A primer on airline pricing

One of the most scorned and disdained – and least understood – pricing strategies is employed by the airline industry, illustrated by this anonymously authored email about purchasing house paint, circulated in Australia where Qantas has a large share of the market:

 

First, a reprise of how ordinary hardware stores sell paint:

 

Customer  Hi. How much is your paint?

 

Salesman  We have normal quality paint for $18 a litre and premium paint for $25. How many litres would you like?

 

Customer  Five litres of normal paint please.

 

Salesman  Great. That will be $90.

 

Now, imagine you are buying paint from Qantas: First you spend days trying to reach them by phone to ask if they have paint. Nobody answers. So, you drive to a Qantas store.

 

Customer  Hi. How much is your paint?

 

Salesman  Well, sir, that all depends on quite a lot of things.

 

Customer  Can you give me a guess? Is there an average price?

 

Salesman  Our lowest price is $12 a litre, and we have 60 different prices up to $200 a litre.

 

Customer  What’s the difference in the paint?

 

Salesman  Oh, there isn’t any difference; it’s all the same paint.

 

Customer  Well, then I’d like some of that $12 paint.

 

Salesman  When do you intend to use the paint?

 

Customer  I want to paint tomorrow. It’s my day off.

 

Salesman  Sir, the paint for tomorrow is the $200 paint.

 

Customer  When would I have to paint to get the $12 paint?

 

Salesman  You would have to start very late at night in about 3 weeks. But you will have to agree to start painting before Friday of that week and continue until at least Sunday.

 

Customer  You’ve got to be kidding!

 

Salesman  I’ll check and see if we have any paint available.

 

Customer  You have shelves FULL of paint! I can see it!

 

Salesman  But it doesn’t mean that we have paint available. We sell only a certain number of litres on any given weekend. Oh, and by the way, the price per litre just went to $16. We don’t have any more $12 paint.

 

Customer  The price went up as we were talking?

 

Salesman  Yes, sir. We change the prices and rules hundreds of times per day, and since you haven’t actually walked out of the store with your paint yet, we have just decided to change. I suggest you purchase your paint as soon as possible. How many litres do you want?

 

Customer  Well, maybe five litres. Make that six, so I’ll have enough.

 

Salesman  Oh no, sir, you can’t do that. If you buy paint and don’t use it, there are penalties and possible confiscation of the paint you already have.

 

Customer  WHAT?

 

Salesman  We can sell enough paint to do your kitchen, bathroom, hall and north bedroom, but if you stop painting before you do bedroom, you will lose your remaining litres of paint.

 

Customer  What does it matter whether I use all the paint? I already paid you for it!

 

Salesman  We make plans based upon the idea that all our paint is used, every drop. If you don’t, it causes us all sorts of problems.

 

Customer  This is crazy!! I suppose something terrible happens if I don’t keep painting until after Saturday night!

 

Salesman  Oh yes! Every litre you bought automatically becomes the $200 paint.

 

Customer  But what are all these “Paint on sale from $10 a litre” signs?

 

Salesman  Well, that’s for our budget paint. It only comes in half-litres. One $5 half-litre will do half a room. The second half-litre to complete the room is $20. None of the cans have labels, some are empty and there are no refunds, even on the empty cans.

 

Customer  To hell with this! I’ll buy what I need somewhere else!

 

Salesman  I don’t think so, sir. You may be able to buy paint for your bathroom and bedrooms, and your kitchen and dining room from someone else, but you won’t be able to paint your connecting hall and stairway from anyone but us. And I should point out sir, that if you paint in only one direction, it will be $300 a litre.

 

Customer  I thought your most expensive paint was $200!

 

Salesman  That’s if you paint around the room to the point at which you started. A hallway is different.

 

Customer  And if I buy $200 paint for the hall, but only paint in one direction, you’ll confiscate the remaining paint?

 

Salesman  No, we’ll charge you an extra use fee plus the difference on your next litre of paint. But I believe you’re getting it now, sir.

 

Customer  You’re insane!

