from product sales is important for the stability and success of its operations. The Product Life Cycle model can be used by consultants and managers to analyse the maturity stage of products and industries. Understanding which stage a product is in provides information about expected future sales growth, and the kinds of strategies that should be implemented.

3. Product Life Cycle model

product_life_cycle_2

The “Product Life Cycle” is the name given to the stages through which a product passes over time. The classic Product Life Cycle has four stages:

  1. Introduction,
  2. Growth,
  3. Maturity, and
  4. Decline.

3.1 Introduction

At the market introduction stage the size of the market, sales volumes and sales growth are small. A product will also normally be subject to little or no competition. The primary goal in the introduction stage is to establish a market and build consumer demand for the product.

There may be substantial costs incurred in getting a product to the market introduction stage. Substantial research and development costs may have been incurred, for example, thinking of the product idea, developing the technology, determining the product features and quality level, establishing sufficient manufacturing capacity, preparing the product branding, ensuring trade mark protection, etc. Marketing costs may be high in order to test the market, launch and promote the product, develop a market for the product, and set up distribution channels.

The market introduction stage is likely to be a period of low or negative profits. As such, it is important that products are carefully monitored to ensure that sales volumes start to grow. If a product fails to become profitable it may need to be abandoned.

Some of the considerations in the introduction stage include:

  • Product development: research and development of the basic technology and product concept, determining the product features and quality level.
  • Pricing: should penetration pricing or a skimming price strategy be used? A skimming price strategy might be appropriate where there are very few competitors.
  • Distribution: distribution might be quite selective until consumer acceptance of the product can be achieved.
  • Promotion: marketing efforts are aimed at early adopters, and seek to build product awareness and to educate potential consumers about the product.

3.2 Growth

If the public gains awareness of a product and consumers come to understand the benefits of the product and accept it then a company can expect a period of rapid sales growth, enter the “Growth Stage”. In the Growth Stage, a company will try to build brand loyalty and increase market share.

Profits are driven by increased sales volume (due to growth in market share as well as an increase in the size of the overall market). Profits might also be driven by cost reductions gained from economies of scale, and perhaps more favourable market prices. Competition in the Growth Stage remains low, although new competitors are expected to enter the market. When competitors enter the market a company might be subject to price competition and increase its marketing expenditure.

Some of the considerations in the Growth Stage include:

  • Product improvement: product quality might be improved, additional features and support services added, and packaging updated.
  • Pricing: if consumer demand is high the price might be maintained at a high level.
  • Distribution: distribution channels might be added as consumer demand increases.
  • Promotion: promotion is aimed at a broader audience. A company might spend a lot of resources on promotion during the Growth Stage to build brand loyalty.

3.3 Maturity

When a product reaches maturity, sales growth slows and sales volume eventually peaks and stabilises. This is the stage during which the market as a whole makes the most profit. A company’s primary objective at this point is to defend market share while maximising profit.

In this stage, prices tend to drop due to increased competition. A company’s fixed costs are low because it is has well established production and distribution. Since brand awareness is strong, marketing expenditure might be reduced, although increased marketing expenditure might be needed to retain market share and fight increasing competition. Expenditure on research and development is likely to be restricted to product modification and improvement, and perhaps research into improved production efficiency and product quality.

Some considerations for the mature product market include:

  • Product differentiation: increased competition in the mature product market means that a company must find ways to differentiate its product from that of competitors. Strong branding is one way to do this.
  • Pricing: prices may be reduced because of increased competition. Firms in the market should be careful not to start a price war.
  • Distribution: distribution intensifies and incentives may be offered to encourage preference to be given over competing products.
  • Promotion: promotion will focus on emphasising product differences and creating/maintaining a strong brand.

3.4 Decline

A product enters into decline when sales and profits start to fall. The market for that product shrinks which reduces the amount of profit available to the firms in the industry. A decline might occur because the market has become saturated, the product has become obsolete, or customer tastes have changed.

A company might try to stimulate growth by changing their pricing strategy, but ultimately the product will have to be re-designed, or replaced. High-cost and low market share firms will be forced to exit the industry.

As sales decline, a company has three strategy options:

  • Hold: maintain production and add new features and find new uses for the product. Reduce the cost of manufacturing (e.g. move manufacturing to a low cost jurisdiction). Consider whether there are new markets in which the product might be sold.
  • Harvest: continue to offer the product, reduce marketing expenditure, and sell possibly to a loyal niche segment of the market.
  • Divest: Discontinue production, and liquidate the remaining inventory or sell the product to another firm.

