Goldratt's "The Goal": Strong Foundation, Weak Structure

I haven’t read that many business books. The ones I have are usually more poorly written than the economics books I read. I know that there is often a dedicated course in business writing in the academy, but in my experience, it isn’t a focus of the program.

So when I was assigned a long business book as additional reading for my operations management class, I wasn’t too jazzed. I was pleasantly surprised though, the Goal isn’t that bad.

To talk about the Goal, I have to talk about the structure. It is a 330-page business novel.  I had no sense on going in what a business novel would be like, and it is basically that, a novel with plot and characters.

The problem is that it is a didactic novel. That means it is teaching you something. And in that role, it is often very heavy handed. The plot is that Alex, the main character who we get to enjoy present tense first person narration though, has been promoted to be the plant manager of his hometown plant. It is not producing the profits that corporate would like to see. On top of that, the orders are late and they’re always in a rush. So corporate comes down and gives Alex an ultimatum – you have three months to turn around the plant or we will look into closing it.          

So what does Alex do? Thankfully, Alex meets an old physics teacher friend of his named Jonah, who happens to be an internationally famous business consultant. The problem here is that Jonah is always busy, so he can’t handhold Alex to improve the plant. This device is here so that you as the reader and the character of Alex isn’t told straight up what changes to make. You/Alex need to find from the stated principles to improve the plant. The whole thing is based on the idea of the Socratic dialogue –where the teacher doesn’t tell you anything but the educate is a coming to knowledge of the student. It’s really heavy-handed, since the author mentions it in the introduction and also has a subplot where Alex’s wife starts reading philosophy and they have a couple dialogue exposition-dump conversations.

Ultimately, Alex does come up with a process of improvement where he takes some of the old rules off the board and looks at defining the ultimate goal of the plant vis a vis the company and what he can do to help the plant meet those goals. He and his team identify bottlenecks in the plant, reimagine them, and the plant is a success. He is promoted to district manager at the end, and he and his team start to see how they could apply the more general principles they had determined to processes that are harder to define than movement of material in a plant. For me, the end was the weakest part because I work in service and I kept trying to figure out how this could apply to me in my job. I still haven’t and I hope there was a sequel or something that applies the goal to a larger organization.

The general processes that Alex worked out by way of Jonah (who is a total stand-in for the author) are:      

1) Identify the system’s constraints

2) Decide how to exploit the system’s constraints.

3) Subordinate everything else to the above decisions

4) Elevate the system’s constraints

5) If in the previous steps, a constraint has been broken, go back to step 1, but do not allow inertia to cause a system constraint.

 

They sound like good general principles, and they work in the book. I do have some issues with the book and the idea though. First of all, the structure of the book feels entirely unnecessary. We as the reader have very little context for what the company Alex works for even makes. It is just some generalized manufacturing plant in a nameless town. That means the process described in the book cannot be fully trusted to have worked. I would like to see evidence-based material to prove that the process works. As it, it might as well be like the mystery writer who cannot really solve mysteries but just knows what he wants at the end so he can work backwards.

Second, the novel approach is just weird. It makes the book longer by three times than it could be to convey the same information. For example, there is a part in the book where the main character takes his son on a walk in the woods with the rest of the Boy Scout troop. The whole thing is just in there to illustrate that any process is only as strong as its weakest link or as fast as its slowest part. And it takes a long time to do so. The characters never really develop a secondary consideration. There’s a whole subplot where Alex and his wife are fighting and she ends up moving out for a while and it is just ridiculous. As a reader of fiction, it is horrible. You don’t know why these characters are in love in the first place and their reconciliation is unbelievable. It is also completely unnecessary for what Goldratt is trying to teach in his book. It just adds pages and I still never really cared about the characters.

Smaller things nagged as well.  For example, what is it about the impetus to restructure the company? Do you need to be close to failure to rethink your processes? Alex only went ahead with it because he had nothing to lose. That gave him reason to change. If things are working well enough at work, why change, even if efficiencies can be found? Another is that this book has been around a while now. Are efficiencies still possible? Or does every generation of managers have to relearn the same general principle here? Further – with the decline of manufacturing in the states to more labor-intensive countries, did the companies that embraced the goal succeed? There’s no indication in the book of the real world, so that bugged me.       
                

One last thing. Alex always refers to the cars he and his wife owns by their make. He has a Mazda, and she has an Accord. If he works in domestic manufacturing, why the heck does his family have two foreign cars?

