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.

Why?

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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Economies of Scale

Posted by PITHOCRATES - December 31st, 2012

Economics 101

Employers are very Reluctant to hire Additional Employees because Labor Costs are their Greatest Costs

When it comes to running a business there is nothing more costly than people.  Employee salaries and wages.  Payroll taxes.  And benefits.  People need a large paycheck to live on and will go to the employer that offers the highest pay.  Government has imposed costly taxes and regulatory costs.  And to further entice good workers employers have to sweeten the deal with some fringe benefits like health insurance, paid vacation time, holiday pay, paid sick days and retirement plans.  It adds up.  Something like this:

As you can see the amount of pay employees are familiar with (the working pay above) is far less than the total cost to the employer.  The employee doesn’t see the 63.1% markup on their working pay that their employer has to pay in addition to paying the employee.  As a business hires more employees these costs add up.  A small factory with 15 workers on the factory floor can cost the employer $1.6 million.  Which is why labor costs are the greatest costs of most businesses.  And why employers are very reluctant to add additional employees.

The more Productive you are the Lower your Unit Cost and the Lower the Selling Price in a Store

Besides labor costs a business like a factory will have material costs, too.  These are variable costs.  They’re variable because they vary with varying levels of production.  The more production there is the more variable costs there are.  In addition to variable costs businesses have fixed costs.  Often simply called overhead.

Factories make things.  Like things you can pick up off a store’s shelf.  Things with low prices on their price tags.  But when it can cost a small manufacturer $1.6 million JUST for its labor costs how can they sell things with such low prices?  By making a lot of those things to sell.  As much as they possibly can with their variable and fixed costs.  What we call economies of scale.  And the more they can make for their given costs the lower the unit cost is for each thing you can buy off a shelf at a store.   As you can see here:

Assuming a factory can produce anywhere from 1,250,000 to 2,750,000 units with a given labor force operating the same production equipment in a factory you can see how the unit cost falls the more they produce.  Which is why there is so much talk about productivity.  The more productive you are (the more you can produce for a given cost) the lower your unit cost.  And the lower the selling price in a store.  Increasing productivity could mean moving an assembly line a little faster.  Or replacing some people with machines.  Things that workers don’t like.  But things consumers love.  For they like low prices when they go shopping.

Employers are very Reluctant to Hire New Employees and Prefer Increasing Productivity with Automation

If you crunch these numbers for the labor costs of 16 and 17 workers you can see how unit costs rise as an employee or two is added to the production floor.  At an annual production of 2,000,000 units the unit cost increases $0.05 (4.6%) going from 15 to 16 workers.  Adding two workers increases the unit cost $0.11 (10.1%).  Doesn’t seem like a lot.  But we notice when something we once bought for $0.99 now costs $1.04.  And we don’t like it.  But business owners like it even less.  Here’s why.

Business may be booming.  Those on the factory floor may be working a lot of overtime to produce at a rate of 2,000,000 units per year.  And are growing unhappy with all of that overtime.  They keep demanding that the owner hire another person.  The owner does.  Increasing unit costs by $0.05.  But the owner hopes the booming economy will continue.  And that they can even increase the production rate.  For if they can sell an additional 250,000 units the unit cost can actually fall $0.07 to $1.02.  Making the addition of a new worker on the factory floor not increase costs.  As the increase in production will make costs fall greater than that increase in labor costs.

But it doesn’t always work like that.  Economic booms don’t always last.  When too many factories increase production to meet booming demand they bring too much supply to market.  Causing prices to fall.  And forcing factories to cut back on production rates.  So instead of increasing the production rate they may find themselves cutting back.  Perhaps going from 2,000,000 to 1,750,000.  A fall of 250,000 units.  Increasing the unit cost $0.21 (19.3%).  Which could very well raise the unit cost above the prevailing market price.  Requiring layoffs.  To get the unit cost back down to $1.09.  Allowing them to sell at the prevailing market price.  And at a production rate of 1,750,000 units that may require letting go more than just one worker.  Maybe even more than two.  Which is why employers are very reluctant to hire new employees.  And prefer increasing productivity with automation.  For it is far easier to make machines increase or decrease production rates than it is to hire and lay off people.  Making it easier and less costly to reach great economies of scale.  Which makes low prices.  And happy consumers.

