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论老子

道,领导也。领导必需要不断呼唤,教导下属以及以身作则。下属的过和错皆因领导懒惰。

 
 
 

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Chapter 31: Fallacy of first-to-market advantage  

2012-06-24 11:03:10|  分类: Buffer Mentality |  标签: |举报 |字号 订阅

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“Visual Management is already very difficult to apply in a factory environment. Even when it is applied rigorously, it is not easy to identify the critical issues that strangle the productivity of profitability of the company. This is because solving it is another issue. What about the market? How do they carry out some form of a visual management to track whether they are winning in he market place or not?” said John.

On the late Friday afternoon, May 23, 2008 John and I boarded a ferry from Lobam back to Singapore. This was the last day for John’s trip to Bintan. During the journey, we discussed about several key issues impacting the growth of the company. Among which we discussed the reason why John picked up a lean project on the product, ground proximity warning system. This is an extremely profitable product line with very good profit margin.

Being new to Honeywell, I asked, “Why does the ground proximity warning system command such a huge profit margin?”

John replied, “Honeywell holds several patents to it. It is that simple.” 

I said, “John, though we hold the patent rights to produce this product, in no time, it may soon be taken over by our competitors. Or if any one of our competitors were to design a similar functioning system without infringing our patents, we will be locked into a price war.

Let me share with you a classic 21st century example.”

“Hey! Eric, we are only into the 8th year of this century. This must be real fresh, current development,” said John.

I explained, “This is a case study that illustrates how buffer mentality in a typical manufacturing company caused it to throw away its first-to-market competitive advantage simply because it ignored the fundamental basic of manufacturing. That is, continually reduce the cost of production in order to be the price leader.

Most companies that are bathing in the sunshine of being the first-to-market usually neglect the importance of continual reduction in their cost of production.  

In one of the year 2005 financial reports, ‘Creative Technology – A Horrific Drop in Margins for Q3 FY05[1] net margins (excluding one-off gains) now just a whisker above zero. While revenue grew 65 percent year-on-year to US$333 million, net profit fell about 87 percent to US$1.1 million compared to market consensus of around US$14-15 million. Gross margin was 23.2 percent compared to 27.1 percent three months ago and 34.5 percent one year ago. Aside from the generally lower margins from MP3 players, Q3 FY05 was substantially hurt by price cuts to match Apple’s price cuts.’

Tactically, the security analyst who was making this report was recommending the stock is a SELL. What’s the problem with Creative Technology?

Obviously, its management was totally caught off-guard by the series of price cuts set into motion by its biggest competitor in the MP3 player market, Apple Computer. During the quarter preceding this quarter of the reporting, MP3 players contributed to 68 percent of Creative Technology’s total revenue. Despite having being in the market for more than 6 years and that is also 2 years ahead of Apple, it did not anticipate that Apple Computer could plan for a series of price cuts.

Each time it brought its price lower, Apple Computer expected its sales volume to increase substantially and possibly eating a big chunk into Creative Technology’s market share. Apple Computer’s sales revenue increased more than 30 percent and its profit growth was at double digit percentage. It was excellent results achieved from a smart execution plan by Apple Computer for the same reporting period (Q3 FY05).

How did Apple Computer do it? What tricks does it have?

No trick at all. Let us begin our journey to understand something called market segmentation.”

John asked, “I am not in marketing. What is market segmentation?”

I continued to explained, “Let’s look at consumers as a pyramid as shown in Figure 18-1. For simplicity, let us split it into three tiers. In the top tier are the rich people who have high spending power. In the middle tier are the well-to-dos with reasonably strong purchasing power. In the lower tier are the masses who will buy a product only if it is priced reasonably within their reach. In this illustration, we’ll call these three tiers the rich-picking market, the mid-market and the mass market, respectively.

Let’s make another assumption about the ratio of consumers among these three different markets. Assume, the ratio of the rich-picking market to mid-market to mass market is one to twenty to a thousand. We all know there are very few affluent people (the rich-picking market); there are about two percent of the consumers who are well-to-do (the mid-market) and the remaining 98 percent are people who earn an average income (the mass market). How do these three different market segments play a part in the life cycle of a new product?

