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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Capital and Capitalism

Posted by PITHOCRATES - May 7th, 2012

Economics 101

Entrepreneurs have an Insatiable Desire to Think and Create

It takes money to make money.  For it is money that buys the means of production.  The land, manufacturing plants, small shops, office space, machines, equipment and infrastructure that make things.  The trucks, barges, container ships, locomotives and rolling stock that transport raw material, work-in-progress and finished goods.  These physical assets are capital.  From assembly lines to inventory control systems to accounting software.  Things that let businesses conduct business.  And make profits.

This is the key to capitalism.  Profits.  It’s what allows businesses to make the things we need and enjoy.  Profits are what make an entrepreneur take a risk.  To spend their life savings.  To mortgage their home.  To borrow from a bank.  They do these things because they believe they will be able to earn enough profits to replenish their life savings.  To make their mortgage payments.  To repay their loans.  AND to earn a living in the process.  It is a risky endeavor.  And far more risky than working for someone and earning a steady paycheck.  But if entrepreneurs didn’t take these risks we wouldn’t have things like the iPhone or the automobile or the airplane.  All of which were brought to us because one person had an idea.  And then invested in the capital to bring that idea to market.

Some business ideas succeed.  Many more fail.  But people keep trying.  Because of that insatiable desire to think and create.  And the ability to earn profits to pay for their ideas.  To build on their ideas.  To expand their ideas.  From the first thoughts of it they kicked around in their head.  To the multinational corporations their ideas grew into.  All made possible by the profits they earned.  The more they earned the more they could do.  As they reinvested those earnings into their businesses.  To buy more capital.  That allowed them to build more things.  And use even more capital to bring these things to market.  Creating jobs all along the way.  Jobs that only came into being because of those profits that started as a single thought in someone’s head.

If you can’t Service your Debt your Creditors can and will Force you into Bankruptcy

This is where corporations come from.  From a single thought.  Profitable business operations grow that thought into the corporations they become.  For corporations are not the evil spawn of the damned.  Corporations come from people having a great idea.  Like Starbucks.  And Ben and Jerry’s.  Who are now everywhere so we can enjoy their products wherever we are.  All made possible by the profits of capitalism.

Who’s up for a little accounting?  You are?  Well, then, you came to the right place.  For we’re going to learn a little accounting.  Right here.  Right now.  Corporations determine their profits by closing their books at the end of an accounting period.  A series of accounting steps culminate in the trial balance.  Where the sum of all debits equal the sum of all credits.  Or eventually do after various adjusting entries.  Once they do the books are balanced.  And business at last can see if they were profitable.  By producing an income statement.  Which lists revenue at the top.  Then sums all costs (materials, production wages, payroll taxes & health insurance for that labor, etc.) that produced that revenue.  Subtracting these costs from revenue gives you gross profit.  Then comes overhead costs.  Fixed costs.  Like rent and utilities.  And overhead labor (corporate officers, management, accounting, human resources, etc.).  They sum these and subtract them from gross profit.  Which brings us to earnings before interest and taxes (EBIT).  A very important profitability number.  For if there is any money left by the time you reach EBIT your business operations were profitable.  Your business was able to pay all the due bills to produce your revenue.  Which leaves just two numbers.  Interest they owe on their loans.  And income taxes.

EBIT is a very important number.  For if it’s not large enough to service your debt everything above EBIT is for naught.  Because if you can’t service your debt your creditors can and will force you into bankruptcy.  Never a good thing.  And what follows is usually the opposite of growing your business.  Shrinking your business.  By seriously cutting costs (i.e., massive layoffs).  And eliminating unprofitable lines of revenue.  Downsizing and reorganizing as necessary so your cost structure can produce a profit at the given market price for your goods and/or services.  A price determined by your competition in the market.  If you cannot downsize and reorganize sufficiently to become profitable then you go out of business.  Or you sell the business to someone who can make a profit.  Because unless you can turn a profit your business will consume money.  And that money has to come from somewhere.  Typically it is the business owner until they run out of life savings and home to mortgage.  Because a bank can’t give you money to lose in your business.  For their depositors put their money into the bank to grow their savings.  Not to shrink them.  So a bank has to be profitable to please their depositors.  And if the bank is using their money to make bad loans they will remove their money.  As will other depositors.  Perhaps creating a run on the bank.  And causing the bank to fail.  So while operating at a loss will save employees jobs in the short term it will cause far greater harm in the long term.  Which isn’t good for anyone.

