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Tuesday, May 25, 2010

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.


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.


Ishamael said...

Aww, I got my very own dedicated post! Tell you what though, this certainly helps to put things into a proper perspective. I'm unsure as to what I'll be purchasing after I finish my Tau, but it is still the case that I'm willing to pay that extra 10-15 percent for the product that I enjoy. So this means that I get to reference this every time I hear people complaining about the price increase.

Thanks bub! :D

Chumbalaya said...

It's been a while since I've taken an economics course, but now it's all coming back.

Way to put things in perspective dethtron.

Now if only this would stop the incessant bitchfitting...

The Lord of Excess said...

Good post and I generally agree with you. On two points I disagree though ... one is ... GW has to exist for there to be a viable mini gaming hobby scene. On that point ... if GW died tomorrow someone would pick up where they left off with surprisingly similar games. Second is that GW can do whatever they want with prices and not have any effect. The big thing from an econ 101 perspective that they risk ... if they do in fact raise prices too high ... is competition. We are already seeing it. Mantic Games ... www.wargamesfactory.com and on and on. Plastic 28 MM minis seem to be something alot of other companies are starting to put out. (cont)

The Lord of Excess said...

I think also when prices get so high that people are willing to start considering just making their own minis via home resin casting, sculpy, etc. and/or proxying more and more. Most players never play in a tournament and don't really need to worry about that side of the equation. So I would argue that the danger to GW is losing market share and or encouraging home grown converting on larger scale and/or just plain piracy of their stuffz. I can only speak to what I'm doing personally. Five years ago I had ... and I'm not lying or bragging ... just saying ... literally 2000 to 4000 points of every main 40K list available to play. I was a fiend for the stuff ... couldn't get enough. I've slowly sold off big chunks of what I used to own ... now I have 4 40K armies left that I still play and add to (Orks, Eldar, and Guard ... which is dormant for now but I want to play soon! I have enough marines in a box to do up 2000 points-ish at some point too). I've considered firing up a new 40K army but just feel a bit .. meh ... about it. Now just a small % of my angst at GW is related to the price increases ... I generally agree that they have a ways to go yet before it really makes me quit. But to me its just one more thing that GW is doing to sour the spirits of their fanboys. My personal pet peeve is the lack of solid support (at least out west) ... but I hear (anecdotally ... just my own experience here) more and more people each year complain about price hikes ... its the tourney scene/store scene killing it for some people ... perception of unjustified price hikes for others (I said perception not reality) ... and just general dissatisfaction with . At some point if the current trend continues ... bad stuffz could happen. They've kept the ship off the rocks for a good number of years I remain optimistic that they'll continue to do so ... I'm just looking over the side of the boat going ... whoa ... those rocks are getting closer. Oh and I would say you grossly oversimplified the recession bit ... dude ... I have a masters degree in pulic admin and I'm currently working on my PhD in poly sci ... and mentioning the recession in any of my classes causes an eruptive debate. I don't think you'd find five economists right now who agree on how bad it was ... or whether or not its still was or is. GDP is a key determining factor in declaring a recession but it isn't the only variable. For example employment, investment spending, capacity utilization, household incomes, business profits and inflation all fall during recessions; while bankruptcies and the unemployment rate rise. Many of those variables are still very much at play. But ... in the case of impact on GW ... I agree that they've largely been unscathed. One last thing I'll say is GW has a really odd model going. I would argue that its not straight econ 101 ... there is some complex shit at play man. You know it too. Factors like big numbers of its customer base being heavily invested in time, money and social ciricles ... being so bought in one way or another how could they leave, etc. Those types of factors are hard to quantify. I think GW currently enjoys a bit more insulation from immediate reactions to price increases because of some of those intangible ... GW oddities. What can I say they are British and make some damn cool stuff ... I can't stop buying it ... even if they piss me off more and more ... I'm still buying!!

The Lord of Excess said...

Sorry for the massive posts ... lol ... didn't mean to rant. I really do agree with your post ... lol.

Dethtron said...

Sweet Jesus Lord of Excess, you've certainly earned your namesake today. First, thanks for the feedback. Second, I will readily admit that the oversimplification of this matter using an econ 101 view of things can be slightly problematic, but in the big picture, I feel it's correct enough to apply here.

As to your main point being that eventually a price will be hit that can no longer sustain the hobby. I agree, it's even burried in my post somewhere. Believe me, with the post length I can see skimming over something like that :) I feel that GW is currently operating to the left of the most efficient point on a S&D graph. So they can raise their prices all they want until they reach that efficient point. Not having all the data available I can't say when or where that will happen, but I think that they have a way to go before it matters.

In response to the recession, I agree and disagree :). Believe me, I know that it sucks for a lot of people and I know that unemployment rates and GDP are not the only factors to measure- just look at this week's trend of people ditching stocks for US treasury bonds right now in the wake of Greece's implosion. That is a sure sign that things still suck and bad. The main theme relevant to my argument is that the majority of people who could afford gaming products in 2007 will still be able to afford them in 2011 and beyond. Any further debate on this will quickly fall into a pointless political discussion that I don't want to have :)

Last Re: competition. I don't think I ever said that GW's demise would collapse the gaming industry. I do think it would take some time for the competition to absorb the new demand following GW's collapse though, since you brought the subject up. Moreover, I think a lot of that marketshare would probably flock to other related industries, like video games, to spend their disposable income.

...and off my high horse. Thanks for keeping the discussion alive lord.

Kirby said...

yay for moneys! Thanks Dethtron. I'd just like to chew on the bone you threw out there regarding the 'recession...'


How much do you have now? None. How many projects have you canned because you have no money? All of them. What did your treasuer say was the reason you believed your cash throwing about was successful...let's see:

"Socks and jocks are selling and this tells me the cash hand outs worked. The economy is stable."

What happened a week after that statement. Did the ONLY Australian manfacturer in the country which produced those items of clothing move overseas? Are you serious? So your money was for...nought. And al those jobs you "saved", well they're overseas you wankers.

10 bucks labor gets in again this election.

/endrant :).

Zero said...

I was about to roll my eyes as I started to read this (since I never give bloggers the benefit of the doubt), but you've succinctly provided an informative primer! Thank you for this level headed analysis.

The only thing I would question is the margin per unit, but the math itself is sound. This is a refreshing alternative to the "GW owes it to us to not raise prices" nonsense.

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Dethtron said...

Shit, Mcuhammadbutt looks like you're my first spammer, thanks for the compliments, though.....

SandWyrm said...

You had me until you said the recession is over. It's not.

We have that illusion, such as it is, because the banking sector is being flooded with free bailout money created from thin air. As the banks spend it, the funds will work their way through the economy, inflating earnings in the businesses which serve that sector first. Until finally those funds reach all sectors and we have a general inflation of the currency.

For anyone not providing services to the banks, business is still very, very bad.

In addition, we still have 2 more waves of sub-prime defaults coming. One this fall and another in 2012. Not to mention the $1.5 Quadrillion in derivatives contracts, whose value is based on those shaky loans actually being worth something.

This isn't over yet by a long shot.

Brent said...

Man, I wish I'd read this article earlier this week. I would have borrowed (stolen) some of your ideas.

I wrote a guest article that's supposed to post on Blood of Kittens later today - anyway, it touches on the topic but doesn't try to analyze it the way you did...

...since frankly I'm not a business student; I'd end up looking stupid!

If it comes up, I'll be sure to point folks here. Great article.