Transcript Froeb_21

Chapter 21
You Be the Consultant
COPYRIGHT © 2008
Thomson South-Western, a part of The Thomson
Corporation. Thomson, the Star logo, and South-Western
are trademarks used herein under license.
Review of Chapter 20



Do not purchase a customer or supplier merely because they
are profitable. There must be a synergy that makes them
more valuable to you than they are to their current owners.
And do not overpay.
If there is unrealized profit at one stage of the vertical supply
chain – as happens when there are regulations preventing a
firm at one stage from raising price – vertical integration,
tying, or bundling can give the integrated firm a way to evade
regulation.
The double-markup problem occurs when complementary
products compete with one another. Setting prices jointly
eliminates the double-markup problem and is often a motive
for vertical integration or maximum resale price contracts
between a manufacturer and retailer.
Review of Chapter 20 (cont.)



Restrictions on intra-brand competition like minimum
resale price maintenance or exclusive territories provide
retailers with higher profit, which gives them incentives to
provide demand-enhancing services to customers.
If there are two retail uses for a product, it may be
profitable for a manufacturer to integrate downstream in
order to practice price discrimination. Vertical integration
stops arbitrage between the two products, which allows
price discrimination.
Outsource an activity if the outsourcer can perform the
activity better than you can.
Example: Excess Heart Valve Inventory

When a surgeon operates to replace a
diseased valve, no one knows what size
replacement valve the patient will need.


To ensure that the right size is available, a Medical
Device Company must keep an entire range of valve
sizes at a hospital.
Salespeople place and maintain an inventory
of valves at hospitals in each region.

Commission based on a percentage of revenue.
Example: Excess Heart Valve Inventory
(cont.)

Because the Medical Device Company does not get
paid until its valves are sold, it must bear the cost of
holding inventory



Calculated as the cost of capital (twelve percent) times the
wholesale cost of the valves placed at hospitals.
The problem facing the Medical Device Company is
that the cost of holding inventory is high relative to the
inventory costs of its competitors.
Discussion: Diagnose and offer solutions
Example: High Transportation Costs

Large coal-burning electric power plant is located on a river



The Transportation Division of the parent utility company is
responsible for transporting coal to the utility and pays barge company
for doing so.
It is the responsibility of the Power Plant Division to unload the barge.



The Power Plant Division is very slow in unloading barges, especially if
more than one barge needs to be unloaded at the same time or if a
barge needs unloading on a weekend.
The Power Plant has only one crew of dockworkers, and they rarely
work overtime or on weekends.
If it takes more than three days to unload a barge, the Transportation
Division is charged for every day beyond three that it keeps a barge.


Every week, a dozen barges arrive loaded with coal to feed the power
plant.
Since very few barges are unloaded within three days, the
Transportation Division faces unusually high transportation costs.
Discussion: Diagnose and offer solutions
Example: Overpaying for Acquired
Hospitals

Health care management company purchases Ambulatory
Surgical Hospitals,


Typically, the purchase price is negotiated to be some multiple of
operating cash flow, typically five to six times EBITDA.


When the development team (those in charge of making
acquisitions) paid too much, it was found that they typically
overestimated EBITA by a significant amount.
Operations was in charge of running the hospitals –
compensated based on a percentage of the difference between
actual EBITDA and budgeted EBITDA.


Of the twelve acquisitions made by the company in 2002, four of
them are unprofitable.
When Development team overpaid, Operations was hurt.
Discussion: Diagnose and offer solutions
Example: Insurance Broker E&O’s

Discussion: Company X is an insurance broker with a network of
more than 40 retail offices

Local brokers have the decision rights to settle small E&O claims

Brokers are compensated on the basis of revenue;

Essentially asked to perform two tasks (higher sales and lower
E&O); but only rewarded for one.

Centralized Legal Department does not get information about
cases until it is too late

Company is experiencing an unusually high number of E&O
losses at the insurance brokerage.

Analyze and propose solutions
What You Should Have Learned

How to identify profitable decisions
















Use the rational-actor paradigm to predict behavior.
Use benefit-cost analysis to evaluate decisions.
Use marginal analysis to make extent (how much) decisions.
Compute break-even quantities to make investment decisions.
Compute break-even price to make shut down decisions and pricing decisions.
Set optimal prices and price discriminate.
Predict industry-level changes using demand/supply analysis.
Develop long-run strategies to increase firm value.
Predict how your own actions influence those of others.
Bargain effectively.
Make decisions in uncertain environments.
Solve the problems caused by moral hazard and adverse selection.
Motivate employees to work in the best interests of the firm.
Motivate divisions to work in the best interest of the parent company.
Manage vertical relationships with upstream suppliers or downstream customers.
Now go forth and find unconsummated wealth-creating transactions, and devise
ways to profitably consummate them