Recent briefings urged us to focus on the direct impact of decisions, rather than following simplistic rules based on ratios or overall performance outcomes, especially profits. But many decisions, such as various spending choices, include a direct profit impact, as well affecting the resources and operating performance in their particular part of the system. In practice, then, many decisions have to balance conflicting aims.

Take the case of an established power company, supplying electricity to a large number of homes. We previously were the sole supplier, but regulatory changes have made it possible for a new rival to compete in supplying power to our customers. If all we wanted was to stop customers leaving, and all that our competitor wanted was to win those same customers, then each of us would keep cutting prices until we both lost money.

As the established supplier, we will likely lose profits from the start as the new entrant takes our customers, and any cuts in price by our rival that we follow will add to this pain. We therefore face a serious conflict between the objectives of keeping customers, which needs price cuts, and maintaining profits which requires holding prices up.

Our rival initially has a simpler aim — merely to win our customers. They know they will not be profitable, so set prices sufficiently below ours to keep winning customers. This cannot continue indefinitely, however, and at some point they must try to become profitable.

What both firms need is a “composite” policy that compares current values for customer switching and profitability with the targets for each, and arrives at a single decision for price that is a good compromise between these conflicting aims. This is shown in Figure 1. Both companies cut prices whenever they lose too many customers, or fail to win enough. But in addition, we raise prices (or cut them less) if our profit margin drops below 10 % – and the larger the shortfall, the more we raise prices. Our rival starts with no objective for profitability, but from quarter six they too seek to get their net margin up to 10 % by raising prices.

The competitor enters with a price cut worth $5/quarter for a typical customer. We are driven to respond to the threat with a price cut of our own, and our strong profitability means we need not cut price by a lower amount. The competitor’s second price cut again steals customers from us, but this time we are barely profitable, so we cut price by rather less than $5/quarter. Meanwhile, the competitor is forced to start considering their profitability, which pushes them into raising prices rather strongly. This puts us in the unexpected position of having a lower price than our rival, leading to the recapture of more than 200 000 customers, nearly enough to cover our fixed costs and make us profitable again.

Figure 1: Composite policies aimed at customer switching and profitability in electricity supply. (Click image to view larger)

This particular outcome reflects the specifics of the policies that these two companies follow, and a variety of outcomes is possible that differ widely in both scale and speed of customer movements, and in long-run profit rates for each firm. For example, if the rival is timid with its pricing and moves by only $2 each time, they do not build a significant business before they are driven to seek profitability, and both companies’ prices end up higher.

In reality, when regulations allow new entry into a market previously served by a monopoly supplier, the whole point of the change is to stimulate price competition and drive down prices. This would not appear to be feasible in the scenario illustrated in Figure 1, because the same amount of business is fought over between two organizations with the same, unchanging cost base. But this is not usually what happens in such cases. First, the new entrant may have much lower overheads than the incumbent, who may not previously have had much incentive to hold down costs. The newcomer could therefore reach a profitable position both sooner than shown here and on a lower scale of business. Secondly, the competitive process itself would likely encourage both companies to reduce costs further, allowing prices to fall, often substantially, even while both competitors become profitable.

Until next time…

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Policy in not-commercial cases

The principles of developing policy to steer strategy are just as relevant to voluntary and public service situations. Here too, it is rarely advisable to link most decisions to the overall performance outcome, because many other influences intervene between each decision-factor and the eventual outcomes. A voluntary organization concerned with fundraising, for example, would gain little information to help decide on its efforts from monitoring simply its flow of cash. It would do better to track the inflow of new donors, the donation rate of donors, and the rate at which previously loyal donors were lapsing.

Another example of connecting policy to key flow-rates concerns many cities’ efforts to reduce homelessness. Voluntary organizations once responded to this suffering by offering food and drink to rough sleepers on the street. The unintended consequence was to discourage the homeless from seeking help to escape from their situation, so with a continuing inflow of new people, the numbers sleeping rough escalated. Policy in many major cities now focuses on slowing the arrival of the newly homeless, and making it easy for people already in that situation to access services that remove them from the situation, such as sheltered accommodation and drug treatment.

Public policy cases, however, often involve multiple agencies, and a wider range of goals that may conflict. A city’s transport policy, for example, may seek to increase public access, reduce travel-times, protect the environment, and stimulate the local economy – not simply ‘grow profits’.

This briefing summarises material from chapter 8 of Strategic Management Dynamics, pages 550-553.

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