The Cost of Recalls and Lost Goodwill

Posted by PITHOCRATES - April 7th, 2014

Economics 101

Manufacturers make a Point of not Killing their Customers because it’s just Bad for Business

There have been some costly recalls in the news lately.  From yoga pants that were see-through.  To cars with faulty ignition switches that can turn the engine off while driving.  Disabling the power steering and airbags.  Resulting in the loss of life.  These recalls have cost these companies a lot of trouble.  Including financial losses from the recalls and lawsuits.  Being called to testify before Congress.  And possible criminal charges.

No surprise, really.  As those who distrust corporations would say.  For they believe they constantly put their customers at risk to maximize their profits.  Even if it results in the death of their customers.  Which is why we need a vigilant government to keep these corporations honest.  So they can’t sell shoddy and dangerous goods that can kill their unsuspecting customers.  Which they will do if the government doesn’t have strong regulatory powers to stop them.  Or so says the left.

Of course, there is one problem with this line of thinking.  Dead customers can’t buy things.  And when word spreads that a corporation is killing their customers people don’t want to be their customers.  Because they don’t want to be killed.  Manufacturers know this.  And know the price they will pay if they kill their customers.  So manufacturers make a point of not killing their customers.  Because it’s just bad for business.

The Longer it takes to Recall a Defective Product the Greater the Company’s Losses

Manufacturing defects happen.  Because nothing is perfect.  And when they happen they are both costly and a public relations nightmare.  As no manufacturer wants to lose money.  And, worse, no manufacturer wants to lose the goodwill of their customers.  Because it’s not easy earning that back.  Which is why executive management wants to acknowledge and resolve these defects as soon as possible.  To limit their financial losses.  And limit the loss of their customers’ goodwill.

Let’s illustrate this with some numbers.  Let’s assume a company manufactures 5 product lines ranging from low price to high price.  The lowest priced product has the greatest unit sales.  And the lowest margin. The highest priced product has the fewest unit sales.  And the highest margin.  The other three items fall in between.  Rising in price.  And falling in margin.  Summarized here.

Cost of Recall - Gross Margin per Product Line R1

So each product line produces a sales revenue, a cost of sales and a gross margin (sales revenue less cost of sales).  Adding these departmentalized numbers together we can get total sales, cost of sales and gross margin.  And subtract from that overhead, interest expense and income taxes.  Summarized here.

Cost of Recall - Net Profit

So on approximately $5.8 million in sales this company earns $312,414.  A net profit of 5.4%.  Fictitiously, of course.  Not too bad.  That’s when everything is working well.  And they have nothing but satisfied customers.  But that’s not always the case.  Sometimes manufacturing defects happen.  Which can turn profits into losses quickly.  And the longer it takes to address the defects the greater those losses can be.

Losing the Goodwill of your Customers will end up Costing More than any Product Recall

Let’s say Product 3 suffers a manufacturing defect.  By the time they identify the defect and halt production of the defective product they’ve produced 20% of the total of that product for the year.  Which they must recall.  Limiting their losses to 20% of the total of that product run.  Which they will have to refund the sales revenue for.  But they will have to eat the cost of sales for those defective units.  And despite the company’s quick response to the defective product and providing a full refund to all customers their goodwill suffers from the bad press of the recall.  Summarized here.

Cost of Recall - Recall

Refunding customers for the 20% of the line that was defective reduced net profits from 5.4% to 0.7%.  And when they lose some customers to their defect-free competition they lose some customer goodwill.  Resulting in a 15% drop in sales.  Leaving manufactured product unsold that they have to sell with steep discounting.  Bringing their sales revenue further down while their cost of sales remains the same.  Turning that 0.7% annual profit into a 2.8% loss.  But as time passes they recover the lost goodwill of their customers.  Limiting these losses in this one year.  Now let’s look at what would probably happen if the company had a ‘screw you’ attitude to their customers.  Like many on the left fervently believe.  Summarized here.

Cost of Recall - Loss of Goodwill R1

The company did not recall any of the defective products.  As word spread that this company was selling a defective product sales of that product soon fell to nothing after selling about 50% of the annual production run.  The other half sits unsold.  Even steep discounting won’t sell a defective product.  And seeing how they screwed their customers on the defective products sales fall on their other products (in this example by 30%).  As they don’t want to suffer the same fate as those other customers.  So what would have been only a $159,929 loss with a recall becomes a $1,494,344 loss.  Over nine times worse than what it could have been without a large loss of customer goodwill.  And this is why executive management moves fast to identify and resolve defects.  Because losing the goodwill of their customers will end up costing more than any product recall.  As it can take years to earn a customer’s trust again.


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Crony Capitalists paid their Friends in Government to Ban the Incandescent Lamp

Posted by PITHOCRATES - January 5th, 2014

Week in Review

Competition makes everything better.  For consumers.  That’s you and me.  For it’s that competition that makes business give us more for less.  To please us.  And to persuade us to give them our dollars for their products.  It’s a great system.  It prevents businesses from giving us shoddy goods at high prices.  For if they did they would lose their customers.  And go out of business.  So competition in free market capitalism gets businesses to choose to please their customers.  By giving them more for less.  Which allows them to stay in business.  Unless they have corrupt friends in government (see Industry, not environmentalists, killed traditional bulbs by TIMOTHY P. CARNEY posted 1/1/2014 on the Washington Examiner).

Say goodbye to the regular light bulb this New Year.

… Starting Jan. 1, the famous bulb is illegal to manufacture in the U.S., and it has become a fitting symbol for the collusion of big business and big government.

The 2007 Energy Bill, a stew of regulations and subsidies, set mandatory efficiency standards for most light bulbs. Any bulbs that couldn’t produce a given brightness at the specified energy input would be illegal. That meant the 25-cent bulbs most Americans used in nearly every socket of their home would be outlawed…

Competitive markets with low costs of entry have a characteristic that consumers love and businesses lament: very low profit margins. GE, Philips and Sylvania dominated the U.S. market in incandescents, but they couldn’t convert that dominance into price hikes. Because of light bulb’s low material and manufacturing costs, any big climb in prices would have invited new competitors to undercut the giants — and that new competitor would probably have won a distribution deal with Wal-Mart.