Some Key Insights of Microeconomics

Lean Back

There was a story tossed around at some point about Henry Ford’s crowning jewel, the River Rouge manufacturing plant. It was said that Ford, who owned the mines for the coal and iron ore and the plantations of rubber trees for the rubber, would have the ships unload their cargo on one end and the other end would spit out fully formed Ford automobiles. This is an example of perfect vertical integration from tree to tearing up the country roads. It is also, what may look to be the best way to realize profit in a market system is vertical integration. A firm will not have to be at the mercy of suppliers, and they can capture whatever profit the supplier firm might have, thus creating more profit within the firm.

It is simplistic and wrong. One of the key insights of microeconomics is that there is a whole constellation of factors to take into consideration when looking at integration, either vertical or horizontal. These are termed “make-or-buy” decisions (Besanko et al. p. 99) and they determine if a firm should obtain an input from a supplier on the market or bring it in-house. The ultimate takeaway is that the profit the supplier firms create is hard to capture because the supplier firms have their own learning curve and their own economies of scale. It may make no sense for an automobile manufacturer to make their own airbags when every manufacture needs airbags, and a supplier can specialize and sell airbags to several companies. This allows the supplier to have lower costs because they are operating at scale where a singular manufacture of automobiles would have higher costs because they are manufacturing for only themselves. The potential exist for the manufacture to be a supplier for other manufacturers, but that is rare because other manufactures do not want to be reliant on competitors for suppliers. This is why Delphi and Mopar were spun off the larger parent companies, and they have gone through further specialization themselves. A further incentive to buy in the market is that by having multiple suppliers a firm can buy an input at the market price and be shielded from any supply chain disruption. Competitive firms do realize a profit, but bringing production of an input in house is no guarantee of capturing that profit both because the supplier is working at scale and there is a potential for the supplier to get lost in the bureaucracy of the firm and the potential profits instead become costs to overhead. Ultimately, it can be the firm that does the least that is the most efficient because it can then utilize the learning curve and the economies of scale for that one thing that they do.

There are other important takeaways of strategic microeconomics. An important thing to take into consideration is that the market is not everywhere and anywhere. A lot of goods and services are available through the internet. Call up Amazon and hope you find a good price and can trust the reviews, and you can buy most anything near the market price depending on how you get it shipped to you. Other products are very tied to the location of the consumer and the supplier. If a particular sweater is only available in Mongolia, and the firm does not ship it, then the buyer has to both find the sweater and go to Mongolia to obtain it. The location of a firm has some very real drivers on how much the customer is willing to pay. The ultimate cost of a good is not just the price paid in market, but also the time it takes to find it and get to it. There is the gas paid and the depreciation of the car, and the opportunity cost involved with the travel. What does a potential customer give up in terms of going to Mongolia to get that sweater? It can be so much that the firm could give them away to American customers and they would not be able to. Instead, the market for that sweater is more realistically geographically defined. Mitigating these search costs (Besanko et al. p. 179) is why it is so common to see multiple locations of some stores. In Chicago, there are Dunkin’ Donuts and Walgreens stores almost every other block. The reason is that though they sell differentiated products, the next best option is similar enough they have to put their stores everywhere or else they will lose potential sales to competitors.

A third important take-away from studying the strategy of competitive markets is the importance of the demand curve. In macroeconomics, the demand curve is given and it is more conceptual, but the slope of the demand curve is important. It is also not wholly a straight line. Individual markets have their own demand curve, and they can be empirically measured to show the inverse relationship between quantity and price, so that the demand curve is a downward sloping line. This has two interesting consequences (Besanko et al. p. 20). First is that an individual firm’s price flexibility is based on the demand curve. The less of a slope the demand curve has, also meaning the more elastic that demand is the less power an individual firm has to set prices. This can be seen in a perfectly competitive market. All the firms in a perfectly completive market have to charge the one price that is also the market rate where the average total cost curve and the marginal cost curve intersect. The downward sloping demand curve has an important consequence at the other end of potential market structures, in a monopoly. In a monopoly, the seller has pricing power, but they still have to face the quantity consequences of that pricing. If they try to take the price higher, they will lose customers. There is a theoretical point of price elasticity called perfectly inelastic demand, where the demand curve is a horizontal line, but that does not reflect the real world. Even in a world where a company had a monopoly on breathable oxygen, there would be a slope to the demand curve because ultimately, the willingness to pay would still be infinite, but the actual ability to pay would be finite. Ergo, there would be a backwards slope to the demand curve, and the monopolist is price constrained.

