Rolls Royce, Cadillac, Moving Assembly Line, Economies of Scale, VCR, Cell Phones and HD Plasma Television

Posted by PITHOCRATES - January 1st, 2013

History 101

The Moving Assembly Line allows GM to Divide their Costs over more Units than Rolls Royce

Rolls Royce automobiles are very expensive luxury cars.  Of impeccable quality.  It may be the finest automobile ever built.  And I say built not manufactured.  For they build a Rolls Royce by hand to ensure that high quality.  By some of the most experienced and skilled artisans to ever hone metal, wood and leather into an automobile.  Because of this they can’t make a lot of them a year.  They set a record sales total in 2011.  By selling 3,538 hand-crafted automobiles.  The entry price for a Rolls Royce?  Around $250,000.

By contrast GM sold 152,389 Cadillac luxury automobiles in 2011 in North America.  These are not hand-crafted.  The Americans build them on moving assembly lines.  Which is why they can build 43 times as many Cadillacs than they can hand-build Rolls Royces.  The entry price for a Cadillac?  About $33,100.  While a top of the line may cost you around $63,200.  Now Cadillacs are nice.  The name has become synonymous with high quality.  The best quality is the ‘Cadillac’ of something.  The quality may not be Rolls Royce quality but few will complain about that quality when sitting behind the wheel of a Cadillac.  They are glad to settle for a Cadillac over a Rolls Royce.  Especially when it costs 7.5 times as much to get into a Rolls Royce than into a Cadillac.

Why are hand-crafted Rolls Royce automobiles so much more costly than Cadillacs manufactured on a moving assembly line?  Economies of scale.  The higher production levels of the mass-produced cars allows GM to divide all of their costs over many more units.  Bringing the unit cost down.  And the selling price.  With fewer sales the unit cost for Rolls Royce is much higher.  As is the selling price.

As Demand grew Manufacturers were able to Bring Prices Down thanks to Economies of Scale

Rolls Royce pays a price for their commitment to quality.  They can’t sell cars as inexpensively as some of their luxury rivals.  But that’s okay for them.  As the market for hand-crafted luxury cars is large enough to keep them in business doing what they love.  Building the finest quality automobile in the world.  And those who want the best can afford to pay a quarter of a million dollars for an entry-level Rolls Royce.  So they do.  Which is why Rolls Royce doesn’t have to worry about economies of scales to compete against their competition.

Before Henry Ford built the moving assembly line cars were too expensive for the working man.  Henry Ford changed that.  Once they started manufacturing the new driving machine on the moving assembly line Ford was able to reach an economy of scale that greatly increased production rates.  Bringing down the unit cost.  And the selling price.  As new products entered the market place they were typically unaffordable to all but the rich.  But then as demand grew manufacturers were able to bring prices down thanks to economies of scale.  Like Henry Ford did with the automobile.

The first commercially viable video tape recorder was the Ampex model VR-1000 in 1956.  It cost $50,000 (about $421,000 today).  It was the size of a kitchen stove.  And about the only place you found them were in television broadcast studios.  From this early beginning came the technology for the video cassette recorder (VCR).  By the mid to late Seventies schools had one they rolled from room to room.  It cost approximately $5,000 (about $19,400 today).  About a decade later you could buy a smaller unit that could do more for around $2,000 (about $4,000 today).  Just before the DVD player and the digital video recorder made them obsolete you could get a nice one for about $100.  They were so small and so inexpensive that you bought one for every television in the house.

Bringing these Prices Down are State-of-the-Art High-Tech Manufacturers throughout Asia

When the first cell phones came out we called them car phones.  Because they were so big and had no real battery life that they were permanently installed in a car.  Connected to the electrical system of the car.  The first real portable cell phone was something that looked like a brick and weighed in around 2 pounds.  The battery gave you maybe an hour of talk time.  And it cost $3,995 in 1982 (about $9,600 today).  By 1993 the price was down to $900 ($1,400 today) but still weighed in at 2 pounds.  By 1996 the weight dropped to about 3 ounces.  It cost about $1,000 ($1,400 today).  By 2002 you could buy a flip-phone with a built-in high resolution camera for $400 (about $510 today).  And so on until they got smaller and more powerful with longer battery lives.  Today you can often get a pretty nice phone free when you sign a contract for service.

Things people like and demand can accelerate this process of quality improvement and lower prices.  For half a century the television has been a fixture in most American homes.  So technology buffs with money were always ready to spend a lot of money on the next best thing.  And when high-definition plasma televisions hit the market it didn’t take long for economies of scale to bring prices down as demand exploded for these beautiful things.  A Panasonic 42″ high-definition plasma television cost around $2,500 in 2004 (about $3,000 today).  About 4 years later you could get a slightly better set for about $700 (about $750 today).  Today you can buy an even better 42 inch plasma set from Panasonic for as little as $400.

Bringing these prices down are state-of-the-art high-tech manufacturers throughout Asia (Japan, South Korea, etc.).  They can mass produce cell phones and televisions and other high-tech goods at remarkable production rates.  Filling ships with their goods to export around the world.  They bring together high-skilled labor and the best in automated production equipment.  They can retool and begin new production so fast that they can fill the demand for the next big thing without missing a step.  And quickly ramp up to an economy of scale wherever they see growing consumer demand.  Bringing down unit costs.  And prices.  Making a lot of happy consumers around the world.

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Inventories

Posted by PITHOCRATES - July 23rd, 2012

Economics 101

Before a Business Earns any Sales Revenue they have to Spend Cash to Build an Inventory

To sell something a business needs to have it on hand first.  Because when it comes to manufactured goods we rarely custom manufacture things.  No.  When businesses sell something it’s something they already have in their inventories.  So how do they get things into inventory?  With cash.  Businesses buy goods and place them in their inventories.  They exchange some of their cash for the goods they hope to sell at a later date.  And the bigger the inventory they maintain the more cash it will take.  Cash they have to spend before they sell these goods.  Which requires financing.  Each large business, in fact, has a finance department.  That works to raise cash.  So the businesses can buy inventory (and pay their operating and overhead expenses) before they start selling anything.