So, simply the threat of competition kept profit margins low on the traditional light bulb — that’s the magic of capitalism. GE and Sylvania searched for higher profits by improving the bulb — think of the GE Soft White bulb. These companies, with their giant research budgets, made advances with halogen, LED and fluorescent technologies, and even high-efficiency incandescents. They sold these bulbs at a much higher prices — but they couldn’t get many customers to buy them for those high prices. That’s the hard part about capitalism — consumers, not manufacturers, get to demand what something is worth.

Capitalism ruining their party, the bulb-makers turned to government. Philips teamed up with NRDC. GE leaned on its huge lobbying army — the largest in the nation — and soon they were able to ban the low-profit-margin bulbs.

When you have collusion between big business and big government you no longer have free market capitalism.  No.  Instead you have crony capitalism.  Where rich people both in business and government collude with each other to make themselves even richer.  While making consumers poorer.

The lamp manufacturers got new laws that forced consumers to pay the higher prices they wouldn’t without a law compelling them to do so.  Making the lamp manufacturers richer.  And the lobbyists poured lobbying money over their friends in government.  Who probably stripped naked and rolled around on it, rubbing that cash all over their naked bodies.  And said God bless global warming.


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Restaurants and Franchises

Posted by PITHOCRATES - August 5th, 2013

Economics 101

Changing a Restaurant Name can be Costly and hurt the Marketing of your Brand

What is the number one business most likely to fail?  Restaurants.  About half of all new restaurants fail within the first 5 years.  Why?  Because people who can cook typically open up restaurants.  And that’s all they know.  Cooking.  Sadly, cooking is the smallest part of owning a restaurant.  And it’s these other areas that people who can cook fail miserably.  Because when they open up a restaurant there’s no operating manual that comes with the building they buy or lease that clearly tells them everything they need to know or do.

Chefs in the finest restaurants are masters of their craft.  Because they study how to master the art of cooking.  They didn’t go to business school.  They went to culinary school.  But running a restaurant is more than cooking.  It’s a business.  A business that must produce revenue to cover all of its expenses.  Which is kind of hard to do when you don’t know how to market your restaurant to get people to walk through the doors.  Without which there is no revenue.  Or when you don’t know all of your expenses.  Which starts with the restaurant’s name.

A good name will not guarantee success.  But a bad name can hurt business.  It should not confuse people.  Such as ’57 Chevy, for example.  Which may be your favorite car.  But people will think cars instead of food when they hear it or see it.  And it shouldn’t discourage them from eating there.  Like Average Joe’s, for example.  Because people rarely go out to restaurants that have just received an average review.  So a name is important.  And if you start with a bad one it can be very costly to change.  There’s building signage.  There could be a pylon sign near the road.  Signage inside the restaurant.  Not to mention replacing all of your menus.  These things cost.  And cause confusion with the identity of the restaurant.  Which could hurt the marketing of your brand.

Getting Menu Prices just Right is often the Difference between Success and Bankruptcy

Choosing a good restaurant location is critical, too.  A nice building you may be able to easily afford will do you no good if it isn’t near people.  As people aren’t going to travel great distances to dine at an unknown restaurant.  Which means choosing a good location may require choosing a costly location.  The purchase price/lease price may be much higher than anticipated.  Property taxes may be higher.  Both real (the land) and personal (the equipment inside).  And may be a cost item that a person who can cook didn’t even know was required.  Like the additional expenses to get all the permits and licenses to open for business.

Once opened there’s payroll.  Which you have to pay even when you’re not doing much business.  And a sit-down restaurant requires a lot of people.  Kitchen help to cook, clean and prep food.  Someone to bus tables and wash dishes.  A hostess to seat customers.  And cash them out.  A wait staff to wait on customers.  A bartender (if you have a bar).  A restaurant needs a general manager, a front of house manager and a back of house manager.  And an executive chef.  If the owner is the executive chef he or she will have to hire others to manage those other areas.  Have a spouse split all management duties with the executive chef.  Stressing the marriage.  Or risk poor service that will prevent customers from returning.

Then there are the utility expenses.  Electric, gas, water and telephone.  A point-of-sale system to track sales and manage inventory.  Or longer hours to allow manual bookkeeping and inventory control.  Dishes, cutlery, napkins, toilet paper, light bulbs, dish soap, filters, grease disposal, etc.  And a pleasing interior design.  As people want to enjoy a good meal in a pleasant environment.  Things that cost.  And things revenue must pay.  Which brings us to the menu.  The thing that will make or break your restaurant.  If you have a 10-page menu to appeal to as many people as possible you will have too much of your money in your food inventory.  And you’ll end up throwing away a lot of slow moving product.  If it’s not unique enough people will have little reason to come into your restaurant.  As will menu prices that are too high will, too.  But if those prices are too low you won’t have enough money to pay for all of these expenses.  Getting these menu prices just right is often the difference between success and bankruptcy.

Buying a Franchise is like Buying a Restaurant that comes with a Complete and Detailed Operating Manual

A big reason why restaurants fail is because owners don’t understand their costs.  And because they don’t understand their costs they don’t know how to size their food portions.  Or how to price their menu items.  Portion sizes that are too large require a bigger inventory.  Which costs more.  Leads to more waste.  And that waste leads to more costs.  While prices too low won’t generate enough revenue to cover those portion sizes.  As well as labor and overhead costs.

In a restaurant the menu is everything.  A person highly skilled in cooking can populate a menu with some delicious dishes.  But a menu too large can confuse customers who don’t want to read a book before ordering.  It could expand the inventory to include a lot of frozen and canned items because they will last longer.  But are more costly than buying fresh.  Whereas a large inventory of fresh items will not last as long.  Leading to a lot of waste.  So a shorter menu allows a smaller inventory of fresh product.  Which increases the quality of the food served.  And keeps costs down.

The restaurant owner can get all of this right but if they can’t get people to walk through that door it’s all for naught.  And getting people to walk through your door can be the hardest part.  There are many options but they all require more time and more money.  And these are things a restaurant owner has little left to spare.  Which is why so few restaurants succeed.  But there is another way to own a restaurant.  One that has a much better chance of succeeding.  And you don’t even need culinary training to succeed.  You can do this by buying a restaurant franchise.