Capitalism works because with Risk there’s Reward

As you can see getting those accounting reports to fairly state the profitability of a business is crucial.  For it’s the only way a business knows if it can pay its bills.  And the way they pay their bills complicate matters.  Revenue and costs come in at different times.  To bring order to this chaos businesses use accrual accounting.  Which includes two very important rules.  To record accurately when revenue is revenue (for example, a down payment is not revenue.  It’s a liability a business owes the customer until the sale transaction is complete).  And to match costs to revenue.  Meaning that every cost a business incurred producing a sale is matched to that sale.  Even long-term fixed assets like buildings and machinery.  Which they depreciate over the life of the asset.  Charging a depreciation expense each accounting period until the asset is fully depreciated.

Because of these accounting reports that fairly state business operations a business knows if they are profitable.  That they can pay all of their bills.  Their suppliers AND their employees.  Their health insurance AND their payroll taxes.  The interest on their debt AND their income taxes.  They can pay all of these when they come due.  And not run out of money when other bills come due.  Which is why they can have confidence when they read their income statement.  Knowing that they paid all their costs due in that accounting period.  Including the interest on their debt.  And their income taxes.  Which takes them to the bottom line.  Net profit.  And if it’s positive they have money to reinvest into their business.  To expand operations.  To increase sales revenue.  Create more jobs.  And they can grow.  But not too much that they lose control.  So they can always pay their bills.  So they can keep doing what they love.  Thinking.  And bringing new ideas to market.

This is capitalism.  Where people take risks.  In hopes of making profits.  They invest in capital to make those profits.  And then use those profits to invest in capital.  It works because there is a direct relationship between risk and profits.  It’s why people take risks.  Create jobs.  And provide the things we need and enjoy.  Because with risk there’s reward.  And accounting reports that fairly state business operations give a business’ management the tools to be profitable.  By matching costs to revenue.  Telling them when they are not using their capital efficiently.  Helping them to stay profitable.  (Unlike anything the government runs.  Because there is no matching of costs to revenue.  Taxes come into the treasury and the treasury pays for a multitude of things.  With no way to know if they are using those taxes efficiently).  And this is capitalism.  Risk and reward.  And accountability.  For when you’re risking your money you become very accountable.  Which is why capitalism works .  And government-run entities don’t.

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FT106: “You can’t have high paying jobs with generous benefits and low consumer prices.” -Old Pithy

Posted by PITHOCRATES - February 24th, 2012

Fundamental Truth

To give Workers High Wages and Generous Benefits a Business has to sell their Goods at High Prices 

The problem with politics is that voters don’t understand economics.  And they demonstrate this by demanding mutually exclusive things all of the time.  Where having one thing makes it impossible to have the other thing.  Like that old saying that goes like this.  You can’t have your cake and eat it, too.   You can have cake.  Or you can eat cake.  But you can’t have cake after eating it.  Because once you eat your cake it is gone.  And there is nothing to have.  These things, then, are mutually exclusive.  You can have one or the other.  But you can’t have both.

Now let’s transfer this train of thought to economics.  And to its most fundamental element.  The demand curve.  Which represents people in the economy.  Consumers.  And the stuff that they buy.  And at what prices they will buy the stuff that they buy.  Let’s take large flat-screen televisions.  The big ones.  Over 60 inches in size.  If they cost the price of a luxury car few consumers will buy them.  But if they only cost the price of a pack of gum consumers will buy them until they have one for every room in their house.  And consumers will buy various amounts at the prices in between.  But in general this one truth holds true.  People will buy more televisions as their prices fall.  And they will buy fewer televisions as their prices rise.  When we show this graphically by plotting how many televisions they sell at various prices we get a demand curve.

Well, you think, why can’t we just sell televisions at the price of a pack of gum?  More people will have televisions.  That’s good.  Because people just love watching television.  And television makers will make more televisions.  Creating more jobs.  And jobs are good.  Everyone says so.  So why not just sell televisions for the price of a pack of gum.  Well, I suppose if we pay the people who make these televisions a wage and benefit package closer to the price of a pack of gum, we could.  But who wants to work for a paycheck that can only buy a pack of gum?  Which brings us back to wanting mutually exclusive things.  To give workers high wages and generous benefits we have to sell goods at high prices.  Which is mutually exclusive to the low prices consumers demand.

