SELF TEST #19A: Type of Industry and Its Profitability

Test #1:
When should a company spend time and money to develop specific forecasts of future prices?

Answer:
This effort is likely to be worthwhile only in industries with low marketing and sales expenses. These are usually cyclical industries with high capital intensity. Industries with normal to high marketing and sales expenses should concentrate their analyses more on the likely expansion of competitors due to high prices and margins in the industry.

Test #2:
What rough guideline might we use to determine whether an industry has low marketing and sales expenses?

Answer:
If the industry has gross margins of 10% or below and has high capital intensity (measured by net capital employed to sales in the Company situation or allocated assets to sales in a business segment analysis) the Company is likely to be a low marketing and sales expense industry.

Test #3:
What is Price?

Answer:
Price is the net cash equivalent a customer pays to a company for its product. In the economic sense, Price is the cost of the next increment of product availability, or industry capacity, that could be brought to the market.

Test #4:
When is Price likely to go up in a market?

Answer:
The Price is likely to rise in a market when there is less availability of product, or capacity, than the industry needs. Price must rise to bring new capacity to the market.

Test #5:
When is Price likely to go down in a market?

Answer:
Prices have an increased likelihood of falling in any market where product availability exceeds current demand. Usually, this occurs as the result of new entrants, low cost competition expansion or demand shrinkage.

Test #6:

What levels of return on equity make an industry a high or low return industry?

Answer:
If the industry has an average return on equity below 8%, the industry is a low return industry and will have many of the characteristics of a Hostile market. If the industry has an average return on equity of 14% or more, it is a high return industry.

Test #7:
Why are high returns a potential problem for an industry?

Answer:
While most industries would like high returns, the industries with high returns attract both new entrants and the expansion of competitors already in the market. If these expansions occur at a rate greater than demand grows, prices and margins in the industry will come under pressure.

Test #8:
What is defensive pricing?

Answer:
Defensive pricing uses tactics which seek to arrest, or minimize, the decline in average prices in an industry. You see defensive pricing in industries where prices are falling.

Test #9:
What is offensive pricing?

Answer:
Offensive pricing raises margins or sales volumes using price. Offensive pricing occurs in industries where prices are generally stable or rising. These Offensive tactics seek to raise the average industry price from its current levels. In some falling price environments, a company may have an offensive pricing opportunity to use a unique low price to win additional sales volume.

Test #10:
What is the practical effect of a Price?

Answer:
The practical effect of a Price is to regulate the amount of product available to customers in the market. If the Price rises and increases margins, there will be more product availability. If the Price falls and margins decline, there will be less product availability. The Price balances product availability, or industry capacity, with customer demand.

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