Buying a franchise is like buying a restaurant that comes with a complete and detailed operating manual.  That tells you everything you need to know and do.  It gives you your menu.  Your portion sizes.  Your menu pricing (or at least a starting point that can be adjusted for your geographic location).  And something even more valuable.  A built-in, extensive marketing program.  So that you can have a flow of people coming through your door the day you open for business.  Because people already know everything about your restaurant because it’s part of a great national (or international) chain.  And they may have just been waiting for one to open near them.  Something a chef opening his or own restaurant can only dream about.  But that franchisee can’t have the satisfaction of bringing their dream to life like that chef can.  As long as he or she is not in that half that fails in the first 5 years.


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How a 12-Year Old Canadian and U.S. Unions see Business Differently

Posted by PITHOCRATES - May 12th, 2013

Week in Review

Advancing technology has greatly increased productivity.  Allowing fewer workers to do what workers a generation earlier did.  Causing our workforce to age.  Fewer workers are entering the workforce than are leaving it.  And costly union contracts paying pensions and health care to those who have left the workforce has decimated union membership.  For the costs they place on business have made these businesses uncompetitive in the market place.  Chasing manufacturing jobs out of the country.  Leaving union membership in the private sector at its lowest rates since the heyday of the labor movement.  To understand why let’s take a business lesson from the Canadians.  Who are trying to encourage their kids to become entrepreneurs.  Unlike in America.  Where business and profits have become a 4-letter word (see Canadian entrepreneurs: Born or made? by BARRIE McKENNA posted 5/10/2013 on The Globe and Mail).

[Entrepreneurial Adventure] pairs students with local business people to create a business, design a product, sell it and then give the profits to charity.


Evidence suggests Canada suffers from a weak entrepreneurial culture. While it’s relatively easy to start a company, the record of turning start-ups into fast-growing and successful enterprises is less convincing.

A 2010 study by Industry Canada…

… found that Canada generates a lower proportion of fast-growing companies than other developed countries, that relatively few small companies export and that the age profile of business owners is getting older…

Many business schools, including McGill University and the University of Toronto, now offer special entrepreneurship programs.

This is a problem.  For the number one job creator in any free market economy are small business owners.  People who go into business for themselves.  Taking great risk.  And hiring people as they grow.  This is the entrepreneurial spirit.  People who start out small.  And become someone like Steve Jobs.  Most people don’t understand the entrepreneurial process.  And the importance of having a business-friendly environment to encourage entrepreneurialism.  To create jobs.  To grow a healthy economy.  Creating new products that make our lives better.  And to do that one of the first things an entrepreneur must learn is what this 12-year-old learned.

“Some things work and some don’t,” acknowledged Alim Dhanani, 12, who worked on project management and Web design for the company. “To sell something, you have to have the right price. Not too small, so you have a profit, but not too big, so people will buy it.”

A 12-year-old can understand this.  The role of prices in the economy.  They have to be high enough to pay the bills.  But low enough to encourage people to buy from you.  Often times it’s not a matter of a business owner determining the price he or she wishes to charge.  They have to figure out how to pay their bills (and earn a profit) at the prevailing market price.  Something labor unions don’t understand.  Or they simply don’t care (see Fast-food workers in Detroit walk off job, disrupt business by Steve Neavling and Lisa Baertlein posted 5/10/2013 on Reuters).

Hundreds of fast-food employees in Detroit walked off the job on Friday, temporarily shuttering a handful of outlets as part of a growing U.S. worker movement that is demanding higher wages for flipping burgers and operating fryers.

The protests in the Motor City – which is struggling to recover from the hollowing out of its auto manufacturing sector – marked an expansion in organized actions by fast-food workers from ubiquitous chains owned by McDonald’s Corp, Burger King Worldwide and KFC, Taco Bell and Pizza Hut parent Yum Brands Inc.

Fast-food workers, who already have taken to the streets in New York, Chicago and St. Louis, are seeking to roughly double their hourly pay to $15 per hour from around minimum wage, which in Michigan is $7.40 per hour…

“People can’t make a living at $7.40 a hour,” said Rev. Charles Williams II, a protest organizer. “Many of them have babies and children to raise, and they can’t get by with these kind of wages.”

Those workers face high hurdles in their fight for better pay. Low-wage, low-skill workers lack political clout and face significantly higher unemployment than college graduates…

The Detroit action was put together by the Michigan Workers Organizing Committee, an independent union of fast-food workers, that is supported by community, labor and faith-based groups such as the Interfaith Coalition of Pastors, UFCW Local 876, SEIU Healthcare Michigan and Good Jobs Now.

The unions want to do to fast-food what they did to the automotive industry.  In this case the union basically gave unskilled workers the wages and benefits of skilled workers.  Sounds great if you’re an unskilled worker.  But the UAW priced the U.S. auto manufacturers out of the market.  The Big Three are a shell of what they used to be.  With both General Motors and Chrysler requiring taxpayer bailouts to avoid bankruptcy.  And pay for their crushing pension and health care cost obligations.  For GM was paying for more people not working than they were paying to work.  Even a 12-year-old can understand that this is a business model that just won’t work.

So what will happen in fast-food restaurants if you raise the labor wage from $7.40 per hour to $15 per hour?  That’s a labor cost increase of 103%.  In the restaurant business the rule of thumb for calculating your selling prices is as follows.  You calculate your food cost then triple it.  For in general one third of a menu price goes to food.  One third goes to labor.  And one third goes to overhead (utilities, rent, insurance, etc.) and profit.  Now let’s take a typical combination meal (sandwich, fries and beverage) price of $7.50.  One third of this price is $2.48 which represents the labor portion of the price.  The increase in labor is 103%.  So we take 103% of the $2.48 ($2.54) and add it to $7.50 to get the new selling price of the combo meal.  Bringing it to $10.04.

What will customers do?  Now that the combo meal will cost $2.54 more will they just continue to eat fast-food like they once did?  Will they stop adding an extra item from the dollar menu?  Will they just buy a burger and eat it with a beverage from home?  Will they just buy from the dollar menu instead of buying combos?  Of course, with the increase in labor costs that dollar menu will have to become the $2.03 menu.  Will people stop going to fast-food as often as they once did?  Some may decide that if they’re paying for a $6 hamburger the may go to a diner or bar for a $6 hamburger.  Worried about the lost business would fast-food owners try to cut their costs elsewhere to try to continue to sell fast-food at the market price?  By hiring fewer people?  Pushing current workers to part-time so they don’t have to give them costly health insurance?  Or will they just close their restaurant.  As people just won’t pay fancy restaurant prices for fast-food.