 

Salesman  But we’re now THIS COUNTRY’S only paint supplier! And don’t go looking for bargains! Thanks for painting with Qantas (R. Baker, Pricing on Purpose, 2006).

Tackling crime - augmenting the virtuous circle

Unemployment and high crime rates tend to go together. A high crime rate is a disincentive to investment, attraction of skills and a damper on tourism and, therefore, exacerbates unemployment. A high crime rate also contributes to a social breakdown and encourages the emergence of bad trends, including mob justice in all its manifestations.

Even though tackling crime is not directly part of an economic policy, because of its direct impact on economic activity it is imperative to include it in any economic proposals.

It is really an intellectual game

 Development is really, ultimately, an intellectual game. 

 

The standard prerequisites for development are well known, but the power of intellect is hardly ever mentioned, if at all.

 

The fact that intellectual capital, intellectual wealth, trumps everything.

 

The intellect of a people to choose and elect the right leaders.

 

The intellect of the leaders to choose and doggedly follow the right policies.

 

The intellect to realise and understand that, ultimately, intellect trumps everything.

 

The intellect to realise that lack of natural endowments/resources does not doom you to failure, that there are many paths to development, that in fact, in a perverse but virtuous way, lack of endowments may actually be a blessing because it frees the intellect to think creatively, to innovate, not to depend on ‘natural capital’, but to depend on abundant, perpetual intellectual capital. Or, conversely, that abundant natural resources are not a prerequisite, nor do they ensure, development and that, perversely, if unaccompanied by intellectual power may actually be a ‘curse’ for they tend to lull the mind and promote lazy thinking.

 

Give me a resource rich country, and I’ll give you a country with none but is at the top of all human and economic development indices.

 

All that is required is to free the intellect and shun lazy thinking like the plague.

Mother Teresa

Where are the Mother Teresas in South Africa? People who are in it not for the careers or the thrill of political debate, but who genuinely want to change people’s lives for the better.

People who are not only able, but prepared to walk in someone else’s shoes, especially the poor and marginalised, the wretched of the earth.

South Africa has got the means to uplift everybody out of abject poverty. At some point, the fact that it’s not happening, somebody has to own the failure, accept the blame. The billions that are squandered, whether it be through corruption or vanity or poorly conceived projects, the failure of economic policies, or policies that are wrong to begin with, somebody has to own that.

Ego trips are not going to help the people. Genuine and implementable solutions will. 

Penetration

 Penetration: The proportion of people in the target market who bought (at least once in the period) a specific brand or a category of goods.

 

 

 

Two key measures of a product’s “popularity” are penetration rate and penetration share. The penetration rate (also called penetration, brand penetration, or market penetration as appropriate), is the percentage of the relevant population that has purchased a given brand or category at least once in the time period under study.

 

EXAMPLE: Over a period of a month, in a market of 10,000 households, 500 households purchased Kill Now brand of flea killer.

 

 

 

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A brand’s penetration share, in contrast to penetration rate, is determined by comparing that brand’s customer population to the number of customers for its category in the relevant market as a whole. Here again, to be considered a customer, one must have purchased the brand or category at least once during the period.

 

 

EXAMPLE:  Returning to the flea killer market, during the month in which 500 households purchased Kill Now, 2,000 households bought at least one product of any brand in this category. This enables us to calculate Kill Now’s penetration share.

 

 

 

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Decomposing Market Share

 

Relationship of Penetration Share to Market Share: Market share can be calculated as the product of three components: penetration share, share of requirements, and heavy usage index.

 

 

Share of Requirements: The percentage of customers’ needs in a category that are served by a given brand or product.

 

Heavy Usage Index: A measure of how heavily the people who use a specific product use the entire category of such products.

 

In light of these relationships, managers can use this decomposition of market share to reveal penetration share, given the other inputs.

