Business 101 or the Whiteness of the Whale

In my recent quasi-Internet fight post "Warfare on the High Accountanseas," which dealt with the the incoming price increase from GW I may have taken some things for granted in my readership.
This is not meant to be an insult to anybody, but if you've never studied economics, accounting, or marketing before, some of what I said may have been slightly confusing. Well a lot of what I said might have been confusing. Understanding business financials is something of a white whale even for those who do it for a living. I will now attempt to give you all a crash course in basic business acumen to help you understand what the hell I was talking about and help you get ahead in life. The more I form my own twisted views of life, the harder it is for me to separate the disciplines of accounting, economics, and marketing from each other. They cross so much of the same territory that it's barely reasonable to view them as completely separate disciplines. So you're going to get a taste of all of those. There is one assumption that I can't avoid, and that is that you have at least a basic understanding of algebra and Cartesian graphing.

Now to get the disclaimer out of the way. Ignoring the class I had yesterday, I haven't had an economics course in about 11 years. I have tried to research things to fill holes in my own knowledge base were applicable, but take all of this with grain of salt. This will no doubt be a gross oversimplification of the financial strength of GW, but there's no way I'm digging into this too deeply. This is just a blog after all. I will also be making a few assumptions/outright guesses here and there where no data are available to me or where I am simply trying to demonstrate a point. I'll do my best to point out that my data are made up when this is case.

Since lots of math may be involved in this (I am this week's mathelete), it is vitally important to the mission that you be listening to math rock while reading the rest of this.



Ishamael wrote the following in the Accountanseas article, prompting me to undertake this insanity:

I don't know jack about the proper running of a business, so I found your commentary quite interesting. I know you just got done with finals, but could you give a comprehensive analysis of this price increase? I've bitched about it with other people, but we're a bunch of broke ass college students who don't know better than to enjoy little plastic men.


It's like watching a pro teach little kids about their abc's.

I don't know that I'd call myself a pro on this subject, but thanks just the same. I'll allow it. I don't know if this will be as comprehensive as I can possibly make it, but I'll at least try to show you why GW can do almost whatever the fuck they what with their pricing without affecting demand for their products or their profits in any significantly detrimental way. I'll also demonstrate that the price ass raping they're giving us could be far far worse, so no more crying "unethical" or any bullshit like that from now on.

Price Elasticity of Demand

This is the first concept that we need to discuss here, as it will by itself pretty much prove my point without having to try too hard.

The first thing you need to understand is that graphing supply and demand can be represented in an oversimplified way by the standard equation for a straight line: y= mx + b. I think there is a slightly different version of this equation for business, but it's the same thing with different variables. Using this, you should be able to relate to better anyway. m is the slope (percentage change of x relative to y) of the line and is very important in economics. Real supply and demand graphs usually don't follow a linear or curvilinear pattern very well, but we are looking at this from a very basic level today.

The slope of a graph of supply is positive where the Y axis is Price and the X axis is Quantity. This means that if you increase your price, the quantity also increases. As the price goes up, a company wants to produce more.

The slope for the demand of a product will be negative. Increases price decreases the quantity of product demanded. Generally speaking the higher the price, the less consumers will want to buy.

The intersection of the lines "supply" and "demand" (S and D on a graph) represents the most efficient quantity and price for a product. This is where profit is highest. Finding the area under this intersection will also give you the total revenue (this is money earned without paying any expenses, so not your profit) at this point. Rarely does a company ever hit this point exactly, as in real life there is pretty much no way to gauge exactly where this intersetion is. Most companies are either producing too much or too little product, putting them at the right or left of the efficient point, respectively.

A basic graph looks like this-

Now back to the line slope. The slope of your line represents something called elasticity. From this point on I don't give a shit about supply, so we'll only be talking about demand. For demand, elasticity shows us how much quantity of product demanded changes in response to a change in price.

This is the formula for finding the price elasticity of demand-

A price is considered Elastic when E is < -1 A price is considered Inelastic when -1< E < 0 So elastic prices suffer great swings in demand when price changes and inelastic products demand changes less relative to a change in price. A perfectly inelastic item has a E or slope of 0. This means that the quantity demanded will always be the same regardless of price. The graph looks like this-

The closest real world example to a perfectly inelastic good I can think of is insulin. People will still demand insulin almost regardless of price. According to Wikipedia the elasticity of demand for insulin in the US is -.01. If the price of insulin were increased 100%, the demand for insulin would only drop by 1%. This makes sense, as users of insulin pretty much need it to live or at least live comfortably. Conversely with an elasticity of -4.4, Mountain Dew is very sensitive to changes in price. Rednecks and gamers would respond to a 100% price increase with a 440% drop in demand.

You'll see why shortly, but we will only be concerned with inelastic demand from here on out. This is what a generic inelastic demand graph looks like. You may need to refer to this later-

As you can see, the line is very steeply sloped, indicating that the price demand relationship is very minor.


Demand for GW Products

Here is where I will make my first assumption. Luxury goods (cars, helicopters, leisure items like hobbies, airfare, jewelry, high class call girls, etc) normally follow an inelastic demand pattern. That means, as shown above, changes in price do not greatly affect quantities demanded. Treating it as a luxury good, we will have to assume that GW products have an inelastic demand. From here on out we'll assume that the Elasticity of a Landraider (which will be used as an example) is -.5. I feel that is a very conservative estimate as theater tickets for teenagers have a elasticity of -.2, beer -.3, and cigarettes -.3 in the US. This shows us a trend for leisure and (slightly) addictive products to be pretty damn inelastic. This just means that my conservative estimate will overstate the change in demand relative to price, meaning GW demand is less sensitive to price change than my assumptions would lead you to believe.

