Many firms don’t know their numbers

Saturday, April 7th, 2018

Alex Tabarrok has learned a lot about industrial organization by watching The Profit, a reality-TV show on CNBC featuring businessman Marcus Lemonis:

In each episode Lemonis buys into a failing small-to-medium-sized business and works to turn it around. Lemonis doesn’t invest in a random sample of businesses nor even in a random sample of failing businesses. Nevertheless, the lessons that The Profit teaches are consistent with the new literature on management which has increased my confidence both in the show and the literature.

In the perfectly competitive model, price is equal to average cost and firms operate efficiently at minimum cost. Yet, Syverson finds that in the typical US industry a firm at the 90th percentile of the productivity distribution makes almost twice as much output with the same inputs as a firm at the 10th percentile. It’s not easy to measure inputs or outputs, of course, but even firms producing very uniform products show big productivity differences.

How can firms that use inputs so inefficiently survive? In part, competition is imperfect which gives inefficient firms a cushion because they can charge a price higher than cost even as costs are higher than necessary. Another reason is that small firms eat their costs.

A typical firm on The Profit, for example, has decent revenues, sometimes millions of dollars of revenues, but it has costs that are as high or higher. What happened? Often the firm began with a competitive advantage — a product that took off unexpectedly and so for a time the firm was rolling in profits without having to pay much attention to costs. As competition slowly took hold, however, margins started to decline and the firm found itself bailing. But instead, of going out of business, the firm covers its losses with entrepreneurs and family members who work without pay, with loans which grow ever larger, and by an occasional demand shock which generates enough surplus revenue to just keep going.

The correct metaphor for competition isn’t a boxing match that knocks out the inefficient firm. The correct metaphor is a slow tide. Inefficient firms must scramble for a bit of high ground but as the tide ebbs and flows they can occasionally catch a breath when their head bobs above the profit line. An inefficient firm can survive for years before it inevitably sinks.

The second lesson from The Profit is that management matters and it matters in systematic and fairly easy to replicate ways. If mis-measurement explained productivity differences, Lemonis would not be able to successfully turn firms around. But he can and does. How?

One of the first things Lemonis does in almost every episode is get the numbers right so he can calculate which products are selling and which have the highest price-to-cost margin. Concentrate production on high-margin, big sellers. Drop the rest. Simple; but many firms don’t know their numbers.

Second, in episode after episode, Lemonis cleans up shop. Literally. He cleans the shop floor and gets rid of inventory that isn’t selling. He then arranges the floor to improve process flow (made easier by concentrating production on fewer products). He then creates an inventory system, tracks orders and the inputs needed to create those orders, and takes advantage of costs savings through economies of scale in input purchases.

Can it be so simple? To be sure, Lemonis is a smart guy but very little of what he does takes genius. We know this because we now have robust evidence from India and Mexico that better management increases profits and productivity and that such increases can be sustained over the long run. In the studies from India and Mexico, randomly selected firms were given access to a “management intervention” and their productivity and profits improved and stayed higher for years after the intervention ended.

Moreover, what were these management interventions? Did some bright Harvard grad recommend a complicated swap-options deal? A new chemical process? A new management form? No. By and large, the interventions were simple. Just like the Lemonis interventions.

Comments

  1. Kentucky Headhunter says:

    So the lesson is that well-run businesses do better than poorly-run businesses? Riveting.

    Seems like the previous owners would always end up looking like idiots if his fixes are fairly simple and straight-forward. And the people who did business with them would maybe feel foolish by association.

  2. Truth teller says:

    Doesn’t explain why most businesses featured on The Profit are actually failures after his so called help

    There should be a tv show following up on what actually happens After The Profit

  3. Steve Johnson says:

    “Seems like the previous owners would always end up looking like idiots if his fixes are fairly simple and straight-forward.”

    That’s overly harsh Kentucky Headhunter – for a few reasons. The previous owners might have been the ones who built the firm from nothing – which required a different set of skills and is far from easy. They could have taken over a smaller company and grew it in good times – also a different set of skills.

    Still not fully foolish but it’s a natural human tendency to get tunnel vision and just stay in “fire fighting” mode dealing with day to day problems and never quite getting around to making changes that improve the long term position of the firm.

    Finally, Lemonis has a huge edge in that if he comes in, puts in a bunch of changes to improve the business and it fails he’s out his investment but he’s not ruined. The previous owners are going to be much more risk averse.

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