Abstract Product prices are an extremely important and sensitive factor in the real world of business. If companies cooperate with each other and maintain prices at a high level, it is usually a practice that is in line with the development interests of various companies, but why are many companies in the abrasives industry in China?
Product prices are an extremely important and sensitive factor in the real world of business. If companies cooperate with each other and maintain prices at a high level, it is usually a practice that is in line with the development interests of various companies. But why do many companies in China's abrasives industry choose to launch a "price war"? What is the reason and purpose of the company's choice of "price war"? What is the law? When I was in elementary school, people often fight on the playground. It is often difficult to predict when a fight will be made: a boy may say that another boy does not like to listen, and the smell of gunpowder between the two sides is getting stronger and stronger, and then he fights. Fortunately, such disputes usually subside quickly and no one will be injured.
There will also be battles between companies. As I said before, working together to keep prices high is usually in the interest of companies. But the company sometimes launches a destructive price war. Although it is as difficult to predict as a campus fight, sometimes the battle between companies is regular.
The economic law of price war
The key factor in predicting price wars is a concept that economists call "Economies of scale." To understand this term, we first need to have some understanding of the company's cost structure. The company's costs are mainly divided into two categories: variable costs and fixed costs. Variable costs are linked to production, and the amount of production is related to the level of variable costs. On the other hand, fixed costs do not change with production. Regardless of the amount of production, the company will have to pay this part of the cost. For example, suppose you open a saw blade factory. The cost of the metal powder required for each saw blade is a variable cost, while the factory rent for the saw blade factory is a fixed cost.
Economies of scale come from the way the company changes its costs when it increases production at a specific time. As production increases, variable costs increase and fixed costs remain unchanged. This means that the higher the company's output, the lower the cost per product: the variable cost of each product is the same, while the fixed cost is spread over more products. Therefore, the more saw blades sold by the saw blade, the lower the rental cost per saw blade. The reduction in the average cost of this increase in production is called economies of scale.
What does this have to do with predicting the battle? If a company has a high fixed cost and its output is much lower than its potential capacity, its unit product cost will be high – because only a small number of products are sharing fixed costs. This will give the company a great willingness to lower the price of the product. Once the price of a product drops, not only can it sell more (to grab sales from competitors or increase overall sales), but it can also reduce unit costs. This is good news. The bad news is that competitors with similar cost structures also want to cut prices. The result is a price war, and the market share of companies will not change much.
The "cost" of price war
That is to say, when fixed costs occupy a large part of the total cost, market demand is very low, and the actual output of the company is much lower than its production capacity, the price war is more likely to start. We have seen this in the history of China's air-conditioning manufacturing industry. There are three companies in China that dominate this industry: Gree, Midea and Haier. During the National Day Golden Week in October 2014, Gree significantly reduced the price of air conditioners. Midea and Haier also quickly followed, resulting in a 40% price cut for some models.
A similar price war has occurred between 2002 and 2004. In those years, even though the cost of materials for air conditioners was rising, the prices of these top brands fell by 20%. The end result is that air conditioner manufacturers have changed from about 300 to 10, and those who are not profitable have all closed.
What do these two times have in common? In October 2014, due to the lower sales of new homes, the summer was also extremely cool, and air conditioner manufacturers were troubled by overcapacity. Similarly, the price war from 2002 to 2004 was also caused by oversupply and companies vying for the market. During these two periods, demand was too low, the company had excess production capacity, and there were not enough products to share their fixed costs.
How high is their fixed cost? I can only make a rough estimate based on public information. According to data since 2014, Midea's operating margin is 8.8%, 75.1% of operating income is used to pay variable costs, and 16.0% is used to pay fixed costs. From this we can calculate the "scale penalty" of the United States, that is, the cost increase caused by the downsizing. For example, if the US production is only 80% and the selling price remains the same, then the company's operating margin will drop to 4.8% (variable cost is still 75.1%, but the fixed cost will increase to 20.1 of operating income). %). Fixed costs are relatively important here because reducing production by 20% almost cuts off half of the profits. Look at Gree's financial situation and you will find a similar "scale penalty."
Does this mean that the fixed cost is not good? Not necessarily. When demand is high, companies with high fixed costs can spread them to more products than companies with higher variable cost ratios. If the sales of new homes increase and they are hit by the heat, air-conditioning manufacturers will be grateful for their high fixed costs.
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