Some considerations for a declining market include:

  • Product consolidation: the number of products may be reduced, and surviving products rejuvenated.
  • Price: prices may be lowered to liquidate inventory, or maintained for continued products.
  • Distribution: distribution becomes more selective. Channels that are no longer profitable are phased out.
  • Promotion: Expenditure on promotion is reduced for products subject to the Harvest and Divest strategies.

4. Criticisms

The Product Life Cycle is useful for monitoring sales results over time and comparing them to products with a similar life cycle. However, the Product Life Cycle model is by no means a perfect tool. Products often do not follow a defined life cycle, not all products go through each stage, and it is not always easy to tell which stage a product is in at any one time. Consequently, the life cycle concept is not well-suited for the forecasting of product sales.

The length of each stage will vary depending on the product and the marketing strategies employed. A Product Life Cycle may be as short as a few months for a fad or as long as a century or more for a product like petrol cars. In many markets the product life cycle is longer than the planning cycle of the organisations involved. Major products often hold their position for several decades or more, indeed, Coca-Cola was introduced in 1886 and is still the leading brand of cola.

The Product Life Cycle is only one of many considerations that a company must bear in mind. The product life cycle of many modern products is shrinking, while the operating life for many of these products is lengthening. For example, the operating life of durable goods like household appliances has increased substantially. As a result, a company that produces these products must take their market life and service life into account when planning.

Some critics have argued that the Product Life Cycle may become self-fulfilling. For example, if sales peak and then decline a manager may conclude that a product is on the decline and cut back on marketing, thus precipitating a further decline.

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Cover letters win interviews

by Tom Spencer on January 8, 2009

in Consulting research

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1. The importance of a cover letter

A cover letter is a short one page sales letter that accompanies your resume as part of your job application. The cover letter is important because it creates a first impression of you with your potential employer.

The main purpose of a cover letter is to obtain an interview, not to tell a lengthy story. A cover letter needs to capture the employer’s interest, indicate why you are writing, show how you will benefit the company, express interest in the position and, most importantly, convince the employer to give you an interview.

Writing a cover letter is like creating a work of art. While there are some general rules that you should follow, each cover letter you write should be distinctive.

2. Personalise your cover letter

One of the most important things about a cover letter is that it differentiates you from all the other applicants. To do this a cover letter should connect with the employer, and reflect your unique personality and the requirements of the job. Here are some points to bear in mind:

2.1 Address a specific person

You should not address your cover letter “to whom it may concern”, this is lazy. If you are unsure who to address your application to, call the company and ask. Make sure you get the person’s title and the correct spelling of their name.

2.2 Own your achievements

You should use the active voice, i.e. you should avoid expressions like “this experience gave me the opportunity to…” or, “these goals were met by me.” You don’t want to sound like everything happened to you or was done by someone else.

2.3 Tailor your story

Tailor your story to the job requirements. You should adapt your cover letter so that you mention the specific skills that the employer is interested in.

2.4 Establish rapport

You need to establish a connection between you and the employer. Mention a mutual contact you might have, explain why you like the company, its culture, or why you have a particular interest in some area of the company’s business.

2.5 Mirror their wording

Imitation is the sincerest form of flattery. If the employer uses specific terms or industry specific language in the job advertisement, mirror this language in your cover letter.

2.6 Be positive

Sell your skills in a positive way. Never complain about past employers, or grumble about any past experiences.

3. Structure your cover letter

It is important that your cover letter follows the right structure. The body of your cover letter should be broken up into four paragraphs.

3.1 Paragraph 1 – Why are you writing?

In the first paragraph you should briefly explain why you are writing to the company in a way that engages the reader. Name the position you are applying for. If you heard about the position through a mutual contact, this is worth mentioning. You may also allude to your career goals in this first paragraph.

3.2 Paragraph 2 – Why are you interested in consulting, and the company?

Explain why you would like to work in consulting, and demonstrate that you would like to work for the company by showing that you have researched the position. Companies want to know that you’re interested in them and understand what they do. For example, you might want to explain specific reasons why the position fulfills your career aspirations and is consistent with your ambitions for the future. You may apply for hundreds of different jobs but you need to make each prospective employer think that their job is the one you want.

