Wednesday, February 18, 2009

Margins and Profit

Before you go any farther, going to let you know up-front: This isn't economics or politics. It's business.

But it's a simple business concept that everyone should understand.

Let me explain the situation. Around a week ago, I met up with some group-mates from my finance class in a lounge around campus. After munching on some delicious Wendy's burgers, we got down to work: we were responsible for running a bank through a simulated economy against the other groups in our class. And we planned on taking it seriously, for a couple reasons.

1. The project is a large portion of our grade. It doesn't matter if we LOSE money, but we need to explain how we arrived at the decisions we did.
2. The winner (IE, the group with the highest stock price at the end) will not have to take the final, and will get to meet the head of the Finance department...hopefully leading to some job connections!

I had spent the previous day staring at the financial statements of the bank for the previous two quarters. And, believe me, it was confusing for a long time. Even if you know the basics of the financial statements, new parts that you've never seen can confuse you if they aren't explained properly. Considering we were just handed statements with numbers on them, yep, I was confused.

But I managed to figure out what was going on with the statements. Our bank didn't seem particularly strong (we were hemorrhaging deposits, losing 5% every quarter. Those are basically personal bank accounts people put in your bank that you use to make money elsewhere), but there was a good opportunity for growth in retail banking by creating mortgages. This basically meant that we will have to open more branches, shift effort away from appealing to business customers, and start focusing and trying to get customer deposits back to get more money to invest,

The story we were given was that consumers are not price-sensitive, so I naturally said that we should advertise a lot, tell our bankers to spend more effort on getting more residential customers, and charge higher rates so we could have better margins.

My friend asked me "So we're going to advertise that we have higher mortgage rates?"

There ain't nothing wrong with asking the question and thinking like a businessman, which includes thinking competitively. It's so common sense that people all across the nation can think like this: cut prices, and that way you can attract more customers and beat your competition. But there are limitations to this kind of thinking.

For example, the most obvious one is that customers might not care about price very much. Starbucks can charge $4 for a cup of coffee, when I can make my own at home for 30 cents. Obviously, price isn't the biggest factor.

Scale can also be a big factor. Sure, by reducing your prices, you might get more customers. What happens if your store or bank cannot handle all those customers? Just as there are economies of scale, so there are diseconomies of scale. Once you are producing beyond a certain point, your costs actually start to rise.

For a bank, you might not have enough employees, so your quality of service suffers. That's REALLY bad if customers also care more about service than price, so you are driving them right in the arms of your competitors. You might also lose the ability to exercise due diligence on loans: you can't spend 6 hours vetting every single person asking for a mortgage when you have one guy to approve them and 1,000 people begging for loans because you are charing 6% whereas everyone else is charging 10%.

And you can't hire more workers either: your bank is only so big! Buying another bank? Extremely expensive, and can't do it because you can't make money when you are charging 6% for a mortgage and giving out 5% on savings accounts. Or, if you CAN make money, it's extremely risky...if you don't get as many loans as you want, your stuck with two banks. Which means you might very go well bankrupt. Plus, hiring more employees means you lose your own personal control. You can't watch over 30 managers as easily as you can watch over 10.

So, if your company is running into trouble, the idea of cutting your prices seems very attractive. Often times, though, it's really a trap and might put your company even more into the dumps.

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