 

 

EXAMPLE:  Eat Wheats brand cereal has a market share in Durban of 6%. The heavy usage index for Eat Wheat cereal is 0.75 in Durban. Its share of requirements is 40%. From these data, we can calculate the penetration share for Eat Wheats brand cereal in Durban:

 

 

 

The Power of Depreciation and Amortisation

Depreciation is a prime example of what accountants call a non-cash expense[1]. Right here, of course, is where they often lose the rest of us. How can an expense be other than cash? The key to that puzzling term is to remember that the cash has probably already been paid. The company already bought the truck. But the expense wasn’t recorded that month, so it has to be recorded over the truck’s life, a little at a time. No more money is going out the door; rather, it’s just the accountant’s way of figuring that this month’s revenues depend on using that truck, so the income statement better have something in it that reflects the truck’s cost. Incidentally, you should know that there are many methods to determine how to depreciate an asset. You don’t need to know what they are; you can leave that to the accountants. All you need to know is whether the use of the asset is matched appropriately to the revenue it is bringing in.

Amortisation is the same basic idea as depreciation, but it applies to intangible assets. These days, intangibles are often a big part of companies’ balance sheets. Items such as patents, copyrights, and goodwill (to be discussed further in a later lesson) are all assets – they cost money to acquire, and they have value – but they aren’t physical assets like real estate and equipment. Still, they must be accounted for in a similar way. Take a patent. Your company had to buy the patent, or it had to do the research and development that lies behind it and then apply for it. Now the patent is helping to bring in revenue. So, the company must match the expense of the patent with the revenue it helps bring in, a little bit at a time. When an asset is intangible, though, accountants call that process amortisation rather than depreciation. I’m not sure why – but whatever the reason, it’s a source of confusion.

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[1] A non-cash expense is one that is charged to a period on the income statement but is not actually paid out in cash. An example is depreciation: accountants deduct a certain amount each month for depreciation of equipment, but the company isn’t obliged to pay out that amount, because the equipment was acquired in a previous period.

Real Options and Decision Trees

If financial managers treat projects as black boxes, they may be tempted to think only of the first accept-reject decision and to ignore the subsequent investment decisions that may be tied to it. But if subsequent investment decisions depend on those made today, then today’s decision may depend on what you plan to do tomorrow.

When you use discounted cash flow to value a project, you implicitly assume that the firm will hold the asset passively. But managers are not paid to be dummies. After they have invested in a new project, they do not simply sit back and watch the future unfold. If things go well, the project may be expanded; if they go badly, the project may be cut back or abandoned altogether. Projects that can easily be modified in these ways are more valuable than those that do not provide such flexibility. The more uncertain the outlook, the more valuable this flexibility becomes.

That sounds obvious but notice that sensitivity analysis and Monte Carlo simulation do not recognise the opportunity to modify projects. In real life, if things go wrong with a project, the company would abandon to cut its losses. If so, the worst outcomes would not be as devastating as a sensitivity analysis and simulation may suggest.

Options to modify projects are known as real options. Managers may not always use the term real option to describe these opportunities; for example, they may refer to “intangible advantages” of easy-to-modify projects. But when they review major investment proposals, these option intangibles are often the key to their decisions.

A primer on pricing, Why is Movie Theatre Popcorn So Expensive?

 To say it is where the theatre owners make their profits is true, but begs the question of why they do not make the profits from ticket sales and sell more popcorn at closer to cost? Eating popcorn is certainly part of the experience of going to the movies, and people will pay for it, yet this explanation is still incomplete.

 

Assuming theatre owners want to maximise their profits, what do they know the rest of us, perhaps, do not? The consummate economist Steven Landsberg provides the answer:

 

I believe he knows this: some moviegoers like popcorn more than others. Cheap popcorn attracts popcorn lovers and makes them willing to pay a high price at the door. But to take advantage of that willingness, the owner must raise ticket prices so high that he drives away those who come only to see the movie. If there are enough non-snackers, the strategy of cheap popcorn can backfire.

 

The purpose of expensive popcorn is not to extract a lot of money from customers. That purpose would be better served by cheap popcorn and expensive movie tickets. Instead, the purpose of expensive popcorn is to extract different sums from different customers. Popcorn lovers, who have more fun at the movies, pay more for their additional pleasure (Landsberg, 1993).