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VCR, VHS Video Tape , Video Store, DVD, DVDs by Mail, Video On Demand, Live-Streaming and Blockbuster

Posted by PITHOCRATES - December 11th, 2012

History 101

The VCR changed the way Families enjoyed Movie Night

The video cassette recorder (VCR) changed the way we watched movies.  Well, some of us.  For the first VCRs were really expensive.  The first ones costing as much as a car.  But by the Eighties the price fell to a few thousand dollars and within the price range of those who really wanted one.  And buy them we did.  Recording everything we wanted on television.  Many of us old enough to have lived during the Eighties no doubt have a box of video tapes we push around occasionally.  Having long forgotten what is on those tapes.  Yet we still push that box around.  Sure that there must be something good on at least one of those tapes.

Recording things off the television was one thing.  But watching movies was another.  For it was expensive to take the family to the movie theater.  Especially if you had three kids or more.  Twenty bucks for tickets.  Another twenty for popcorn, candy and drinks.  A night at the movies could cost a family $40 or more.  If you went to the movies once a week that could add up to nearly a car payment.  Which made taking the family out to the movies a very expensive endeavor.  If there was only another way for the family to enjoy movie night.

And then it happened.  They started releasing movies on video tape.  The same movies that had played in the theaters.  They weren’t cheap.  The first movies cost as much as $80 or more.  But once you paid that $80 you could watch that movie as often as you wanted.  With as many people as you wanted.  And eat as much popcorn, candy and drinks you wanted.  Even adult beverages without the worry of having to drive home.  Yes, the VCR changed the way some of us watched movies.  Those who could afford to pay $80 or more for a movie on video tape.  But there was another option for those less financially endowed.  The video store.

To Help Augment their Income Video Stores started to sell Popcorn, Candy and Drinks

Some of the first video stores required an annual membership fee.  Which wasn’t cheap.  As well as a rental fee for the movies you rented.  Did these stores rake in the money because they were so greedy?  Not really.  Remember that in those early days these stores were paying $80 for their videos.  If they had 3 copies (on average) of each that’s $240 a title.  If they had 300 hundred titles in their store that came to $72,000 in video tapes.  Anyone who has ever rented video tapes knows that they weren’t always the best of quality.  When you place a video tape into a VCR and press play a magnetic head presses against the tape.  This constant pressure and friction wears the tape out over time.

So after spending some $72,000 to stock their store they probably had to replace at least one of each title for 20% of their stock each year.  Adding another $4,800 in costs.  As well as buying some new titles with every new release.  Five copies of two new releases a month would add another $9,600 a year.  So after spending some $72,000 to stock the store they probably spent another $15,000 a year on additional video tape purchases.  Add in rent, utilities, interest on their debt, insurance, a paycheck for the owner and an employee or two that little video store could cost up to $250,000 a year to operate.  All of which they had to recover from rental fees and membership fees.  And the occasional rewind fee for those who forgot to be kind and rewind.

In time those video tape prices came down.  Allowing video stores to drop their membership fees.  They may not have liked losing that large source of income.  But it was either that or see their customers go to the stores without the membership fees.  To help augment their income video stores started to sell popcorn, candy and drinks.  Just like the theaters.  For what is a movie without popcorn, candy and drinks?  Instead of movies these stores now rented a family night together.  A one-stop shop to rent some competitively priced videos.  And to load up with some not so competitively priced snacks.  The snacks may have been a little on the pricy side.  But they were convenient.  Allowing family night to begin sooner without having to make another stop to buy some groceries.