That 12-year-old in Canada would understand how the higher labor costs would affect business.  Causing changes in buying habits.  And changes in business practices.  He would not start up a fast-food franchise if labor prices were 103% higher than they are now.  For he would have to raise prices high enough to pay the bills.  But when he did they might be too high to get people to come in and buy food.  Causing a fall in business.  And a loss in revenue.  Making it more difficult to pay the bills.  That 12-year-old would see this as bad business.  Because he understands that a business owner can’t charge whatever he wants to charge.  He has to figure out how to stay in business while selling at the prevailing market price.  And though he may love fast-food he knows that his allowance won’t be able to buy as much as it once did.  So he would reduce his purchases at fast-food restaurants.  Just as his father will probably take the family out less often because of the higher prices.  Just as single mothers struggling to pay their household bills will, too.  But the unions don’t understand this.  Or simply choose not to.  Instead they just tell the workers that their employers are greedy.

It’s a sad day when a 12-year-old has better business sense than our unions.  Then again if unions cared about business they wouldn’t have bankrupted two of the Big Three.


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Capitalism puts People First while Socialism puts the State First

Posted by PITHOCRATES - April 20th, 2013

Week in Review

SeaWorld is going public.  In the initial public offering (IPO) filing they discuss the unpleasant business of their animals potentially killing people.  Which has happened in the past.  Of course, they don’t want their animals to kill people.  For it will adversely impact the bottom line (see SeaWorld: Our Investors Should Know That It’s Bad For Business When Our Killer Whales Kill People by Matthew Boesler posted 4/18/2013 on Business Insider).

This incident and similar events that may occur in the future may harm our reputation, reduce attendance and negatively impact our business, financial condition and results of operations.

A lot of people think that if government doesn’t regulate businesses they will wantonly put their customers at risk.  Even killing them with dangerous products or unsafe conditions.  People in government believe this with every fiber of their body.  So they can keep growing the size of government.  Creating ever more government jobs.  And they try to scare people whenever anyone talks about cutting the funding of government.  Saying people will die from these ruthless businesses putting profits before people if they are not there to regulate them.  Which is preposterous.

The SeaWorld’s IPO shows that if you harm your customers you will lose your customers.  And if you lose your customers you will make fewer profits.  Which means the profit incentive makes customers safe.  Because a business knows the more customers they have the more profits they can make.  So they have a financial incentive not to hurt their customers.  Something they didn’t have in the state-owned business of the former Soviet Union.

There was no fear of losing customers in the former Soviet Union if they killed their customers with faulty products.  Because there was no competition.  Just layer upon layer of bureaucrats.  And no one sued the ruling communists in the Soviet Union.  They may sacrifice the occasional bureaucrat if the outside world was aware of some incident.  But it was just another tragedy in the Soviet Union and life went on.  The people just had to put up with substandard quality.  And accept the occasional deaths.

Why?  Because in socialism where they put people before profits they actually put the state before the people.  Where bureaucrats protect themselves.  And other bureaucrats.  Because their state jobs are all that matter.  While in a country where there is capitalism the profit incentive puts people before the state.  Because any person felt mistreated by a business could simply take their business elsewhere.  Which forces businesses to bend over backward to please their customers.  Something you just don’t experience while renewing your driver’s license.


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FT135: “If corporations aren’t people than neither is government.” —Old Pithy

Posted by PITHOCRATES - September 14th, 2012

Fundamental Truth

Corporations get Wealthy by either Pleasing their Customers or Pleasing Government

Mitt Romney said during the Republican primary campaign that corporations are people.  And the Left castigated him.  While late-night comedy made jokes with that snarky, all-knowing condescension.  Because everyone on the Left knows that corporations aren’t people.  They’re evil, soulless entities.  Unfeeling and cruel.  Who care only about profits.  While poisoning our environment.  Everyone on the Left will agree with this.  And those CEOs?  They’re the worst.  A bunch of greedy, old, white men.  Except those women who shattered the glass ceiling.  Who the Left celebrates.  Even though they run evil, soulless entities.

So what is a corporation?  Other than something that comes from the bowels of hell?  Well, perhaps the simplest explanation is this.  A corporation is a business structure that lowers consumer prices.  Which reduces the cost of living for poor and middle class families everywhere.  Huh?!?  No.  That can’t be right, you say.  Because corporations are evil and soulless.  On top of that they’re not people.  So why would some evil, soulless non-humans do something that is very beneficial to humans?  In a word, greed.

There are two ways corporations can get wealthy.  Either by pleasing their customers.  With high quality, great selection and low prices.  Or by pleasing government.  Allowing them to give their customers lower quality, poorer selection and higher prices.  Because their friends in government limit competition.  So they don’t have to please their customers.  Wal-Mart is an example of a company getting rich by pleasing customers with high quality, great selection and low prices.  Wal-Mart shoppers enjoy going to Wal-Mart.  The American auto industry is an example of companies getting rich because of government.  Which restricted free market competition as much as possible in the auto industry.  Raising prices and lowering quality.  Because of this auto shoppers don’t enjoy buying American cars as much as foreign imports.  Which has made Toyota the number one car company.

The more Corporations Pursue Profits the more Choice, Quality, Variety and Lower Prices Consumers Have

Selling a large variety of high quality goods at low prices will attract customers.  And increase sales volume.  That leads to profits.  Which is what those greedy corporations want.  And one of the best ways to do this is through economies of scale.  Growing larger to have greater purchasing power.  And selling so many units that you can charge less per unit to recover overhead costs.  Thus allowing you to sell at lower prices.  And the bigger you get the more you can lower your prices.

