To Waste or to Waist: That is the question

 

     As is true of many people growing up in the US, I was encouraged to always clean my plate (encouraged is putting it mildly -- I remember being required to still be sitting at the dining table at 3am (and even longer if "necessary") because I hadn't cleaned my plate). The general principle of not wasting food is a good one -- the dangling of "there are starving people in xxx" is NOT a good one as the reason for people starving in parts of the world is political and not economic (cleaning my plate, or not, would make no difference).

     If I took food onto my plate and then told "take what you want, eat what you take" then that would also be reasonable. I would learn to take only what I was hungry for and would eat and there would not be any immediate wastage. (Eventual wastage was/is dependent on how much was left at the end of the meal and whether there were unplanned meals where leftovers were a strong source of food.)

     Having others put food on my plate and then being required to eat it was NOT a good principle. It primarily taught me to ignore my feelings of satiation. There was no such thing as being "full" or "content" as long as there was still food left. This system of superfluous portions continues into the present day with "supersizing" and eating-out portions in general. There is always the possibility of bringing food home but, honestly, how many times does it go home to be later thrown out?

     Being able to overeat has been a source of status in many societies in the past. Actual overeating, however, has not been, and is not, healthy for anyone.

     This principle also comes true in business areas. It's always tempting to get a lot of something because you can get it for less per unit. Buy 50 for $100,  buy 100 for $150. But there are hidden costs to buying more than you currently need. Storage, logistics in general. Yes, you may save money (even allowing for hidden costs) but might that extra capital being held as storage of an item be more useful for something "now"? This is the primary driving principle for "just in time" deliveries of materials. When this is combined with primary storage working with multiple consumers then both types of savings can take place -- quantity savings for the primary storage location with "just in time" savings of space and capital for the consumers.

     As personal consumers of food, we also tend to put the surplus into storage. That storage affects our health and our waistlines. It is difficult to average out food consumption and purchasing to create an optimum "no extra, no waste" situation. It is more difficult with one person than two, more difficult for two people than for five. There is also the need to balance need versus cost. If buying four cucumbers costs only 25 cents more than buying two, then buying four is the obvious bargain, correct? But what if I said that you can only reasonably use two cucumbers before the others go bad? You end up saving 25 cents (and storage space) by NOT buying the larger quantity.

     "To waste or to waist". My childhood training taught me one set of values. My knowledge, as an adult, tells me otherwise. But that doesn't make it easy to change. It can also be difficult, in business, to pass up bargains where the real value received does not match up to the price. As always, all aspects of a transaction -- or transaction's journey -- must be considered.

     

The Economics of the Road Runner: Acme is the winner

 

     As a child (and as an adult), I watched a cartoon about the Coyote and the Road Runner. The "plot" in each cartoon is for the coyote to catch the road runner in order to eat it. In spite of the overt physical violence, no longterm harm is done to either of the characters (note, there are books, videos, and probably podcasts concerning the "Physics of Looney Tunes" which do NOT follow conventional laws of physics) and the creativity and persistence are amazing. I don't know how widely these US cartoons have been distributed. They were created for Looney Tunes (Warner Brothers) and are something that I can watch over and over.

     All of the traps and schemings appeal to the technical person in me. But, of late, I cannot get it out of my head about the economics of the Coyote and the Road Runner. We have a coyote wanting to eat a road runner. An average road runner (the one in the cartoons is quite a bit larger) is about ten ounces (about 283 grams). The edible portion of the road runner is probably no more than half of that -- 5 ounces (140 grams). Baluga caviar is about $500/ounce. So, if road runner meat is as expensive as the most expensive caviar, it would be about $2500. (Much more likely, it would be about the same as alligator meat -- $1.25 per ounce -- but we're giving an extreme example here.)