Big Oil’s Exxon Mobil was not as profitable as GE and Apple in 2010

Yes, you can’t have low consumer prices and high pay and generous benefits.  Because, per the demand curve, higher prices mean fewer things sold.   And fewer things sold mean lower sales revenue.  And sales revenue pays for everything in a business.  Including wages and benefits.  Which means lower sales revenue means less money available to pay wages and benefits.  And any company that tries to pay high wages and provide generous benefits has to do one of two things.  Have a product they can sell a lot of at high prices.  Or go bankrupt.  Two of the Big Three Detroit automakers tried to do the former and failed.  So they went bankrupt.  And the government bailed them out.

So to pay employees well these companies need to be profitable.  Unlike the Big Three.  And to be profitable you have to have sales revenue large enough AND prices high enough to generate profits.  Profits so large that they can provide high wages and generous benefits.  Unlike the Big Three.  Because they couldn’t sell enough cars at high enough prices to pay those high union wages and generous union benefits.  But some companies have been profitable.  Including one corporation liberal Democrats love to hate.  Exxon Mobil (a member of a group liberal Democrats derisively call Big Oil).  One company that the current liberal Democrat administration loves and partners with in green energy technology.  General Electric.  And one corporation liberal Democrats just love period.  Until Steve Jobs died, at least.  Apple. 

In the fourth quarter of 2010, the profits for Exxon Mobil, GE and Apple were, respectively, $9.25 billion, $4.46 billion and $4.31 billion.  The first thing that jumps out at you is that Big Oil is making twice as much money as the corporations liberal Democrats love.  Which is why they hate them.  And why they love to bitch about high prices at the gas pump.  While at the same time they are rejoicing about those high prices.  Because those high gasoline prices help push their green energy agenda.  But these profit numbers are misleading.  Because they don’t factor in the cost of producing those profits.  And the most common way we do that is by dividing these profits by the sales revenue that generated them.  Giving us net profit margin.  When we do this for Exxon Mobil, GE and Apple we find their net profit margins on those profits were, respectively, 8.79%, 10.8% and 21.2%.  Of the three Big Oil is the least profitable.  And Apple is the most profitable.  In fact, nearly 2.5 times more profitable than Exxon Mobil.  But no one is demanding that the government step in and lower the price of Apple’s products.  Unlike they do with Big Oil.

The Government’s Regulatory and Compliance Costs increase the Price of Gasoline at the Pump

So why is Big Oil less profitable than those other businesses?  Well, for one, you can’t drill for American oil in China.  Like GE and Apple can build products in China.  And by working in the United States Big Oil is subject to massive regulatory and compliance costs.  And government regulates few things more than the oil industry.  The permitting process alone just to drill an exploratory well can take years for approval.  And millions of dollars.  It wasn’t like this when gas was cheap in America.  Before all of this regulation.  In the days when John D. Rockefeller was refining petroleum no one was complaining about high prices.  In fact, his competition complained about his low prices.  Prices they couldn’t match.  Asking for the government to investigate them for antitrust violations.  Which they did.  And busted up Standard Oil.  So they could sell their products at higher prices.  But when you can manufacture goods in China you can escape all of these regulatory and compliance costs.  And governmental insanity of protecting consumers by raising consumer prices.

Some may counter that the net profit percentage isn’t the important number.  But the dollar amount of their profits.  The same people who say we shouldn’t look at the dollar amount rich people pay in taxes.  But what they pay as a percentage of their income.  Which is an example of a double standard.  Determining how much profit is too much by one standard for Big Oil (dollars).  But determining by another standard how much rich people should pay in taxes (percentage).  It doesn’t make good sense.  But it makes good politics.  Especially when you have nothing but class warfare to rely on to win an election.

The attack on Big Oil is also irrational.  For Big Oil can do one thing that even GE and Apple can’t do.  Provide high wages and generous benefits to American workers.  Because American oil deposits can only be extracted in America.  By American workers.  If only government will cease their attack on Big Oil.  And allow people to drive gas guzzlers if they want to.  Let them fill up those tanks.  Increase the demand for gasoline.  If they did and we got rid of the anti-gasoline policies Big Oil will go after that oil and bring it to market to meet that demand.  Making it inexpensive and plentiful just like John D. Rockefeller did.  Before government stepped in to ‘protect’ consumers.  And added so many regulatory and compliance costs that has since jacked up the price at the pump so much that it is eating away an ever larger share of a family’s budget.  And ultimately reducing their standard of living.  Without even getting any high paying jobs with generous benefits in the bargain.  And if you ask me that’s a pretty sad job of protecting consumers.

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