These and other ideas in microeconomics are crucial takeaways from the science. Some things that may look to be common sense on the surface are actually more complex once the math is grafted on the too easy narrative statements. Integration is not always perfect, there is a cost to search, and the demand curve can be limiting. Any prospective manager, as well as current manager, should be cognizant of these results of microeconomics.

References

Besanko, D., Dranove, D., Shanley, M., & Schaefer, S. (2013). Economics of Strategy (6th ed.). New York: Wiley.

The United States Steel Corporation: Still Building America

Careful, it's hot

      

           The United States Steel Corporation as known now has its roots in the mania for conglomeration that existed in the early years of the twentieth century. It was formed in 1901 when Elbert Gary and J. P. Morgan combined their steel holdings with that of Andrew Carnegie. The early company also housed the holding of several other steel companies that it bought out. At its founding, it was the largest enterprise ever by market capitalization ever, valued at 1.4 billion dollars (“History”). Over the course of the company’s history, it has reorganized and diversified. It bought oil companies and their related chemical divisions. Eventually as specialization came into vogue, these were spun off so the company could focus on its core competencies. In 2001, the company split to become two separate companies, U. S. Steel and the Marathon Oil Corporation (“History”). U. S. Steel has also faced competitive pressure over time. Various foreign steel companies have been able to underprice some of the smaller providers in the steel market. These companies have gone into bankruptcy and U. S. Steel has been able to pick up the companies and their related facilities and technologies. These acquisitions have happened in both the United States and abroad (“History”). Through the vicissitudes, U. S. Steel remains a leader in the international steel industry. Today, the company produces sheet steel both hot and cold rolled, coated steel, and tubular products (“Products”). Basically, if it is made of steel, The United States Steel Corporation can make the steel.

            A look the financial statements reveal some difficulty. As of 2013, the last financial statement available, the company had been through five straight years of losses (Annual Report p. 1).  Much of this can be forgiven because these five years have been in the recovery after 2008’s financial crisis, but it is still a bit troubling given that the recession ended in 2009. The company’s main product is a commodity product, and if it cannot control costs, then lower cost suppliers both home and abroad may force them from the market. On one hand, their long history is a selling point. The steel from the United States Steel Corporation can be expected to have the century of knowledge and know how behind it, especially since steel is now all the company does. They have the economies of scale and are far enough down the learning curve to take advantage of this knowledge base. On the other hand, an old company has legacy costs. The factories are aging and the labor agreements in the industrial belt still exist. The workforce is largely unionized, though it has decreased as automation has ramped up.

            The industry itself faces headwinds. The world economy is having troubles with growth in China slowing the fate of that economy is up in the air. This is a huge uncertainty as recently Chinese growth has used almost half of the global steel output (“Outlook”). Other large economies are having their own issues. The European Union has had several countries face recessions during the course of the recovery from the financial crisis, and the United States has not bounced back as quickly as some would have hoped. The global uncertainty means that analysts are predicting a muted 2% growth in the global industry in 2015 (“Outlook”). Periods of uncertainty are nothing new to the United States Steel Corporation, they have gone through the ups and downs of the last 114 years and they are still intact.

            In 2014, Mario Longhi, president of the United States Steel Corporation, laid out his plans to recover competitiveness and take the parenthesis off of the net income line. In his letter to shareholders in the 2013 annual report, Longhi emphasized improving safety, introducing more focus on the Six Sigma manufacturing process, new labor agreements, shutting down the oldest plant in the company, and investment in new efficient manufacturing equipment (Annual Report p. 3.-5).  All of these are efforts to cut costs that are integral to success in what is a narrow-margin commodity business. One final strategy Longhi is perusing is to try to close out the American market through reliance on trade agreements. Because of the thought that the American market is so open, many foreign suppliers have been accused of selling steel to the American market below cost. Such a move, called “dumping” is not allowed through free trade agreements or for members of the World Trade Organization. By both cutting costs and making sure others are playing by the rules, the United States Steel Corporation hopes to extend its history into the next hundred years.