     In many of the cartoons, the coyote purchases massive amounts of tools, supplies, and equipment (from the Acme Manufacturing company). For an average episode, I would make a guesstimate of maybe $15,000 of merchandise. (Some episodes are all ingenuity or low-tech stuff -- but we're talking about an average episode.) So, here is the coyote -- who has access to delivery services and mail-order/online ordering -- paying $15,000 to catch $2500 worth of meat. (And he caught the road runner only once -- and then couldn't eat it.)

     So, besides being something to think about forever, what about it? Who cares? It's a cartoon.

     Ah, but businesses and individuals do this all of the time. For businesses and freelancing individuals (who can fruitfully use their time for other things) there is a cost to time and effort coming up with solutions. At Bell Labs, we were warned on a regular basis to not fall into the NIH (Not Invented Here) trap. If I have five people working two weeks on a problem that can be purchased from someone else, is it a bargain or do I have a set of coyotes trying to catch a road runner? Maybe yes, maybe no. Does your particular "road runner" do just what you want it to or will you need to adjust the product, or the infrastructure which would use it? If so, how much? Do you have something else productive for your cast of coyotes to do (if not, you have some other serious things to think about within your business)?

     Sometimes, in order to get just what you require (or, if usable multiple times, to provide longterm economy) it is worthwhile to do it yourself. But count your costs. Especially the costs that aren't obvious. If you pay money for things, that is obvious. If it takes you eight hours to do something, that cost isn't obvious. If it causes you great stress, that adds to the "cost". If you enjoy doing it, that lessens the "cost". The balance of costs versus value (as is true for many things in life) is not always easy to ascertain.

Exit Plans: Tantalizing Optimism for Entrepreneurs

     When I was a partner in my own company, one of the things we (very optimistically) discussed from time to time was our "exit plan".  An "exit plan" is what is able to be done if personal circumstances change, or there is a desire to do something else, or (alas) we just want to stop the existing work. Owning shares of a private company has varying obligations and expectations depending on the corporate charter and the corporate laws of the state. But, in general, any ownership is "non-liquid". There is no inherent correspondence to a monetary value and shares may, or may not, be possible to be sold to another for some mutually agreed value.

     Building up the value of the company is a foundational desire for all corporate situations. And we did, with a 60% growth rate over the first six years of business. With escalating value (as measured by gross income, number of clients, and size of portfolio) the "exit plan" became of even more interest.

     Would we work to get acquired, go public, continue to stay private and expand? Staying private had many appealing points and we had no problems staying in that state -- but it did not solve "exit" needs. We decided that, for us, the notion of going public did not appeal. We did not deeply study the process, so I cannot pass along any pearls of "wisdom" we obtained in that study. It requires a lot of bureaucracy and a very appealing (not just solid) business plan to attract both an underwriter and investors for the IPO. The overhead largely precludes its use for very small companies (you can define "a small company" for yourself).

     Which leaves us with preparing for acquisition (only larger, well established, already public companies usually go through mergers). There are a number of aspects associated with valuation for acquisition. Gross income, Net income (profit margin), size of portfolio, "cost of entry" (how special is what you do -- could just anybody with just general knowledge easily do it),  intellectual property (patents, copyrights, ...), seasoned informed staff (who will continue after acquisition), market projections, and other both tangible and intangible aspects.

     Usually, the final valuation is expressed in terms of "multiples" of gross income. A "1x" valuation says the business is viable but they just think it is worth taking over but no special benefit or advantage. Less than a "1x" valuation is more in the "fire sale" area -- there are things that the company have that are useful but the business itself is not viable. Companies aim for a multiple of greater than 1. At certain periods of time, I have seen multiples of as much as 15 times (you may have seen higher). When the economy is not booming, a multiple of 6 times gross income might be considered a very nice number.

