Consumer surplus is an interesting word that I picked up recently from a very well-travelled CFO client. Why is it significant? We look at financial numbers every quarter by segment and by region because these are aligned to accountabilities. But do they capture the health of a running business?
Businesses make or lose money for a variety of reasons. Analysts pore through tons of environmental, competitive and policy information to try and get a grip on how their portfolio companies will fare on their forecasts. But here’s what puzzles me. Tail winds are usually unpredictable and non-sustainable – whether the FED changes interest rates, or the price of a barrel of oil moves, they may well impact the numbers. But both have little or nothing to do with the intrinsic value of a business. So the question is, outside of the sailing weather, is the ship strong enough to make the journey at speed.
If you look at the best businesses in the world, they don’t derive their value from supply side efficiencies. They almost always win on the demand side. Easier said than done, but far more rewarding and sustainable in the long term.
And the argument is not about the Apples or the BMWs. It is as much about a Starbucks and a Hyundai which operate in cutthroat environments like retail and automobile, and yet enjoy high margins. This is not because they are the cost leaders in their business. If you look at their MIS carefully you will find that their ASPs (average selling price) is better than the competition for comparable offerings. If you go back a little further, you will find two more interesting bits of information. Normally these businesses enjoy high loyalty and high advocacy. In other words, they command better pricing at a higher level of predictability.
The health of these businesses are directly reflected, in what my CFO friend refers to, as their consumer surplus. The definition and delivery of their value proposition converts into volumes and pricing that the competition cannot hope for. Businesses that can consistently generate high consumer surpluses are usually the ones that enjoy investor confidence and hence high PE ratios. Interestingly, in such cases no one in the system is winning at anyone else’s cost. Suppliers are usually paid decently and on time, employees are well recognised and rewarded, trade partners are happy and the consumer is a contented, loyal advocate. Can one expect low shareholder returns from such firms?
Nirvana indeed. But rare is that enterprise that can line up all these ducks in a row. I have had the good fortune of dealing with some very accomplished manufacturing businesses. The better ones will be highly evolved on supply chain, manufacturing and logistics. As a result, the rate of wastage is low and their costs rank among the best in the world. Bharat Forge and the like have made supply side efficiency into a fine art. You can name a dozen Indian firms off the top of your head that fall into this bracket.
Ironically, consumer surplus is not as much hard work and is more financially rewarding. It just needs the same management focus and bandwidth as the supply side. The healthiest firms have very strong systems on the demand side as well. Think of this: firms like McDonald’s and Forbes don’t run operations. They generate most of their earnings from licensing their brand. So all they have is brand management systems and metrics.