Week 11: Best Practices 10

Ch10 Industry Cycles: Be Prepared for Trouble in Your Sector of the Economy

Chapter Opening Questions

A business manager in a capital-intensive industry needs to monitor its own industry cycles because they routinely experience ( a visual cycle of over investment, over capacity, and the price work).

Summary

Why capital-intensive industries are different

Elements that make capital-intensive industries prone to overbuilding:

• high overhead
• long lead time to put new capacity in place
• low rates of depreciation

A hypothetical example illustrating how the cost structure could induce huge swings in prices and profitability.

	mining company (VC = $25/ton, FC = $20/ton)	strawberry importing company (VC = $40/pound, FC = $5/pound)
When the price is above $45	keep producing because it is profitable	keep producing because it is profitable
When the price dips below $45 in a downturn	Little change to production. There is little flexibility because much of the cost is fixed. The company keeps operating as long as the price is not lower than VC, $25.	Decreased production. The company is flexible because much of the cost is variable. For example, it can cut production with layoffs.

The early warning system for capital-intensive industries

• A capital intensive company’s early warning system must include indicators of new capacity being added in the industry.

Managing through the industry cycle

• Recognize and understand the nature of cycles in your industry. In boom times, don’t add capacity, but instead amass cash. During industry downturns, buy out weak competitors capacity.

Think contrarian.

	A manager should:
When prices rise and competitors announce new expansion plans	Stop adding new capacity. Sock away cash and wait for the industry’s over-expansion to play out.
When writers gather up all the bad news at the bottom of the market	Pick up new capacity as troubled competitors offer up equipment and facilities at discounts. Do not move too quickly and wait for real distress by monitoring the financial conditions of weak competitors.

Summing up

• Capital intensive businesses face additional problems that other companies dont face. They are vulnerable to profit killing cycles of overbuilding.

Economic terms

Explan each of the following terms in your own words. The author explains the terms in the textbook. If necessary, you may also Google the term on the Web. Good resources include:

• The Economist
• Fun economic videos

Explain the terms in your own words briefly.

Variable Cost (page 222)

• Costs that can be eliminated by cutting production, which may include labor costs, raw materials, and energy.

Fixed Cost or Overhead (page 223)

• Expenses a company committed to paying regardless of its output. They are shown in the operating expenses section of a companys profit and loss account.

Economic Depreciation (page 227)

• The value of an asset decreases over time due to use, wear and tear or obsolescence.

Economic events

Describe the characteristics of the following events briefly.

the case of high oil prices in 2022

• When Russia first attacked Ukraine, the oil prices went through the roof, jumping from around $76 per barrel at the start of the year to over $110 per barrel. They expect that oil prices will roughly stay the same for the remainder of the year.