But to get big you need to take a lot of risks.  And the biggest risk is borrowing enormous sums of money.  Because it takes money to make money.  The kind of money one person typically doesn’t have.  So how to get it?  By incorporating.  Becoming one of those evil, soulless entities.  So you can give your customers a large variety of high quality goods at low prices.  When a business incorporates a few things happen.  First of all the business becomes a legal entity.  Which protects the people running the business.  By diversifying risk to its numerous shareholders.  Who assume that risk in exchange for ownership.  Incorporating also opens the capital markets for them.  Where they can sell bonds to finance growth.  Or sell stock.  Allowing them to raise the large sums of money to open more stores/plants.  Hire more people.  And achieve economies of scale.

The more corporations that do this the more choice consumers have.  The better quality.  And the lower prices fall.  Just think of something you’ve bought recently.  And the choices you had.  The stores you visited.  The websites you visited.  How you found exactly what you were looking for and paid what you thought was a fair price.  And how you enjoyed the whole process.  Now compare that experience with, say, renewing your driver’s license.  Where you have no choice in quality or price.  Compare the friendly faces at your favorite store with the joy of waiting for them to call your number at the DMV.  When the number being served is 76.  And you have number 12.  Worse, when you make the “I have places to go look” to the civil servants behind the counter working at a snail’s pace you don’t get a friendly smile in return.  You get a look of contempt.

People in Corporations put on a more Human Face than Government Workers because they Want to Please You

When you get poor service at a store you will complain.  You will talk to management.  You will threaten to take your business elsewhere.  Or you will just take your business elsewhere without telling anyone at that business.  Giving them no chance to correct a problem that will discourage customers shopping with them.  Which is the worst thing that can happen to a business.  Because they can’t fix a problem they don’t know about.  But if they know about it they will fix it.  Because if they don’t you will take your business elsewhere.  The last thing they want you to do.  So they will strive to make your experience a good experience.

If you get poor service at the DMV, though, you don’t want to get the people who can make you wait forever angry.  Instead you smile and tell them what a great job they’re doing.  Because you can’t go anywhere else.  Which is par for the course whenever you have to deal with the government.  Where customer service is not in the employee handbook.  Which is why people usually feel fear and/or dread whenever they have to deal with a government bureaucrat.  Especially the IRS.  Which is why the dark world George Orwell wrote about in Nineteen Eighty-Four was about the oppressive world of socialism.  Not an oppressive world where corporations take over.  Because they could never do that in a free market economy.  They could only do that in a world where government chooses winners and losers in the private sector.  Which would be a world without competition.  Where there was no large variety of high quality goods at low prices.  But the grey world that Orwell wrote about in Nineteen Eighty-Four.

So what’s the difference between corporations and the government?  The people.  The people in corporations put on a more human face because they want to please you.  Because they have to please you to stay in business.  The people in government, though, don’t.  Because government doesn’t have to please you.  And don’t try to.  For where else are you going to go?


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Free Market Competition

Posted by PITHOCRATES - July 2nd, 2012

Economics 101

Competition makes Everything Better for Consumers

Let’s go back a hundred years or so.  When the railroads were making their way west.  Through barren and unforgiving country.  Where a depot is built in the middle of nowhere.  One day it will become a city but now is just a shack or two.  And a water tower along the tracks to replenish the steam locomotives.  This is the closest thing to civilization for hundreds of miles.  Railroad building supplies head west on the new track to continue the track further west.  And the trains stop to fill their locomotives with water.  You look at all that traffic passing that depot and decide to open up a diner/saloon to replenish all those people.  Who are earning wages.  But have nothing to spend them on for hundreds of miles around.

There’s no electricity yet.  Or ice.  So the meat shipped to the diner may not be the freshest.  But you can cook it with a lot of spices to hide any bad taste in case the meat is rancid.  Liquor comes out without any spoilage.  It’ll last so long that you can keep watering it down to make more money per bottle.  Your diner/saloon can be dirty and overrun with bugs.  You can just throw the bugs into the pot to make the meat go further.  It doesn’t matter.  Because for most of your customers this is the only place to come to eat and drink.  Even if they get ill from eating bad meat they’ll keep coming back.  Because where else are they going to go?

Your costs are low.  And your prices are high.  You’re doing very well.  It’s nice being the only diner/saloon at this depot.  But then a town starts growing around the depot.  And another diner/saloon opens.  It’s cleaner.  They serve fewer bugs in their food.  Their meat is less rancid.  Their liquor is less watered down.  And their prices are lower.  Everyone who eats and drinks at this depot-town eats and drinks there.  Not at your filthy shack.  You quickly go from making a lot of money to making nothing at all.  Because this new competition in town took away all of your business.  For competition makes everything better for consumers. 

When the Government Interferes with the Free Market there is no Incentive to Please their Customers

Competition is key to the free market economy.  And it’s the most important thing.  Even more important than government regulation.  Because with competition you don’t need regulations.  You don’t need inspectors.  You don’t have to file complaints.  You don’t have to wait for corrective action.  Because if you have competition you have something that works better.  And faster.  Pleasing customers.  If you don’t please them more than your competition then you will lose your customers to your competition.  This is a powerful incentive to lower your prices.  Improve the cleanliness of your establishment.  And to improve your quality.  Competition makes businesses try harder to please their customers.  On their own.  Without compulsion.

In the above example the first diner/saloon owner could have appealed to the government.  Asked the government to prohibit the second establishment from opening.  Saying that it was destructive competition.  That they were dumping lower-priced food and drink onto the market to put the first establishment out of business.  So they could raise their prices higher and lower their quality when they do.  That the market wasn’t large enough to support two businesses.  That their lower prices mean they will pay their employees less.  And a whole host of other bad things that will follow if this second business opens.  Of course the second business has none of these complaints.  Because they offer better quality at lower prices.  They don’t need the help of government.  Just a competitive free market.

If the first business should prevail in their request for government help the government will take action.  Force the second business to shut down.  Make them sell their food and drinks at higher prices.  Charge them a special excise tax on all their sales to raise money to transfer to and help the first business.  Or some other action to make the market ‘fair’ again.  Which means allowing the first establishment to continue to sell lower quality at higher prices.  Which they would.  For with the power of government helping them they have no incentive to please their customers.  So they don’t.  So people with no choice have to pay more for lower quality.  And this is what happens when the government interferes with the free market.