 

This answer is more precise, since the important point is that “some moviegoers like popcorn more than others,” and the theatre owner cannot separate these customers when they are outside queueing up for the movie. A method was needed to separate the snack eaters from those who just want to watch the movie, which the concession stand provides since it allows the customers to divide and self-identify themselves. This may seem a subtle point, but it is highly profitable, since segmenting different types of customers allows the theatre owners to charge them varying prices depending on the value received.

 

Students, children, and people with large families are usually more price sensitive, and not likely candidates to spend money on snacks. The theatre owner does not want to turn these customers away, and hence keeps the box office price lower by charging higher prices to snack eaters. What you are really buying when you purchase a movie ticket is an opportunity set – a chance to enjoy the movie, or to enjoy it with popcorn. Economists call this a two-part tariff, defined as a pricing strategy in which the customer must pay a fee in exchange for the right to purchase the product. Examples abound of this strategy: country clubs charging membership fees and monthly dues; Gillette charging for the razor then the blades; amusement parks charging an entrance price followed by a price for each ride (R. Baker, Pricing on Purpose, 2006)

Walking and chewing gum

 Many of our leaders can’t walk and chew gum at the same time

They let us down, they let the team down

 

Even in matters of life and death

Types of Cash Flow

You’d think a cash flow statement would be easy to read. Since cash is real money, there are no assumptions and estimates incorporated in the numbers. Cash coming in is a positive number, cash going out is a negative one, and net cash is simply the sum of the two. In fact, though, we find that nearly every nonfinancial manager takes a while to understand a cash flow statement. One reason is that it is always divided into categories, and the labels on the categories can be confusing. A second reason is that the positives and the negatives aren’t always clear. (A typical line item might say, “(increase)/decrease in accounts receivable”, followed by a positive or negative number. Is it an increase or a decrease?) A final reason is that it can be tough to see the relationship between the cash flow statement and the other two financial statements.

I’ll take up the last issue in the following lesson. Right now, let’s just sit down with a cash flow statement and learn the basic vocabulary.

Types of Cash Flow

The statement shows the cash moving into a business, called the inflows, and the cash moving out of a business, called the outflows. These are divided into three main categories.

Cash From or Used in Operating Activities

At times you’ll see slight variations to this language, such as “cash provided by or used for operating activities”. Whatever the specifics, all of this is more accountant-speak: too many accountants can’t say, “operations”, they have to say, “operating activities”. But whatever the exact language, this category includes all the cash flow, in and out, that is related to the actual operations of the business. It includes the cash customers send in when they pay their bills. It includes the cash the company pays out in salaries, to vendors, and to the landlord, along with all the other cash it must spend to keep the doors open and the business operating.

Cash From or Used in Investing Activities

Note that investing activities here refers to investments made by the company, not by its owners. The biggest subcategory here is cash spent on capital investments – that is, the purchase of assets. If the company buys a truck or a machine, the cash it pays out shows up on this part of the statement. Conversely, if the company sells a truck or a machine (or any other asset), the cash it receives shows up here.

Cash From or Used in Financing Activities

Financing refers to borrowing and paying back loans, on the one hand, and transactions between a company and its shareholders on the other. So, if a company receives a loan, the proceeds show up in this category. If a company gets an equity investment from a shareholder, that too shows up here. Should the company pay off the principal on a loan, buy back its own stock, or pay a dividend to its shareholders, those expenditures of cash also would appear in this category.

You can see right away that there is a lot of useful information in the cash flow statement. The first category shows operating cash flow, which in many ways is the single most important number indicating the health of a business. A company with a consistently healthy operating cash flow is probably profitable, and it is probably doing a good job of turning its profits into cash. A healthy operating cash flow, moreover, means that it can finance more of its growth internally, without either borrowing or selling more stock.

The second category shows how much cash the company is spending on investments in its future. If the number is low, relative to the size of the company, it may not be investing much at all; management may be treating the business as a “cash cow”, milking it for the cash it can generate while not investing in future growth. If the number is high, relatively, it may suggest that management has high hopes for the future of the company. Of course, what counts as high or low will depend on the type of company it is. A service company, for instance, typically invests less in assets than a manufacturing company. So, your analysis has to reflect the big picture of the company you’re assessing.