 

Figure 31-1: A hypothetical example of market segmentation

 

When a new product is invented, the people running the marketing department have a huge responsibility to induce mass awareness and interests in the product while targeting to make money out of selling relatively few units of the product. One way to do so is to introduce it at a high price. This pricing strategy could be right for two reasons.

First, introducing a new product at a high price is easily one of the best ways to advertise it as a highly desirable new gadget or item for everyone. The newspapers and magazines talk about it. People read about it and start to dream about buying one if they have the money. Pricing it well out of the reach of most of the consumer who are in the mid-market and mass market, makes it into a strong wish list by the masses. Therefore, setting a high initial price can be a very effective way in creating awareness and interests in a new product. 

Second, marketing people believe they can make as much money as possible out of anything they sell. They always start off with targeting the sales of a small volume of product to the rich-picking market. Consumers from this market do not compare prices when they make a purchase. They often buy expensive goods because it makes them feel good and a bit of a show-off. The price therefore, is going to be set high during the product introduction phase to profit from these rich people who have high spending power. And this group is not complaining.

At such high prices, the pioneering company (in this case, Creative Technology, who was the pioneer of MP3 players) made fabulous gross profit margins even though the cost of production at this phase of limited production volume is relatively high. After deducting other direct expenses and indirect fixed overheads, the company still made hefty profits.

Most pioneering companies will not find it difficult to make money during this initial phase of product introduction as long as their marketing department made their calculations right and the marketing folks accurately sized up the potential sales volume that can be expected from this rich-picking market. With such large profit margin, even a fool can make money. So could Creative Technology.

However, a rich-picking market can sometimes dry up fairly quickly and becomes no longer large enough to absorb the gradual increase in production volume. To stay in business, the company must look for market growth to increase the demand for its product. The only way to grow its market size is to move one tier down.

Based on our earlier assumption, the mid-market segment is twenty times the size of the rich-picking market segment. But the catch here is that the marketing people must lower the selling price of the same product in order to reach out to this market. After all they are not as rich as the people in the rich-picking segment.

How much lower in price depends on one very important factor - how much lower the company can cut its cost of production? The lower the cost of production, the lower the price can go in order to expand the market size and thus, brings in larger profit gained from the much larger sales volume.

Certainly, it will be suicidal for a company to cut its price much more than it can cut its unit cost of production. If it does so, it will end up losing money on every unit of product it sells. Therefore, market research is vey important in order to size up the right pricing.

In manufacturing, a large expansion in production capacity generally leads to economies of scale. Theoretically, if the production output increases in multiple times, the unit cost of production drops drastically many times over. In real life, however, the drop in the cost of production may not be as much as the company desires it to be. It all depends on the effectiveness of its management in bringing down costs.

For example, among the few competing companies, one may be able to reduce its unit cost by half, another perhaps, by a third and another maybe by a quarter. Of course, the first company is going to be the most profitable followed by the second company, given the same selling price for the same product range. The third company could be slightly profitable or may even begin to lose money on every unit that it sells. 

Apple Computer must have planned it out carefully to cut prices several times in 2005 while its factory consciously reduced costs to match its planned price cuts. By leading the pack in reducing its MP3 player’s price, Apple Computer’s revenue increased tremendously after each price cut. Gross margin decreased slightly but the huge increased in sales volume more than made up for the planned price reduction to produce higher net profit, quarter after quarter.

In other words, a volume player (e.g. Apple Computer) had successfully made use of the increase in sheer sales volume to make up for the slight loss in gross profit margin and this had produced strong profitability growth for Apple Computer.

I believe the management team of Creative Technology knew this game very well but were just not able to cut its production cost quick enough. This was evidently shown in its gross margins that dropped by one-third in just one year. They were like sitting ducks and were caught off-guard by Apple Computer’s series of price cuts.

My guess is the root cause of why Creative Technology had not been able to lower its cost of production fast enough is simply because of buffer mentality. They think their first-to-market position is offering them a good buffer against new entrants and incumbents alike. This buffer mentality had wrongly sent a self-destructing signal that there is no need to measure the productivity level of their factory!

