3 Sep 2014

Growth Vs Profitability: How can different business orientation distort a supply chain?

The construction of total revenues function is relatively easy. Revenues are the multiplication of price and quantity; and total revenues will depend on the consumer’s sensibility or elasticity to changes on price, what is generally described as demand function. Depending on the degree of market power firms ‘make’ or ‘take’ the price, which determines the quantity. Total revenues have an inverse U-shaped, and they are maximized when the demand is unit elastic. The level of complexity increases when we bring the cost function into the analysis; which is the missing ingredient to profit determination. The optimal price that maximizes profits is more challenging to find, but a standard rule says that price that maximizes profits are (significantly) larger than prices that maximize revenues.

Standard economic theory assumes that all firms are profit maximizers. With the exception of governmental and not for profit organizations, this assumption is probably true in the long run. At some point all companies pursue to produce profits, and ultimately remunerate shareholders. But, what happen when firms participating in the same industry have different business orientation? 

This is what is happening currently in the book industry, with the conflict between e-retailer and publishers. Stakeholders and investors in those companies are completely different and hence they pursue different objectives. While publishers are by nature profit-maximizers and need to remunerate authors and investors in the short run; e-retailers are revenue maximizers, and pursue to increase their installed based of customers and to increase their share value. 

Let’s analyze more in depth the e-retailers strategy with the case of Amazon. Data can be obtained from its annual reports and Nasdaq. Figures attached show:
  1. Amazon has had an exponential growth in revenues from 2000. The average annual growth rate in the period 2000-2006 was 23%, which increased to 28% in the subsequent period, 2007-2013.
  2. There is a huge correlation between revenues and share price. After 2000 the correlation between those figures is almost 95%. 
  3. Amazon is a company that hasn’t had significant profitability from their outset in 1997. From 2003 to 2013 its profit margin rate has been close to 0%, just avoiding losses. 
  4. There is not significant correlation between profit margin rate and market share. 
But, what is the impact of e-retailers’ business orientation on revenues growth in the supply chain? As theory predicts revenue maximizers want to set a smaller price than profit maximizers. This goes against to their providers - the publishers - who have preference for profits. This dispute is distorting all the book industry; and we can see the evidence in press. For instance, the ‘famous’ dispute between Hachette and Amazon, who are currently in negotiation of new agreements on how to price Hachette’s books. 

The dynamic nature of the book industry (i.e. introduction of digital formats) make it very difficult to make predictions about how is going to evolve the power and structure in the supply chain. Some constructs like consumer value, operations, costing, or managerial perceptions, are in clear evolution and change. All these topics will be explored in the following years from different angles, and I expect to add relevant insights within the umbrella of QVaDiS research group and our industry partners.

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