     Another point of view is to look at acquisitions from the respect of "pain points". ("Pain points" can also apply to hiring decisions.) Say company X has a wide portfolio of products from A to H, but not something that fills in the "C" area. Getting a company that fills in the "C" gap addresses a current "pain" -- a loss of opportunity. Or company Q has a product FG that is rated only in the bottom half in comparison to its competitors and there is a smaller company T that has a product FZ which is rated at, or near, the top. This addresses the "pain point" of not being well competitive by purchasing the ability to bring the competitor's product into the fold. Other "pain points" exist. The basis is that there is something that the acquiring company finds difficult to do, or have, internally and can fill that need from outside.

     So, you boost your value as much as you can. You have a general idea for whom you might fill some need/pain. Now you need a matchmaker -- someone who can find the company with the need that you can provide -- and who will negotiate a mutually acceptable amount. The matchmaker can be an employee of either company or she/he can be someone in an independent company that specializes more in M & A (Mergers and Acquisitions).

     Part of the negotiation will involve continued commitments. Perhaps they want you (generic "you" -- it might be a number of people) to stay around for a couple of years. Perhaps they want you to leave immediately. Perhaps the company has to meet some type of goal within the next year or two. Perhaps the payments are done over time, each payment of which has to meet a specific criterion or set of criteria.

     At some point, IF the acquisition succeeds, you are now ready for your next great adventure.

The Value Equation: A formula with no fixed parameters

    People are always searching for a "good value". But what does value mean? Value is certainly a subjective matter -- the value for one person will differ from the value for another person. Still, even though it is variable, there are certain things that make up value. I call this "the Value Equation". Real economists may very well have a better formula for this concept -- but I like mine for general simplicity and use.
    My Value Equation is Quality * Quantity * (1 / Cost) = Value. I would love to have Cost not be used as a reciprocal (divided into 1) but that is really how it relates to value. The lower the Cost the greater the Value -- a reciprocal situation. There is one other factor that indirectly affects the Value Equation. That is Affordability. It interacts with Cost in some manner but I don't know how to directly put it into the equation. Let's just say that if you have more money available then cost becomes less important.
    Quality is the most subjective part of the equation. If one person really loves something then their perception of quality increases. In a similar way, if another person really hates something then the quality becomes less. It is even possible for it to become negative. A negative quality would indicate that the thing being evaluated goes against moral values. If you hate internal combustion engines then a more powerful engine has less quality for you because it uses more gasoline and probably emits more pollution. If you don't mind internal combustion engines then a more powerful engine has things about it that you love and will increase the quality for you.
    Quantity is the only part of the equation that is mostly fixed. I say "mostly" because it is not always true that "more is better' for some people. A huge drink ("big gulp") sounds great until one evaluates the health consequences of drinking too much sugar or artificial sweeteners. A huge sandwich that is more than one should eat either becomes "wasted" (thrown out) or "waisted" (accumulated as fat into your body).
    Even cost is a variable factor. First, the price that is charged is not fixed. Often, wealthy people (or celebrities) are charged less for things because they can "take it or leave it" and because their possession and use of it provide a return advertising value for the supplier. Second, in most instances cost does not reflect "total cost". Total cost is the price of all events that exist from harvesting the raw materials to manufacture to distribution to reclamation of the object and the environment from which the raw materials were harvested. Total cost is rarely used -- a good portion of the cost is absorbed by the general population and subsidized by the taxpayers.
    Even with the subjective variability of the parts of the equation, it is still easy to see how it is used. Something that is of high quality, in the desired quantity, at a low cost will give the greatest value. If the quality goes down, the value goes down. If the cost goes up the value decreases (but may not be so important if it is very affordable).
    How would you define quality? Do you see a limit on quantity that provides value or is "the more the merrier"? Do you consciously take into account "total cost" when you buy something. Do you "waste" or "waist" or do you try to always get just the correct quantity?
    Although the Value Equation can be used as a framework -- the final answer is still up to you.

The economics of supersizing

I have to be careful when I talk about economics as it is such an all-pervasive subject that it is easy for me to lose focus. I consider it to be "applied sociology" -- or a measured way of evaluating how people interact and value each other within society.