DVDs by Mail, Live-Streaming Movies and Video On Demand put the Familiar Video Store out of Business

The VHS video tape dominated the entertainment market until the DVD came along.  A small flat disc.  Much simpler.  With no moving parts.  And you never had to rewind a DVD.  Putting the video tape rewind machine manufacturers out of business.  They could manufacture DVDs so inexpensively that they changed the model for home entertainment.  Going from renting to purchasing.  Video stores stocked DVDs to rent.  But as the DVD price fell further it was difficult to rent them.  For if someone could buy a new release for about $15 you really couldn’t charge much to rent it.  Making it difficult for the video stores to stay in business.  They could sell DVDs instead of renting them.  But it was the big box retailers that had the best prices on DVDs.

Because the DVD was so small and light there was something else you could do with it.  You could mail it.  So instead of going to a video store only to see the movie that you wanted to rent was out of stock you simply went online.  And rented the movie you wanted and some distribution warehouse mailed one of their many copies to you.  Some companies let you keep the movie as long as you wanted without any late fees.  Forever eliminating those late night drives to the video store before midnight in your pajamas to drop the video in a drop box before that late fee kicked in.  The DVD is so convenient to handle that they can even put them into vending machines at your grocery store.

With the ability to see almost any movie you wanted to see without having to go to a video store made it difficult for the video stores to remain in business.  For they were trying to compete with other businesses that didn’t have to pay rent, utilities, interest on their debt, insurance, a paycheck for the owner and an employee or two.  While their costs went up the prevailing market price to watch a movie in the home fell.  Then came movies on demand from cable providers.  And live-streaming on the Internet.  Which didn’t even need a distribution warehouse or a massive inventory of DVDs.  Or warehouse employees.  Movies just sat on a server connected to the Internet.  Which is why it is difficult to walk into a Blockbuster video store these days.  (Blockbuster basically invented the big box video store.)  But you’ll be able to rent a DVD by mail, live-stream a movie online or watch a video on demand from Blockbuster.  The new business model allowing them to remain in business at the prevailing market price to watch a movie in the home.  Unlike the old model based on brick and mortar stores that led to their bankruptcy.

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Product Pricing

Posted by PITHOCRATES - December 10th, 2012

Economics 101

The First Thing a Business has to do to Determine their Selling Price is Determining their Costs

Did you ever think about how businesses price their products?  Do they just pull numbers out of the air?  Do they just charge as much as they want?  No, they don’t.  Because they can’t.  For if one gas station charges $12 for a gallon of gasoline while the station across the street is only charging $3.50 guess where people are going to buy their gas from.  So free market competition prevents businesses from charging whatever they want.  So how do they determine what to charge?

Well, some look at what their competitors are charging and match it.  Or charge a little less.  To steal customers away from the competition.  Which can work.  But it can also bankrupt a business.  For if a business owner doesn’t know his or her costs selling at the market price could fail to recover all of their costs.  The market price limits what they can charge.  But if their costs are too great to stay in business selling at the prevailing market price they have to do something about reducing their costs.  Which they can’t do if they don’t know their costs.  So the first thing a business has to do to determine their selling price is determining their costs.  Like this.

This is an abbreviated fictional income statement showing last year’s results.  And forecasting next year’s results.  EBT stands for earnings before taxes.  Income taxes for this year are based on the 2011 federal tax tables.  Income taxes for next year are based on the proposed Obama tax rates (increasing the top marginal rate from 33% to 39.6%).  The business is a subchapter-S where the business earnings pass through to the owners’ personal income tax returns.  The owner does not draw a salary but draws $125,000 from retained earnings to support him or herself, his or her stay-at-home spouse and their 3 children. The percentages show each number as a percentage of revenue.