            A preliminary look at the most recent quarterly earnings shows that there may be some life in the company and the turnaround strategy is working. For the year ending December 31, 2014, U. S. Steel was able to claim a net income of $102 million against an almost $2 billion loss in 2013 (“Earnings”). Some analysts are skeptical that the company can maintain this growth, since the declining oil prices have decimated the oilfield services. These companies are large business customers of steel, since they rely on the tubular products that companies like U. S. Steel make. However, this is one point where the recently rising oil prices may have an unseen benefit: it keeps the steel companies in business.

References

Besanko, D., Dranove, D., Shanley, M., & Schaefer, S. (2013). Economics of Strategy (6th ed.). New

            York: Wiley.

Robinson, R. (2015, Jan 30). What to Make of U.S. Steel’s Killer Earnings. Wall Street Daily. Retrieved from http://www.wallstreetdaily.com/2015/01/30/u-s-steel-x-earnings/

United States Steel Corporation. (2015). Annual Reports. The United States Steel Corporation. Retrieved from https://www.ussteel.com/uss/portal/home/investors/annualreports

United States Steel Corporation. (2015). History of U. S. Steel. The United States Steel Corporation. Retrieved from https://www.ussteel.com/uss/portal/home/aboutus/history

United States Steel Corporation. (2015). Sheet Products. The United States Steel Corporation. Retrieved from https://www.ussteel.com/uss/portal/home/products/sheet

Zacks.com. (2014, Oct  22). Steel Industry Outlook: US Shows Resilience, China Lags - Industry Outlook. Nasdaq.com. Retrieved from http://www.nasdaq.com/article/steel-industry-outlook-us-shows-resilience-china-lags-industry-outlook-cm405175#ixzz3Tk2ePldx

Market Structure

          

Yay "Free" Market!

              A market is a description of the where buyers and sellers of goods and services meet to exchange goods and services. In the olden days, it was a physical place and often set times. The Greeks called their market the agora. It is where the term agoraphobia is derived from. People who do not like being around people were afraid of, at the root, being around people where they congregated the most.

            Thankfully, for the agoraphobic and the buyers and sellers of goods, when the term market structure is brought up, it is not talking about which vendor gets the choice stalls by the entrance. The market is all around us, and it is not just one market. There is an individual market in each good and service that equals the entire market when summed. Instead, when economist talk about market structure, what they are really talking about is the individual power the market sellers have to set their prices and the profits available at in those markets. The market power is a direct relationship with how many sellers of a good there are, and how hard it is for a new seller of the good or service to start selling.

            The best way to think of all the possible market structures is to think of a spectrum. On one end, there is a market with only one seller. This is what is termed a monopoly. On the other end there is a market with an infinite number of sellers, or at least so many that one firm entering or leaving the market makes no effect on the market, because the idea infinite sellers is just a simplification. Two other market structures rest in the middle: Oligopoly and Monopolistic Competition. Monopolistic competition has fewer suppliers than perfect competition, and an oligopoly has fewer still. Each of the four market structures will be dealt with in turn.

            The first kind of market is a market in perfect competition. This is the market that is unaffected by a firm or other seller deciding to sell or stop selling. A firm in a market with perfect competition is one that is a price taker. The market price is the only price they can receive for what they are selling because if they price their goods higher than the market price, then no one will buy what they are selling. No one will buy what they are selling is because a potential consumer can just walk on over to the next person selling what they are selling and buy it at the market price. There is no differentiation this scenario because by definition what firms are selling are all the same. The simplest example of this is agricultural products. If Alpha Corp is selling apples at four bucks and Beta Corp is selling apples at four bucks, then Gamma Corp has to be able to sell at four bucks or else it should not enter the market for apples.

How is this four bucks determined? It does not come from the sky. The crucial part of perfect competition is that there is no economic profit to be made.  Economic profit is often called “rent” the price over and above costs that a firm should make. That is not to say that there is no accounting profit to be made, or else no firms would enter the market. Instead, the price in a perfectly competitive market is one where the price is equal to the marginal cost where it intersects with the average total cost curve. A firm in a competitive market would maximize profit by selling as many apples as it takes until the marginal cost of the last apple sold equals the market price (Besanko et al. p. 173).