This is how the retail stores work.  For manufacturers it’s a little different.  They make things.  Out of other things.  Things that go through various stages of production before becoming a finished good.  So to make these things requires different types of inventories.  Raw goods.  Work in process.  And finished goods.  When they pull raw goods out of inventory and begin working with them they become work in process inventory.  When finished goods come off the final production line they enter finished goods inventory.  The finance department secures the cash to buy the raw materials.  And for the equipment and labor used through the stages of production to produce a finished good.  Which enters finished goods inventory until they sell and ship these goods.

Before a business earns any sales revenue they have to spend huge amounts of cash first to move material through these inventories.  Cash they can’t use for anything else.  Like paying their overhead expenses.  Or servicing their debt.  So it’s a delicate balancing act.  You need inventory to produce revenue.  But if you run out of cash you can’t produce any inventory.  Or pay your bills.  A large inventory creates a large variety of things for customers to buy.  But if customers aren’t buying that large inventory will consume cash leaving a business struggling to pay its bills.  If they become so cash-strapped they will cut their prices to unload slow moving inventory.  Cut back on production rates.  Even cut back on expenses.  As in cost-cutting.  And lay-offs.

Good Inventory Management is Crucial for the Financial Health of a Business

A business doesn’t start generating cash until they start selling their finished goods.  Sales numbers may sound high but most sales revenue goes to pay for the costs of producing inventory.  A firm’s accounting department records these revenues.  And matches them to the cost of goods sold.  Which in a retailer is what they paid to bring those goods into inventory.  A manufacturer may use a term like cost of sales.  Which would include all the costs they incurred throughout the stages of production from bringing raw material into the plant.  To the labor to process that material.  To the energy consumed.  Etc.  Everything that was an input in the production process to place a finished good into inventory.  So from their sales revenue they subtract their costs of goods sold (or cost of sales).  The number they arrive at is gross profit.  Which has to pay for everything else.  Rent, utilities, marketing and advertising, non-production salaries and benefits, insurances, taxes, etc.  And, of course, interest on the cash their finance department borrowed to start everything off.

There is a unique relationship between inventories and sales.  There are countless things that happen in a business but what happens between inventories and sales receives particular attention.  A business’ greatest cost is the cost of goods sold.  Or cost of sales.  Everything that falls above gross profit on their income statement (the financial statement that shows a firm’s profitability).  This cost is a function of inventory.  The bigger the inventory the bigger the cost.  The smaller the inventory the smaller the cost.  This is a direct relationship.  You move one the other follows.  Whereas the relationship between sales and inventory is a little different.  The higher the sales revenue the bigger the inventory cost.  Because you have to have inventory to sell inventory.  However, there is no such corresponding relationship for falling sales.  As sales can fall for a variety of reasons.  And they can fall with a falling inventory level.  They can fall with a steady inventory level.  And they can fall with a rising inventory level.

In business sales are everything.  There are few problems healthy sales can’t solve.  It can even overcome some of the worst cost management.  So rising sales revenue is good.  While falling sales revenue is not.  There are many reasons why sales fall.  But the reason that most affects inventories is typically a bad economy.  When people scale back their purchases in response to a bad economy a firm’s sales fall.  And when their sales fall their inventories, of course, rise.  Until management scales back production to reflect the weaker demand.  Because there is no point building things when people aren’t buying.  Those who don’t scale back production will see their sales fall and their inventories rise.  Creating cash problems.  Because sales aren’t creating cash.  And a growing inventory consumes cash.  Making it difficult to meet their daily expenses.  Such as payroll and benefits.  As well as paying interest on their debt.  Which can lead to insolvency.  And bankruptcy.  So good inventory management is crucial for the financial health of a business.

If Retail Sales are Falling and Inventories are Rising Bad Times are Coming

Businesses target specific inventory levels.  During good economic times they increase inventory levels because people are buying more.  During bad economic times they decrease inventory levels because people are buying less.  And they monitor changes in the actual sales and inventory levels continuously.  Adjusting inventory levels to match changes in sales.  To balance the need to have an inventory flush with goods to sell.  While keeping the cost of that inventory to the lowest level possible.  All businesses do this.  And if you track the aggregate of the inventory levels of all businesses you can get a good idea about what’s happening in the economy.

John Maynard Keynes used inventory levels in his macroeconomics formulas.  The ‘big picture’ of the economy.  Looking at inventories tied right into jobs.  If sales are outpacing inventory levels then businesses hire new workers to increase inventory levels.  So sales growing at a greater rate than inventory levels suggest that businesses will be creating new jobs and hiring new workers.  A good thing.  If inventory levels are growing greater than sales it’s a sign of an economic slowdown.  Suggesting businesses will be reducing production and laying off workers.  Not a good thing.

Because of the stages of production changes in finished goods inventories can create or destroy a lot of jobs.  For if the major retailers are cutting back on inventory levels due to weak demand that will ripple all the way through the stages of production back to the extraction of raw materials out of the ground.  Which makes inventory levels a key economic indicator.  And when we combine it with sales you can pretty much learn everything you need to know about the economy.  For if retail sales are falling and inventories are rising bad times are coming.  And a lot of people will probably soon be losing their jobs.  As the economy falls into a recession.  Which won’t end until these economic indicators turn around.  And sales grow faster than inventories.  Which indicates a recovery.  And jobs.  As they ramp up production to increase inventory levels to meet the new growing demand.

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