The third category shows to what extent the company is dependent on outside financing. Look at this category over time, and you can see whether the company is a net borrower (borrowing more than it is paying off). You can also see whether it has been selling new shares to outside investors or buying back its own stock.

Finally, the cash flow statement allows you to calculate Warren Buffett’s famous “owner earnings” metric.

Wall Street in recent years has been focusing more and more on the cash flow statement. As Warren Buffett knows, there is much less room for manipulation of the numbers on this statement than on the others. To be sure, “less room” doesn’t mean “no room”. For example, if a company is trying to show good cash flow in a particular quarter, it may delay paying vendors or employee bonuses until the next quarter. Unless a company delays payments over and over, however – and eventually, vendors who don’t get paid will stop providing goods and services – the effects are significant only in the short term.

The Power of Understanding Cash Flow

First, knowing your company’s cash situation will help you understand what is going on now, where the business is headed, and what senior management’s priorities are likely to be. You need to know not just whether the overall cash position is healthy but specifically where the cash is coming from. Is it from operations? That’s a good thing – it means the business is generating cash. Is investing cash flow a sizeable negative number? If it isn’t, it may mean that the company isn’t investing in its future. And what about financing cash flow? If investment money is coming in, that may be an optimistic sign for the future, or it may mean that the company is desperately selling stock to stay afloat. Looking at the cash flow statement may generate a lot of questions, but they are the right ones to be asking. Are we paying off loans? Why or why not? Are we buying equipment? The answers to those questions will reveal a lot about senior management’s plan for the company.

Second, you affect cash. As I’ve said before, most managers focus on profit, when they should be focusing on both profit and cash. Of course, their impact is usually limited to operating cash flow – but that’s one of the most important measures there is. For instance:

·       Accounts receivable. If you’re in sales, are you selling to customers who pay their bills on time? Do you have a close enough relationship with your customers to talk with them about payment terms?[1] If you’re in customer service, do you offer customers the kind of service that will encourage them to pay their bills on time? Is the product free of defects? Are the invoices accurate? Does the mail room send invoices timely? Is the receptionist helpful? All these factors help determine how customers feel about your company, and indirectly influence how fast they are likely to pay their bills. Disgruntled customers are not known for prompt payments – they like to wait until any dispute is resolved.

·       Inventory. If you’re in engineering, do you request special products all the time? If you do, you may be creating an inventory nightmare. If you’re in operations and you like to have lots in stock, just in case, you may be creating a situation in which cash is just sitting on the shelves, when it could be used for something else. Manufacturing and warehouse managers can often reduce inventory hugely by studying and applying the principles of “lean” enterprise, pioneered at Toyota.

·       Expenses. Do you defer expenses when you can? Do you consider the timing of cash flow when making purchases? Obviously, I’m not saying it’s always wise to defer expenses; it’s just wise to understand what the cash impact will be when you do decide to spend money, and to take that into account.

·       Giving credit. Do you give credit to potential customers too easily? Alternatively, do you withhold credit when you should give it? Both decisions affect the company’s cash flow and sales, which is why the credit department always has to strike a careful balance.

The list goes on. Maybe you’re a plant manager, and you are always recommending buying more equipment, just in case the orders come in. Perhaps you’re in IT, and you feel that the company always needs the latest upgrades to its computer systems. All these decisions affect cash flow, and senior management usually understands that very well. If you want to make an effective request, you need to familiarise yourself with the numbers that they are looking at.

Third, managers who understand cash flow tend to be given more responsibilities, and thus tend to advance more quickly, than those who focus purely on the income statement. In the following part, for instance, you’ll learn to calculate ratios such as days sales outstanding (DSO), which is a key measure of the company’s efficiency in collecting receivables. The faster receivables are collected, the better a company’s cash position. You could go to someone in finance and say, “Say, I notice our DSO has been heading in the wrong direction over the last few months – how can I help turn that around?” Alternatively, you might learn the precepts of lean enterprise, which focuses on (among other things) keeping inventories to a minimum. A manager who leads a company in converting to lean thereby frees up huge quantities of cash.