Once upon a time, during a telephone interview with Google, I talked with them about how I thought Google was in a fantastic position to create an interlinked database of products, employment, and salaries. As only one example, such a database, and associated tools, could be of enormous help in figuring out how to migrate from a fossil fuel economy to a renewable fuel economy while minimizing the effects on the economy and individual workers. (Later, with 35 years of software architecture, programming, and managerial experience, Google called me in to interview for a marketing position -- they definitely have a sense of humor.)

See how easy it is for me to lose focus!

In the area of focus for this blog, supersizing involves a combination of total profits and perceived value. Perceived value is a subjective matter -- it depends on the individual and their history. In the US, it is considered to be of greater value to get more food for less money per amount -- in spite of the fact that the greater amount is unneeded and ends up being waisted (misspelling intentional). In most European countries, quantity does not enter into the equation for value as much as quality. In some other countries, it is a sufficient struggle to just get enough to eat.

When a product is sold, it is sold at a specific price. This price can be determined in one of two general ways. These are basically "cost plus" or "demand pricing". With "cost plus", the price is determined by a specific amount added to the cost of producing the item (including all overhead such as building costs, utility costs, storage, labor, and inventory loss). So, if a thingamabob costs $1 to make, store, sell, and so forth and the company wants to make 20% profit on selling thingamabobs, the price will be set at $1.20. With "demand pricing", the price is set to the highest amount that will lead to the greatest total profit. This is a bit more complicated.

"Net profit" is the difference between all the costs associated with making and selling something and the amount for which it is sold. In the "cost plus" example, there is a net profit of $0.20 or 16 2/3% (20 divided by 120). In "demand pricing", net profit is determined in a similar fashion except that the goal is to maximize the total profit.

In order to maximize total profit, the goal is sell the MOST possible at a specific net profit such that the total amount is the greatest. For example, selling 1000 of something that has a net profit of $0.20 will give a total profit of $200. Selling 500 of something that has a net profit of $0.50 will give a total profit of $250. So, even though you are selling less, you end up with a greater amount of total profit. But, if you get especially greedy and start selling something a a net profit of $1 and only sell 100, you will end up with only $100 profit.

The practice of pricing for "demand pricing" is an art and involves marketing (convincing you it is something you want), branding (letting you recognize the product and make positive associations that increases its perceived value),  and competition.

If you have a product that is desired by people and you are the only one who makes the product then you can demand the greatest amount. If you have a product that is made by many different companies and there is little perceived difference of value, then you enter what is called "commodity pricing" which usually has small net profits per item and requires mass production and sales to be profitable.

So, we come down to the area of supersizing (finally, you say). Supersizing (in the US) does two things -- it increases the perceived value and it increases the net profit (it MAY also increase total sales because of the increase in perceived value ). Let's say that you sell a tidbit that has $0.50 costs associated with what goes into it (raw, or pre-processed, food ingredients), $0.30 labor, $0.50 overhead (such as building, heating, lighting, franchise fees, etc.), and $0.30 for sales (marketing, "free" toys, posters, advertising, etc.). You then sell the tidbit for $2, giving a net profit of $0.40/item (or 20%).

If you can convert that sale into buying something bigger -- let's say twice as big. then the only thing that you have increased is the costs of what goes into it. [There is, admittedly, a little more overhead concerning storage of more stuff but that is often balanced with a reduction in cost of buying raw materials.] So, rather than $0.50 of stuff going into it, there is $1 associated with the costs. You then sell the item for $3 and you make a net profit of $0.90/item (or 30%). If you make it three times as large and sell it for $4, you would make a net profit of $1.40/item (or 35%). This is how supersizing translates into FAT profits (OK, I admit it, I like puns).

In summary, as long as people see greater value in buying more food for less per amount, it will be difficult to persuade companies to not supersize as this is an easy way for them to achieve greater profits. The only route is to change mindset to demand greater quality rather than greater quantity.