3.3 Paragraph 3 – What do you have to offer?

Explain why you are qualified for the position. Use your most important qualifications and skills to show that you have the experience and skill to perform the tasks and fulfil the responsibilities of the position. If you are responding to a job ad that lists selection criteria, you should say how your skills and experience meet each of the criteria they’re looking for. Make sure that it’s clear how your education and skills are transferable, and thus relevant, to the position that you are applying for.

3.4 Paragraph 4 – Suggest the next steps

Direct the employer to your enclosed resume. Provide your contact information (phone number and e-mail address) and welcome them to get in touch. Indicate your availability for an interview and, if you want to be assertive, state when you will contact the company to set up a meeting. If you are merely enquiring about possible job openings, indicate when you will phone to follow up on your enquiry (ten business days is a pretty good guide). It’s important to finish off by thanking the employer for their time and consideration.

3.5 Signing off

Conclude your cover letter with an appropriate sign-off like “Yours sincerely”, and leave four blank lines to allow space for you to sign your name. You should use blue ink instead of black ink to sign your name because black ink may look like a photocopy.

4. Polish your cover letter

In addition to personalising and structuring your cover letter, you also need to make sure that your cover letter is polished and professional. Here are some things to keep in mind:

4.1 Be concise

Keep the length of your cover letter to one page. Don’t use more words than you need to. Use short sentences and simple language. It might be a good idea to use bullet points to list your key skills.

4.2 Be informative

Don’t just summarise your resume. Consider the job description and highlight the skills and experiences from your resume that fit the employer’s requirements.

4.3 Keep it relevant

Keep your message relevant and to the point. The purpose of your cover letter is to highlight your resume and obtain an interview, not to tell them everything you’ve ever done.

4.4 Be professional

Don’t be too colloquial, for example, break down contractions like “I’ve” and “I’m” to “I have” and “I am”. Your cover letter should never be hand written. Also, make sure you include your contact details on the cover letter.

4.5 Proofreading is important

There are likely to be lots of mistakes in your cover letter after you have written the first draft. You should get friends and/or family members to proof read your cover letter. It is important to have at least one set of fresh eyes look at the document before you send it out.

4.6 Check your spelling and punctuation

Use spell check, it’s not that hard. Spelling mistakes make a bad first impression and are easily fixed by running a final spell check before sending the cover letter. Also, be careful when using words like “there/their/they’re”, “your/you’re”, “effect/affect”, “its/it’s”, etc.

4.7 Adapt your cover letter for online

If you are submitting your application by email, you should indicate the position you are applying for in the subject line of your email. Before emailing your application, send it to yourself first to make sure there are no formatting errors. You should attach your cover letter and resume as a single document; if you were sending an application by post you wouldn’t send your cover letter and resume in two separate envelopes.

5. Sample cover letter

I have prepared a sample cover letter to give you an idea of what your cover letter might look like when it’s finished. The paragraphs highlighted in yellow provide an explanation of what you might include in each paragraph: sample cover letter.

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Five C analysis of borrower creditworthiness

by Tom Spencer on December 28, 2008

in Analysis framework

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What are lenders looking for?

It is important to understand what lenders look for when they lend money because companies often need to borrow money for various reasons: increase cash reserves, refinance existing debt, pay regular operating expenditures, research and development, capital expenditure, product development, expansion into new markets, strategic acquisitions, etc.

There are five criteria that most lenders use to assess a borrower’s creditworthiness:

  1. capacity to generate sufficient cash flows to service the loan;
  2. collateral to secure the loan in case the borrower defaults;
  3. capital that shareholders have invested in the business;
  4. conditions prevailing in the borrower’s industry and broader economy; and
  5. character and track record of the borrower and the borrower’s management.

It is important to keep in mind that lenders don’t give equal weight to each criterion and will use all five criteria to create an overall impression of a company’s creditworthiness. Lenders are typically cautious and weakness in one of the five criteria may offset strength in all of the others. For example, if a company is in a cyclical industry (e.g. construction, auto, or aviation) the company may find it difficult to borrow money during an economic downturn even if the company shows strength in all of the other criteria. Similarly, if a company’s management has a bad reputation and poor track record then the company may find it difficult to borrow money even if it has strong financial statements.

Taken together, these five criteria indicate a borrower’s ability and willingness to repay its debts. As such, if you are advising a company in relation to raising finance, you must ensure that each of the five criteria is fully addressed in your loan request.