But my general point here is that cash flow is a key indicator of a company’s financial health, along with profitability and shareholders’ equity. It’s the final link in the triad, and you need all three to assess a company’s financial health. It’s also the final link in the first level of financial intelligence.

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[1] There is an argument to be made, though, that it may not be desirable for your salespeople to discuss payment terms with customers in case they alienate them (except, of course, in negotiating contracts). In a “good cop, bad cop” situation, your salespeople always play “good cop” and leave the “bad cop” part to credit control.

The Power of Financial Ratios

Ratios indicate the relationship of one number to another. People use them every day. A football player’s scoring rate per matches played, that is, how many goals scored for a given number of games. The odds of winning a lottery jackpot, say one in 6 million, show the relationship between winning tickets sold (1) and total tickets sold (6 million). Ratios don’t require any complex calculations. To figure a ratio, usually, you just divide one number by another and then express the result as a decimal or as a percentage.

All kinds of people use all kinds of financial ratios in assessing a business. For example:

·       Bankers and other lenders examine ratios such as debt-to-equity, which gives them an idea of whether a company will be able to pay back a loan.

·       Senior managers watch ratios such as gross margin, which helps them be aware of rising costs or inappropriate discounting.

·       Credit managers assess potential customers’ financial health by inspecting the quick ratio, which gives them an indication of the customer’s supply of ready cash compared with its current liabilities.

·       Potential and current shareholders look at ratios such as price-to-earnings, which help them decide whether a company is valued high or low by comparison with other stock (and with its own value in previous years).

The ability to calculate them – to read between the lines of the financials, so to speak – is a mark of financial intelligence. Learning about ratios will give you a host of intelligent questions to ask your boss or CFO. And, of course, I’ll show you how to use them to boost your company’s performance.

The power of ratios lies in the fact that the numbers in the financial statements by themselves don’t reveal the whole story. Is net profit of $10 million a healthy bottom line for a company? Who Knows? It depends on the size of the company, on what net profit was last year, on how much net profit was expected to be this year, and on many other variables. If you ask whether a $10 million profit is good or bad, the only possible answer is the one given by the woman in the old joke. Asked how her husband was, she replied, “Compared to what?”

Ratios offer points of comparison and thus tell you more than the raw numbers alone. Profit, for example, can be compared with sales, or with total assets, or with the amount of equity shareholders have invested in the company. A different ratio expresses each relationship, and each gives you a way of gauging whether a $10 million profit is good news or bad news. As we’ll see, many of the different line items on the financials are incorporated into ratios. Those ratios help you understand whether the numbers you’re looking at are favourable or unfavourable.

What’s more, the ratios themselves can be compared. For instance:

·       You can compare ratios with themselves over time. Is profit relative to sales up or down this year? This level of analysis can reveal some powerful trend lines – and some big warning flags if the ratios are headed in the wrong direction.

·       You can also compare ratios with what was projected. To pick just one of the ratios we’ll be examining in this part, if your inventory turnover is worse than you expected it to be, you need to find out why.

·       You can compare ratios with industry averages. If you find that your company’s key ratios are worse than those of your competitors, you definitely want to figure out the reason. To be sure, not all the ratio results we discuss will be similar from one company to another, even in the same industry. For most, there’s a reasonable range. It’s when the ratios get outside of that range, as Sunbeam’s DSO did, that its worth your attention.

There are four categories of ratios that managers and other stakeholders in a business typically use to analyse the company’s performance: profitability, leverage, liquidity, and efficiency. I will give you examples in each category. Note, however, that many of these formulas can be tinkered with by the financial folks to address specific approaches or concerns. Tinkering of this sort doesn’t mean that anyone is cooking the books, only that they are using their expertise to obtain the most useful information for particular situations (yes, there is art even in formulas). What I will provide are the foundational formulas, the ones you need to learn first. Each provides a different view – like looking into a house through windows on all sides.

First, do no harm

 To employees

To stakeholders

 

To the community

 

To the government and institutions and laws and rules

 

To the environment…

 

Thereafter, the sky is the limit