Free Market Competition delivers High Quality at Low Prices with the Most Efficient Allocation of Resources 

Competitive free markets also guarantee that businesses use resources in the most efficient manner.   As they try to sell the highest quality at the lowest price they will buy very carefully.  They will buy only the things they can sell.  And only enough of them to meet their demand.  For if they buy more than they can sell it will only raise their prices.  As those prices have to pay for the things they sell.  And the things they can’t sell.  So there is a very strong incentive to buy only what they absolutely need.  Leaving things for others to buy.  Which is much better than having some government bureaucrat allocate resources.

Suppose the government owned the railroad and all the depot-towns along the line.  And each depot has a diner/saloon.  Each depot-town is about the same size.  So the government bureaucrat ships the same supplies to each depot.  One barrel of flour.  One barrel of cornmeal.  One barrel of salted pork.  Two sacks of beans.  Four sacks of coffee.  Five cases of whisky.  And so on.  But the people don’t eat and drink the same in each of these depot-towns.  Some drink more liquor than others.  Some drink more coffee than others.  Some eat more meat than others.  Some eat more beans than others.  Depending on the season.  The cattle drives.  Whether the farmers are sowing or reaping.  The religious pilgrimages.  The weather.  Etc.  The local diner/saloon owners are in tune with the rise and fall of demand.  But the government bureaucrat 2,000 miles away isn’t.  So some receive more than they can use.  Others run out before the next shipment.  Making the allocation of resources inefficient.  Leading to waste.  And higher prices to pay for all of that waste.

Free market competition always works best.  And the more problems that we solve by creating more competition the better the solutions are for the people ultimately paying the prices.  The consumers.  As free market competition delivers high quality at low prices with the most efficient allocation of resources.  Giving us things like the high-definition television.  The smartphone.  The tablet computer.  And our morning coffee.  Where quality just keeps getting better while prices keep falling.  When we don’t use free market competition we get high prices, poor quality and inefficient resource allocation.  From cable television that increases rates while lowering quality (we’ll be at your house either sometime in the morning or sometime in the afternoon tomorrow or the day after.  Please have someone available at your home to meet our technician).  To waiting in line to renew your driver’s license.  Which is about as enjoyable as a root canal.


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FT101: “Unlike government a business tries to fix bad policy before it bankrupts them.” -Old Pithy

Posted by PITHOCRATES - January 20th, 2012

Fundamental Truth

If Businesses give their Employees Overly Generous Pay and Benefits they will not be able to Stay in Business

A lot of people say businesses are greedy.  That they are always trying to go on the cheap when it comes to their employees.  The fatal flaw of capitalism some even say.  That need to make a profit.  And because of the profit-incentive businesses try to use as few employees as possible.  While paying them as little in pay and benefits as possible.  Which they, of course, do.  Because that’s the only way they can stay in business when their customers are doing the same.  When we go to the store looking for the maximum value at the lowest price.

You see, a business has to earn enough sales revenue to cover all their costs.  And their sales prices include these costs.  If these costs are too high people won’t buy from them.  So this is the reason why they pay their employees as little in pay and benefits as possible.  Because of us.  And our greed.  To keep as much of our money as possible when shopping.

So businesses can’t be overly generous to their employees.  For if they are they are then faced with two choices.  Raise prices to pay for this generosity.  Thus dissuading consumers from buying from them.  Which reduces their sales revenue.  Or they can choose not to raise their prices.  Which will increase their costs greater than their sales revenue.  Either way it’s bad for business.  For if they give their employees overly generous pay and benefits they will lose money.  And not be able to stay in business.

Businesses must make these Difficult Choices if they wish to Survive in the Real World

In free market capitalism businesses have real constraints.  They can’t be overly generous.  Because they won’t be able to earn enough revenue to cover their costs.  But neither can they be too miserly with their employees.  Because they have to be generous enough to entice them to work for them.  It’s this balancing act between generosity and being too cheap that causes a business problems.  Because in good economic times employees like to demand more.  And if they don’t get it where they currently work they will leave and work for someone else.  So employers are generous.  Sometimes too generous.  Which they usually learn when the good times end and they can no longer cover their costs at the new levels of revenue during those bad economic times.

A business cannot raise revenue by simply saying ‘raise revenue’.  For it is not up to them.  It’s up to the consumer.  And during bad economic times they’re just not buying like they once were.  Which leaves a business only one choice.  They must cut costs.  Either by cutting back on pay and benefits.  Or by really cutting back on pay and benefits.  By laying off employees.  It’s either that or they will bankrupt themselves out of business.

All businesses must make these difficult choices.  If they wish to survive.  Because they live in the real world.  Capitalism.  Where there are winners and losers.  And where businesses fail because they don’t make the difficult choices when they have to.  We’ve all seen a favorite store go out of business.  It may not always be because of the cost of their employees.  But it is always because they’re not earning enough revenue to cover their costs.

Difficult Choices are Rarely Politically Expedient and don’t bring in Many Votes

Health care costs and pensions have been the biggest costs businesses have struggled with.  That’s why defined benefit pension plans are a thing of the past.  Unless you’re in a union.  Or in government.  And employees are contributing more to the cost of their health care benefits.  Why?  Because of our aging population.  People are having fewer babies and are living longer.  And consuming more health care and pension benefits in their retirement than the actuaries ever dreamed possible when they created the health care benefit and defined benefit pension plans.

It’s no different in the public sector.  In fact, it’s worse.  Government grew.  And taxes grew to pay for that growing government.  It became more expensive to have babies.  So people had fewer.  Made possible by birth control and abortion.  Now there are fewer and fewer young people entering the work force to pay the taxes to pay for the ever growing number of seniors in their retirement.  Again, something the actuaries never calculated.  And there’s no way to fix it.  It’s a failed model.  But government won’t give up on this bad policy.  Unlike businesses have.  Because government doesn’t operate in the real world.  Like those businesses.

Government can do things businesses can’t.  They can tax.  They can run deficits.  Paid by massive borrowings.  And they can print money.  So they don’t have to make the difficult choices.  And chose not to.  Because those difficult choices are rarely politically expedient.  And don’t bring in many votes.