You need to Sell at the Right Price and at the Right Volume to Pay all of the Bills

The difference between this year and next year is the rise in costs.  Obamacare and other business regulations increase the cost of sales (direct labor, benefits, direct supplies, etc.) by 2%.  And they increase fixed overhead (rent, utilities, administrative labor, benefits, etc.) by 2%.  They will have to recover these higher costs in higher prices.  Which will likely reduce unit sales.  But because each unit will sell for more we assume sales revenue remains the same.

The higher costs cause EBT to fall.  A lower EBT means lower federal income taxes.  But it also means less retained earnings to invest back into the business.  The reduction in retained earnings is $36,604.28.  Which limits investments to grow the business.  And leaves a much smaller cash cushion after some of those retained earnings are reinvested into the business.  To pay for the unexpected.  Like a new piece of equipment that fails and halts production.  Things worked well in the current year.  The business owner would like to have things work as well in the following year.  Which means not exposing themselves to such a dangerous cash position.  And how do they do that?  By raising their prices to make next year’s retained earnings as large as this year’s.  By recovering those retained earnings in higher prices.  Like this.

Let’s assume these numbers are for a coffee shop that sells only one type and size of drink (say a large espresso-based drink) to simplify this discussion.  If we subtract this year’s cost of sales from revenue we arrive with the markup on our direct costs.  Dividing this number into cost of sales we get a markup percentage.  For this year it was 72%.  In the current year let’s assume they sold 302,406 cups of coffee.  Which comes to about one cup a minute.  Dividing the costs of sales by the number of cups of coffee sold gives a unit cost of $2.58 for a cup of coffee.  Adding the 72% markup to this cost brings the selling price to $4.45.  Coffee sold at this price and at this volume produced enough revenue to pay all the bills, provided an income for the owner and his or her family while leaving enough left over to invest back into the business.  And provide a cash cushion for the unexpected.  As well as paying state income taxes, city income taxes, etc.

A Business must bring their Cost Structure in Line to be able to Sell at the Prevailing Market Price

To arrive at the new selling price we added the loss of retained earnings to next year’s revenue.  And re-crunched all of these numbers.  Because we are raising the price we can expect a small fall in revenue as customers buy less.  The higher costs and lower unit sales volume raised the unit cost.  The markup percentage is 1 percentage point lower but because the unit cost is higher so is the markup amount in dollars.  Which raises the selling price by $0.32.  Increasing the price of a cup of coffee to $4.77.  But is it enough?  As it turns out, no.  Because the new price raises revenue enough to push the business into a higher tax bracket.  Taking the business owner back to the numbers.

Because of the higher tax bracket, and the higher top marginal tax rate, this higher price still results in a loss of retained earnings.  About another $30,000.  So going through the whole process again brings the selling price up to $4.87.  Adding a total of $0.43 to this year’s price.  As long as the prevailing market price is around $4.87 for a large espresso-based drink this business owner should be able to keep his or her cost structure in place and stay in business.  However, if this exceeds the prevailing market price the business owner will have to make some spending cuts to bring his or her cost structure in line to sell coffee at the prevailing market price.  Make some assumptions.  And some adjustments.  Then crunch these numbers again.  And again.  For getting this price right is very important.  Too high and people will go elsewhere to buy their coffee.  To low and they won’t be able to pay all of their bills.

This may not be how all businesses determine their selling price.  But however they do it they have to bring their cost structure in line to be able to sell at the prevailing market price.   Because if their price is too high no one will buy from them.  If it’s too low everyone will buy from them.  Making them happy.  Until they realize they can’t pay all of their bills because their prices are too low.  The above example was complicated.  And that was with only one product.  Imagine a store full of products to sell.  And trying to calculate new prices on numerous products to cover the costs of new taxes and new regulations.  It’s not easy.  Which is why business owners don’t like big change coming from Washington.  For this change requires important decisions to make.  And if they get these decisions wrong and don’t find out until 6 months or so later they may dig themselves into a hole they won’t be able to get out of.  Putting them out of business.

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