A business manager in a capital-intensive industry needs to monitor its own industry cycles because they routinely experience a repetitive cycle of over investment, over capacity, and price changes. This leads to long lead times on expansions and slow rates of depreciation within the industry.
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. |
The early warning systems for a industry that is capital-intensive is fairly straightforward. They need a way to measure new capacity coming online in its industry and an actual timeline. This timeline need to include all important data for the industry, an example of this would be when something is ordered. That way you would be able to track competitors movement.
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 are extra volatile and therefore need extra layers of protection in their early warning systems.
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 those costs that can be eliminated by cutting production. This may include labor costs, raw materials, and energy.
Costs that are fixed in the short-run are overhead: interest and depreciation, insurance, and some administrative staff expenses. These expenses are not reliant on the amount of goods/services the business produces.
Economic depreciation is also the same as tax or accounting depreciation, it is a depreciation of the market value of an asset over time. Economic depreciation considers both physical wearing out of equipment as well as obsolescence.
Describe the characteristics of the following events briefly.
The most evident reasoning for the increased oil prices is the war between Ukraine and Russia. As Russia is one of the biggest oil providers of the world, them invading Ukraine lead to countries stopping their importation of Russian oil. This sudden lack of oil lead to the drastic increased prices we are experiencing today.