Let’s consider each of the five criteria in a little more detail:

1. Capacity

Capacity to repay a loan is the most important criterion used to assess a borrower’s creditworthiness. The borrower must be able to satisfy the lender that it has the ability to repay the loan. To satisfy itself of the borrower’s capacity, the lender will consider various factors including:

  1. Profitability: What are the revenues and expenses of the borrower?
  2. Cash flows: How much cash flow does the business generate? The lender is interested not only in cash flows from operations, but also cash flows from investing and financing activities. What are the timing of cash flows with regard to repayment?
  3. Payment history: What is borrower’s payment history and track record of loan repayment?
  4. Debt levels: How much debt does the borrower have? How much debt can the borrower afford to repay?
  5. Industry evaluation: What is the normal debt/liquidity level for companies in the borrower’s industry?
  6. Financial ratios: There are a number of financial ratios, such as debt and liquidity ratios, that lenders will evaluate before lending money: e.g. debt to equity ratio, debt to asset ratio, current ratio, quick (acid test) ratio, operating cash flow ratio, working capital ratio, etc.

2. Collateral

While cash flows are the primary source for the repayment of a loan, collateral provides lenders with a secondary source of repayment. Collateral represents the assets that are provided to the lender to secure a loan. In the event that the borrower fails to repay the loan, the collateral may be seized by the lender to repay the loan.

The borrower must usually provide the lender with suitable collateral. To do this, the borrower normally pledges hard assets like real estate, office equipment or manufacturing equipment. However, accounts receivable and inventory might also be pledged as collateral.

Service businesses and small companies may find it difficult to provide lenders with the collateral they require because they have fewer hard assets to pledge. If the borrower doesn’t have the necessary collateral, the lender may require personal guarantees from the borrower’s directors or from a third party such as the borrower’s parent company.

3. Capital

Capital is the money that shareholders have personally invested in the business. Capital represents the money that shareholders have at risk should the business fail.

Lenders are more likely to lend money to a borrower if shareholders have invested a large amount of their own money in the business. If the business runs into financial difficulty, then the capital of the business provides a cushion for repayment of the loan. If shareholders have a large amount of capital invested in the business, this indicates they have confidence in the business venture and that they will do all that they can to ensure the borrower does not default on the loan.

4. Conditions

Conditions refer to two factors that the lender will take into account. Firstly, conditions refer to the overall economic climate, both within the borrower’s industry and in the economy generally, that could affect the borrower’s ability to repay the loan. For example, during recessions and periods of tight credit it becomes more difficult for small businesses to repay loans and more difficult for lenders to find money to lend. Thus, during these periods a small business will find it difficult to borrow money and must present lenders with a flawless loan application.

In considering the overall economic climate a lender may consider various questions including:

  1. What is the current business climate?
  2. What are the trends for the borrower’s industry? How does the borrower fit within them?
  3. What is the short and long-term growth potential in the industry?
  4. How is the market characterised? Is it an emerging or mature market?
  5. Are there any economic or political hot potatoes that could negatively impact the borrower’s growth?

Secondly, conditions refer to the intended purpose of the loan. The borrower’s reasons for seeking the loan should be spelt out in detail in the loan application. Will the money be used to buy new equipment for expansion? Will the money be used to replenish working capital to prepare for a seasonal inventory build-up?

5. Character

Character refers to the general impression that the borrower makes on the prospective lender. The lender will form a subjective judgement as to whether the borrower is sufficiently trustworthy to repay the loan.

Lenders want to put their money with companies that have impeccable credentials. Relevant factors that a lender may consider in deciding whether the borrower is sufficiently trustworthy include:

  1. What is the character of each member of the management team?
  2. What reputation do management have in the industry and the community?
  3. What educational background and level of experience does management have?
  4. What is management’s track record?
  5. What is the overall consumer perception of the borrower?
  6. Is the borrower progressive about its waste disposal, quality of life for its employees, and charitable contributions?
  7. Does the borrower have a track record of fulfilling its obligations in a timely manner?
  8. What is the borrower’s payment history and track record of loan repayment?
  9. Are there any legal actions pending against the borrower? If so, what is the reason for these legal actions?

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List of consulting firms in India

by Tom Spencer on December 14, 2008

in Consulting firms

Post image for List of consulting firms in India

Previously I created a list of certain consulting firms in Australia and America. I have decided to do the same thing for India. This list provides quick access to a list of the top consulting firms in India and provides a short description of each. I hope you find it useful.

The list of consulting firms is long, so I have divided the firms into 3 categories:

  1. Strategy and general business consulting firms in India
  2. IT consulting firms in India
  3. HR consulting firms in India

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