A Landraider currently costs $57.75. As mentioned in a previous post, it is believed that the profit margin on this is 72% (if sold through direct channels, I'm not going to figure out retail channel markup, but it's probably 20 and 40 something % ). From that we can assume that the cost of producing a Landraider model is $57.75 x (1-.72) = $16.17. This number will be important later.

Let's pretend that there is a current demand for 10,000 Landraiders. With the assumed elasticity of -.5, what will our revenue and profit be at the new proposed price of $62? What was it at the old price of $57.75?

Pencils down, here's the solution: +edited.  I screwed up the % change and therefore units at new price fixed now+

Old revenue at 10,000 units. 10,000 units x $57.75/unit= $577,500
Gross margin $ is $577,500 x (.72) = $415,800

Price is changing by ($62-$57.75)/$62 * 100% = 6.85%

Therefore our demand will change by -.5 * 6.85% = -3.43%

Our new quantity demanded will then be 10,000 units * (1-.0343) =  9,657 units

New revenue is 9,657 units * $62/unit= $598,734
Gross margin % is now ($62- $16.17)/$62 * 100% = 74% (this assumes that the cost is the same as last year)


Gross margin $ is now $598,734 * (.74)= $443,063

So in spite of selling 343 less units, we wind up making an additional $27,263 in gross margin (profit before taxes and other miscellaneous charges).

Now if you were to keep going at higher and higher prices, you'll notice that your gross margin % and $ keep rising. My theory is that GW is on the left side of the intersection of Supply and Demand. This means that until you hit the "efficient" price, GW can continue to raise their prices without negatively impacting revenue. In short, they could raise prices even more and not have to give a flying fuck about loss of revenue and margin and they aren't increasing their prices as much as they could.


Where does all the money go?

If GW is making 72% profits currently on their products and may be increasing that to 76% or better how is it that they only retained 10% of their operating income in 2009? Well there are a lot of reasons. The 72% margin above is something called product gross margin. It only represents the costs needed to produce the item. Subtract out all of your other expenses and you get something called net income from operations. Subtract out your insurance expenses and you get net operating income. Take out taxes and you've got net operating profit after taxes (NOPAT). This is the important number. It represents how much profit you have left after all the bills are paid. GW, being a manufacturer, wholesaler, and retailer has a fuck load of expenses to pay for to stay open. Could they cut their costs to keep prices down? Possibly, but they are already addressing that according to the annual report, as I mentioned in my previous post. Also cutting costs usually means cutting jobs. Do you really want somebody to lose their job so you don't have to pay $4.25 more for a plastic tank? There is only so much fat that they can trim, and a lot of their long-term cost cutting measures, such as switching over more and more to plastic models, cost a lot in the short-term.

What happens to the 10% profit that GW realizes? Well that is something called retained earnings or earnings kept by the company. This can be used to reduce debts, make investments, pay dividends to shareholders, make equipment improvements, or sit there for emergencies. A company doesn't want to have too much money laying around not doing anything, bu having some free capital to pay for shit is necessary.

How does GW's 10% NOPAT stack up to other companies? Procter and Gamble netted about 13% in the first quarter of 2010, down from a 4th quarter 2009 high of nearly 25%. Kraft foods international posted about a 7.5% NOPAT in 2009. As you can see GW is right in there. They may have obscene product margins, but running a business is quite expensive. It is important for investor's in the company to increase the NOPAT as much as possible. If the company is not performing up to shareholders' expectations they can do anything up to and including taking legal action against the company in question. For GW to continue to operate they must continue to try and increase their profits as much as able.

And what of this recession?

Seriously, fuck off. According to the Federal Reserve Economic Database (FRED), the US recession ended a while ago. Though it was the worst drop since te early 80s, the US Gross Domestic Product (GDP, amount of goods and services produced in a country in total and a strong indicator of a country's financial health) only dipped about 2.5% anyway. Unemployment peaked at about 10% and is on the decline. That sucks, but things have been a lot worse- I'm looking at you early Reagan administration. The so called "recession" is not an excuse for you to become cheap all of the sudden, since there's a good chance that you have been in no way directly affected by the market (unless you are trying to buy a home or get financing). I am sorry if, like me, you have been directly affected by this, but things will look up. For the overwhelmingly vast majority of people, taken as a whole, the economy didn't tank like many would have you believe and has left them in about the same position as they were in in 2007. The sky isn't falling. Need I also mention that we're talking about a luxury/leisure item here. It's a non-essential good that is bought primarily by a demographic who has had little to no change in disposable income. So the economic downturn or whatever you want to call it shouldn't affect GW sales dramatically, unless it has increased their manufacturing or selling and administrative costs in some way.

Conclusion

If nothing else, hopefully you know can see why GW can raise their prices without worrying much about their profit. You should also see that things could be much worse and be happy that GW appears to be balancing your desires with their own needs pretty well, meaning you will keep buying their shit and they will continue to be a business (this is called the going concern assumption- we assume that GW will continue to operate in the future). I haven't really touched on why they need to increase their prices as much as why they can do it, but suffice to say that their costs are going up and they have a lot of past good equipment and licensing investments that still need paying off. They also need to step up their marketing efforts to continue to grow their customer base, as they have admitted that their acquisition of new customers is stalling out a bit. That will cost money, but ensure that we still have a hobby in 10+ years.