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FT99: “We don’t need government to protect consumers because dead consumers can’t buy anything.” -Old Pithy

Posted by PITHOCRATES - January 6th, 2012

Fundamental Truth

Corporations Care for our Personal Well-Being because they Care about Profits

A lot of people feel that if it weren’t for government big corporations would kill consumers with faulty, defective and dangerous goods.   That the only thing that prevents these evil corporations from killing us wholesale to maximize their profits is a caring government.  Because the only things corporations care about are profits.  Which is true.  But because they do they also care for our personal well-being.  For to make profits you have to sell.  And if you kill the people that buy from you you’re not going to sell much.

Case in point, the big 1982 Tylenol scare in Chicago.  Seven people died from five tampered bottles of Tylenol.  They found three additional bottles still on store shelves.  Johnson & Johnson, the maker of Tylenol, moved swiftly.  Not to hide anything.  But to protect their customers.  They initiated a nationwide recall, pulling some 31 million bottles of Tylenol out of the market.  They placed national advertisements warning people not to consume any acetaminophen (the chemical compound that is Tylenol).  Fully cooperated with local and federal authorities.  And introduced tamper-resistant packaging.  The 1982 Tylenol scare cost Johnson and Johnson 77% of their market share.  But because of their prompt actions to protect their customers as well as the general public, they regained their market share.  And the people’s trust.

During the Seventies the DC-10 had a series of high-profile accidents.  A cargo door design caused a near crash over Windsor, Ontario.  And a crash in France.  Ground crews thought they closed the door properly.  They didn’t.  The doors blew out and damaged the hydraulic control systems when the sudden decompression collapsed the floor into those control lines.  A DC-10 taking off from Chicago O’Hare lost a wing-mounted engine, damaging the leading edge slats and hydraulic controls.  Mechanics had changed that engine without following proper maintenance procedures.  As a result they overstressed the pylon mounting flange which failed during their take-off roll.  The DC-10 got a reputation for being unsafe.  When McDonnell Douglas resolved these issues a lot of people were still wary about getting on a DC-10.  Which didn’t help orders from airlines.  They ceased production with the last delivery in 1989 after delivering only some 446 aircrafts.  Some of which are still flying today.

If Businesses Endanger their Customers their Customers will Take Notice and Stop being Customers

McDonnell Douglas designed the DC-10 to compete against the Boeing 747, the first wide-body jet.  It couldn’t carry as many people but it could take off from shorter runways.  And with one less engine it burned less fuel.  It was a successful economic model.  And competed well against the 747.  But the 747 had/has a better safety record.  And reputation.  They’re still building them today.  With over 1400 having been delivered through 2011.  A number the DC-10 may have approached if it wasn’t for that reputation earned in the Seventies.

If businesses endanger their customers their customers will take notice.  And stop being customers.  That’s why Johnson and Johnson acted quickly.  And recovered.  McDonnell Douglas did not.  With declining sales Boeing eventually bought them out.  And retired the MD-11 (the latest version the DC-10).

Paying Consumers provide Great Incentive for Business to try and Predict Every Possible Failure

Johnson and Johnson led the way during the Tylenol scare.  The FDA caught up to them.  The FAA forced design modifications to improve the safety of the DC-10.  After approving the original design that they subsequently deemed unsafe.  Aircraft are complex machines.  No one can predict every possible failure.  In business.  Or government.  But the paying consumers provide great incentive for business to try.  Because dead consumers can’t buy anything.


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FUNDAMENTAL TRUTH #27: “Yes, it’s the economy, but the economy is not JUST monetary policy, stupid.” -Old Pithy

Posted by PITHOCRATES - August 17th, 2010

DURING UNCERTAIN ECONOMIC times, people act differently.  If business is down where you work, your company may start laying off people.  Your friends and co-workers.  Even you.  If there is a round of layoffs and you survive, you should feel good but don’t.  Because it could have been you.  And very well can be you.  Next time.  Within a year.  In the next few months.  Any time.  You just don’t know.  And it isn’t a good feeling.

So, should this be you, what do you do?  Run up those credit cards?  By a new car?  Go on a vacation?  Take out a home equity loan to pay for new windows?  To remodel the kitchen?  Buy a hot tub?  Or do you cut back on your spending and start hoarding cash?  Just in case.  Because those unemployment payments may not be enough to pay for your house payment, your property taxes, your car payment, your insurances, your utilities, your groceries, your cable bill, etc.  And another loan payment won’t help.  So, no.  You don’t run up those credit cards.  Buy that car.  You don’t go on vacation.  And you don’t take that home equity loan.  Instead, you hunker down.  Sacrifice.  Ride it out.  Prepare for the worse.  Hoard your cash.  Enough to carry you through a few months of unemployment.  And shred those pre-approved credit card offers.  Even at those ridiculously low, introductory interest rates.

To help hammer home this point, you think of your friends who lost their jobs.  Who are behind on their mortgages.  Who are in foreclosure.  Whose financial hardships are stressing them out to no ends.  Suffering depression.  Harassed by collection agencies.  Feeling helpless.  Not knowing what to do because their financial problems are just so great.  About to lose everything they’ve worked for.  No.  You will not be in their position.  If you can help it.  If it’s not already too late.

AND SO IT is with businesses.  People who run businesses are, after all, people.  Just like you.  During uncertain economic times, they, too, hunker down.  When sales go down, they have less cash to pay for the cost of those sales.  As well as the overhead.  And their customers are having the same problems.  So they pay their bills slower.  Trying to hoard cash.  Receivables grow from 30 to 45 to 90 days.  So you delay paying as many of your bills as possible.  Trying to hoard cash.  But try as you might, your working capital is rapidly disappearing.  Manufacturers see their inventories swell.  And storing and protecting these inventories costs money.  Soon they must cut back on production.  Lay off people.  Idle machinery.  Most of which was financed by debt.  Which you still have to service.  Or you sell some of those now nonproductive assets.  So you can retire some of that debt.  But cost cutting can only take you so far.  And if you cut too much, what are you going to do when the economy turns around?  If it turns around?

You can borrow money.  But what good is that going to do?  Add debt, for one.  Which won’t help much.  You might be able to pay some bills, but you still have to pay back that borrowed money.  And you need sales revenue for that.  If you think this is only a momentary downturn and sales will return, you could borrow and feel somewhat confidant that you’ll be able to repay your loan.  But you don’t have the sales now.  And the future doesn’t look bright.  Your customers are all going through what you’re going through.  Not a confidence builder.  So you’re reluctant to borrow.  Unless you really, really have to.  And if you really, really have to, it’s probably because you’re in some really, really bad financial trouble.  Just what a banker wants to see in a prospective borrower.