Moving down the spectrum is a market structure where there are fewer firms and the products have some sort of differentiation. Instead of looking at apples or oranges, the market could be juice and firms could be selling apple juice or orange juice. In a monopolistic competitive market, there are many sellers. A difference between monopolistic competition and perfect competition is that in a monopolistically competitive market there is a slope to the demand curve. In perfect competition, the slope of the demand curve is zero, meaning it is a flat line at the market price, or perfectly elastic. Any price that is not on the demand curve results in a quantity sold of zero. This is not true in monopolistic competition. The sloping demand curve means that there is some flexibility for a firm to sell on price. They can climb to the top of the tallest tower and scream that their juice is better (vertical differentiation) or they can shout that their juice is closer (horizontal differentiation). The firm can even tout that it has a qualitatively inferior product, but at a lower price. As long as those prices are at or above that magical sport where the marginal cost curve intersects with the average total cost curve, the firm should be in business. That is the quantity they want to make to stay in business. If above, that means it is making an economic profit. That profit means that the market will attract entrants who want a piece of that pie, and it will continue to do so until total economic profit for the market goes to zero (Besanko et al. p. 180). Such is the nature of monopolistic competition. The flip side is also true, though. If there is negative economic profit to be made, the firms with the highest costs will leave the market and equilibrium profit will go back to zero.

A market with even fewer firms is an oligopoly. A defining characteristic of a market that can be called an oligopoly is that the firms within the market are very aware of the actions of the other firms in the market, whereas in the previous markets studied the firms all acted rather independently of each other (Besanko et al. p. 180). One example of a contemporary oligopoly is the large farm equipment market, where two firms, Deere and Caterpillar dominate. In high concentrated markets like the one for large farm equipment, the potential for informal coordination exists so that the participating firms can split the market and reap the rewards of their power. This means that the firms have power to set prices. The firms are no longer price takers, but are price makers up to a point.  Many models exist to describe both a static and a dynamic market that is split between large players. The key takeaway is that the firms will realize the most profit in the sort if they act as if they were a single monopolistic firm, through tit for tat pricing and other ways to coordinate pricing without deliberately forming an illegal cartel. The problem is that as long as there are not significant barriers to entry, other firms will see the profit potential and try to enter that market so that economic profit drops. This is why oligopolistic competition is often seen in industries where there are large capital and regulatory barriers to entry, such as large farm equipment manufacturing or mobile telephony. Other firms maintain their oligopoly through network effects and high switching costs, such as social media and banking.

The final form a market can take is when the bulk of the supplying is done by one firm. This does not mean that other firms cannot exist in a monopolistic market, but that for overall price and quantity produced they more or less do not matter (Besanko et al. p. 176). This is not to say that a monopolist can charge any price for the goods and services it sells. The demand curve is not perfectly inelastic; it is also downward sloping. This means that if a monopoly raises its prices, then it will lose customers. The profit maximizing quantity produced of a monopolist is where the marginal revenue of the last item sold equals the marginal cost of making it. This means there is a limit to how much a monopolist can produce until its profits start decreasing. In this way, the monopolist is the market. It can structure prices in ways to limit entry, but in practice, you see very few monopolies in the real world. Federal regulators for the last 140 years in the United States have been wary about the potential of monopolistic markets driving up the cost of goods and the quality of the goods sold. Market concentration does drive up price, as noted by economist Leonard Weiss (Besanko et al. p. 191), but that does not mean all monopolies are bad. Microsoft was able continue with its dominance over the personal computer operating system market because even though it reaped high profits, the consumers ultimately benefited from the network effects of having industry standard software. Note though that even this monopoly was transient. As the use of computers changed, the stranglehold of Windows and the Office products waned. The lasting monopolies are instead those that are considered natural monopolies, where duplication of services is inefficient. The best example of this is in the distribution of utilities. Laying pipe over the right of ways is most efficient when there is only one entity doing it. It is also easiest when there is state coordination to grant those right of ways or to appropriate them through eminent domain – something that is not within the rights of a private corporation (Kelo v. City of New London excluded). This is why the monopolies that do persist are either highly regulated or have been subsumed into the state apparatus.

In the end, there is no one best market structure. Each market is different based on the goods and the services sold, and the various barriers to entry and exit. The important thing is that for each market and each firm within a market, there is an optimal amount of goods and services that can be provide to maximize. The challenge for each firm is hitting that sweet spot.

References

Besanko, D., Dranove, D., Shanley, M., & Schaefer, S. (2013). Economics of Strategy (6th ed.). New York: Wiley.