Without monitoring its factory’s productivity closely, they were not able to control its cost of production well and thus, were left with little hope of achieving much cost savings from economies of scale. Its inability to match Apple Computer’s price cut simply means whatever advantage Creative Technology had by being the first-to-market incumbent (two years ahead of Apple Computer) were lost fairly quickly. And in no time, Creative Technology may be out of the MP3 market altogether simply for not being able to compete on cost.

Creative Technology is in every sense as great a company as Apple Computer is in the MP3 player market. It ventured two years earlier than Apple Computer. At the time of writing this book, Apple Computer had reversed the situation and wrestled more than 80% of the market share. Three years ago, it was Creative Technology who was holding on to 83% of the market share.

If Creative Technology had focused on its factory’s productivity to bring its cost of production down quickly, Apple Computer would have found it a formidable competitor and would not dare to use aggressive price cut as an effective tool to wrestle market share from Creative Technology. It remains a very good chance for Creative Technology to make money in a market with few players in the MP3 market.

Without doubt, over the next year or two, the main competition among the MP3 player manufacturers will be in the mass market. Prices will have to drop even much further in order to make MP3 players priced at a level well within the affordability of the masses.

As a direct projection from the current competitive forces among the current manufacturers, how low the price of an MP3 player can go will most likely be dictated by Apple Computer’s ability to cut its cost of production.

Unless Creative Technology changes its mindset into turning itself into a cost leader, it will not make drastic moves to cut its cost of production quick enough to maintain its position in the MP3 market. That will leave Apple Computer to continue to lead in making every proactive move to lower the selling price of MP3 players whenever it reduces its unit cost of production. Creative Technology being unable to follow suit in lowering costs, it will find itself priced out of the market very soon.

As recent as early 2005, everyone knows Creative Technology was in the most enviable position to have designed the first MP3 player. It should have enjoyed all the advantages of being the first-to-market player, and had therefore, positioned itself to make huge profits if only it had actively cut costs to maintain a price advantage.

Its decreasing profit margin due to price erosion was a direct result of its failure to recognize that it is imperative to reduce its unit production cost. Of course, increasing its factory productivity is the best way to cut its cost of production. But it did not.

As of now, Apple Computer will continue to capitalize on its prowess in cutting the cost per unit through effective utilization of its factory capacity. There is no doubt about that.

In my opinion, Creative Technology will continue to moan the loss of margins due to its failure to anticipate the steepness of Apple Computer’s price cuts - each time blaming the loss of margin as the reason for its poor profitability instead of its buffer mentality which in the first place was the root cause of its’ lost in competitiveness.

Everybody in the manufacturing industry knows that increasing the factory’s productivity by quantum leaps is the only way to cut cost drastically. Lowering the unit cost of production is the only way to achieve a lower price to reach out to the masses. This is an ageless truth in market pricing.

Many companies often give themselves an excuse that they do not need to control its cost of production tightly, be it they are the current market leader or first-to-market incumbent. Such an excuse is a different form of buffer mentality and unfortunately, is a fatal symptom commonly seen among mediocre managers. Such companies are bound to lose fairly quickly whatever advantage they have earned currently as market leader. Creative Technology happens to be one of these companies managed by mediocre managers. Why do I say so?

Creative Technology indeed had produced a number of very creative, first-to-market and exceptionally good products. Other than the Sound Blaster sound cards that are installed in the majority of personal computers, the rest of these innovative products, however good they are, did not make it to the mass market. Creative Technology threw away its many crown jewels through its failure to induce a strong discipline of achieving a high level of productivity to drive costs down.

If you were to ask an investor which type of company he prefers to invest in, his reply will be a company with reasonably good products led by a strong management team and not in favor of a company with strong products but led by a mediocre management team. In the MP3 player market Apple Computer appears to me, to be the former, and Creative Technology the latter.”

John was a little tired of my long talk. He said, “I understand where we stand now in the ground proximity warning system. Despite the advantage we have today, we have to continuously reduce our cost of production. This is the surest guarantee that we are the market leader for a long time to come.

We must watch our productivity closely and remove as much cost out of our production system as possible. This is the reason why I am picking up this project.”



[1] Published on-line by www.netresearch-asia.com

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