A business manager in a capital-intensive industry needs to monitor its own industry cycles because they routinely experience a viscous cycle of over-investment, over-capacity, and the price war. There are wide swings in the market products and the profitability of capital-intensive industries.
Capital-intensive industries are prone to cycles of over-investment in capacity, leading to prolonged periods of unprofitable operations. Cycles in these industries are worsened by long lead times for capacity additions and low rates of depreciation.
Elements that make capital-intensive industries prone to overbuilding:
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. |
A capital intensive company’s early warning system is rather easy to figure out: These companies have to include indicators of new capacity added within the industry. Actual time-lines are possible in this early warning system.
Managers must recognize and understand the nature of cycles in the focused industry. During economic booms, it is wise to amass cash rather than add capacity. During downturns, buying out weaker competitors’ capacity is a smart move.
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. |
Capital intensive businesses face additional issues other companies do not. They are vulnerable to profit-killing cycles of over-building. Attention to adding systems of monitoring industry-level capital investment is important.
Explain 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:
Explain the terms in your own words briefly.
Variable costs are defined as costs that can be eliminated by cutting production including labor costs,materials, and energy.
These are costs that can be fixed in the short run. Interest, depreciation, insurance, and administrative are all examples of Overhead.
This considers both physical wear-out of equipment and obsolescence. This reduces the amount of effective capital.
Describe the characteristics of the following events briefly.
The aftermath of Covid-19 in 2021 caused global shortages across the oil industry. Prices for oil, gas, and electricity sky-rocketed. Oil prices became cheap before Covid-19 because of supply and demand. Once Covid hit oil became extremely cheap because there was so much with so little need with people staying home because of teh pandemic. Oil producers stopped production rates. Once the Pandemic ended, a conflict escalated between Russia and Ukraine. Sanctions on Russia halted exported oil from Russia and oil prices soared. America is the largest producer of oil in the world but it still isn’t producing enough oil per day to allow this country to be energy independence. America still imports oil every day from the Middle East. Interestingly American energy companies and investors fear that prices on a barrel of oil will stay high enough for the companies to make profit from more drilling. There is a stand-off between oil executives and investors on Wall Street that is basically halting the production of more crude oil and the American people are suffering because of it.