Well, not really.  In fact, it’s the exact opposite.  A banker will want to avoid you as if you had the plague.  Besides, the banks are in the same economy as you are.  They have their finger on the pulse of the economy.  They know how bad things really are.  Some of their customers are paying slowly.  A bad omen of things to come.  Which is making them really, really nervous.  And really, really reluctant to make new loans.  They, too, want to hoard cash.  Because in bad economic times, people default on loans.  Enough of them default and the bank will have to scramble to sell securities, recall loans and/or borrow money themselves to meet the demands of their depositors.  And if their timing is off, if the depositors demand more of their money then they have on hand, the bank will fail.  And all the money they created via fractional reserve banking will disappear.  Making money even scarcer and harder to borrow.  You see, banking people are, after all, just people.  And like you, and the business people they serve, they, too, hunker down during bad economic times.  Hoping to ride out the bad times.  And to survive.  With a minimum of carnage. 

For these reasons, businesses and bankers hoard cash during uncertain economic times.  For if there is one thing that spooks businesses and banks more than too much debt it’s uncertainty.  Uncertainty about when a recession will end.  Uncertainty about the cost of healthcare.  Uncertainty about changes to the tax code.  Uncertainty about new government regulations.  Uncertainty about new government mandates.  Uncertainty about retroactive tax changes.  Uncertainty about previous tax cuts that they may repeal.  Uncertainty about monetary policy.  Uncertainty about fiscal policy.  All these uncertainties can result with large, unexpected cash expenditures at some time in the not so distant future.  Or severely reduce the purchasing power of their customers.  When this uncertainty is high during bad economic times, businesses typically circle the wagons.  Hoard more cash.  Go into survival mode.  Hold the line.  And one thing they do NOT do is add additional debt.

DEBT IS A funny thing.  You can lay off people.  You can cut benefits.  You can sell assets for cash.  You can sell assets and lease them back (to get rid of the debt while keeping the use of the asset).  You can factor your receivables (sell your receivables at a discount to a 3rd party to collect).  You can do a lot of things with your assets and costs.  But that debt is still there.  As are those interest payments.  Until you pay it off.  Or file bankruptcy.  And if you default on that debt, good luck.  Because you’ll need it.  You may be dependent on profitable operations for the indefinite future as few will want to loan to a debt defaulter.

Profitable operations.  Yes, that’s the key to success.  So how do you get it?  Profitable operations?  From sales revenue.  Sales are everything.  Have enough of them and there’s no problem you can’t solve.  Cash may be king, but sales are the life blood pumping through the king’s body.  Sales give business life.  Cash is important but it is finite.  You spend it and it’s gone.  If you don’t replenish it, you can’t spend anymore.  And that’s what sales do.  It gets you profitable operations.  Which replenishes your cash.  Which lets you pay your bills.  And service your debt.

And this is what government doesn’t understand.  When it comes to business and the economy, they think it’s all about the cash.  That it doesn’t have anything to do with the horrible things they’re doing with fiscal policy.  The tax and spend stuff.  When they kill an economy with their oppressive tax and regulatory policies, they think “Hmmm.  Interest rates must be too high.”  Because their tax and spending sure couldn’t have crashed the economy.  That stuff is stimulative.  Because their god said so.  And that god is, of course, John Maynard Keynes.  And his demand-side Keynesian economic policies.  If it were possible, those in government would have sex with these economic policies.  Why?   Because they empower government.  It gives government control over the economy.  And us.

And that control extends to monetary policy.  Control of the money supply and interest rates.  The theory goes that you stimulate economic activity by making money easier to borrow.  So businesses borrow more.  Create more jobs.  Which creates more tax receipts.  Which the government can spend.  It’s like a magical elixir.  Interest rates.  Cheap money.  Just keep interest rates low and money cheap and plentiful and business will do what it is that they do.  They don’t understand that part.  And they don’t care.  They just know that it brings in more tax money for them to spend.  And they really like that part.  The spending.  Sure, it can be inflationary, but what’s a little inflation in the quest for ‘full employment’?  Especially when it gives you money and power?  And a permanent underclass who is now dependent on your spending.  Whose vote you can always count on.  And when the economy tanks a little, all you need is a little more of that magical elixir.  And it will make everything all better.  So you can spend some more.

But it doesn’t work in practice.  At least, it hasn’t yet.  Because the economy is more than monetary policy.  Yes, cash is important.  But making money cheaper to borrow doesn’t mean people will borrow money.  Homeowners may borrow ‘cheap’ money to refinance higher-interest mortgages, but they aren’t going to take on additional debt to spend more.  Not until they feel secure in their jobs.  Likewise, businesses may borrow ‘cheap’ money to refinance higher-interest debt.  But they are not going to add additional debt to expand production.  Not until they see some stability in the market and stronger sales.  A more favorable tax and regulatory environment.  That is, a favorable business climate.  And until they do, they won’t create new jobs.  No matter how cheap money is to borrow.  They’ll dig in.  Hold the line.  And try to survive until better times.

NOT ONLY WILL people and businesses be reluctant to borrow, so will banks be reluctant to lend.  Especially with a lot of businesses out there looking a little ‘iffy’ who may still default on their loans.  Instead, they’ll beef up their reserves.  Instead of lending, they’ll buy liquid financial assets.  Sit on cash.  Earn less.  Just in case.  Dig in.  Hold the line.  And try to survive until better times.

Of course, the Keynesians don’t factor these things into their little formulae and models.  They just stamp their feet and pout.  They’ve done their part.  Now it’s up to the greedy bankers and businessmen to do theirs.  To engage in lending.  To create jobs.  To build things.  That no one is buying.  Because no one is confident in keeping their job.  Because the business climate is still poor.  Despite there being cheap money to borrow.

The problem with Keynesians, of course, is that they don’t understand business.  They’re macroeconomists.  They trade in theory.  Not reality.  When their theory fails, it’s not the theory.  It’s the application of the theory.  Or a greedy businessman.  Or banker.  It’s never their own stupidity.  No matter how many times they get it wrong.


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