Capital investment in production capability is the weakest link in the business value chain. It always has been and likely always will be. It’s the driving force behind the tendency towards cartels, collusion and monopolies. While it can make the first entrant into a brand new market, in the long run it usually breaks everyone, playing no favorites between the initial innovators and the late comers. It’s the problem of supply and demand in its purest form.
To illustrate the conundrum, imagine a market where each player has 20% of the total market production capacity. The first into the market enjoys the premium pricing benefits of a green field with no competition. Others soon join the party. With just four participants, everything is still peachy – only 80% of the demand can be met, so there is still plenty of margin to go around. Things tightens up with the entry of the fifth player – margins are still acceptable, but growth must now come at the cost of someone else’s market share.
But it’s that sixth entrant that ruins the fun for everyone. The industry is now over capacity. Prices get driven downward to the level of variable costs, but the elasticity of demand never seems to respond proportionally – after all, I only need one refrigerator and one washing machine, and I can only make use of so many TV’s or even automobiles. It’s essentially Garrett Hardin’s famous “Tragedy of the Commons”, where everything is fine with 99 cattle on the pasture, but where the 101st leads to overgrazing and certain environmental / economic collapse.
If you are an executive in manufacturing, you have seen this effect many times over, and it has become the bane of your existence. The opposite, lack of capacity leading to pricing discretion, is typically a euphoric but short-lived phenomenon that might happen once in your career if you are lucky.
Excluding bankruptcy or getting out of the market altogether, there are six or seven principle ways in which most businesses attempt to address this iron law of economics:
- Driving cost out of the production process and out of the supply chain. As most efficiency gains are readily copied and adapted across the industry, this is seldom a long term differentiator, but it does become table stakes – if you can’t quickly improve on costs and efficiency, you’ll be the first to fold.
- Increase the value throughput. This approach gives rise to the familiar feature / function / performance arms race. But unless one of the market players cannot keep up with the innovation, this doesn’t do much for the capitalist other than set the variable cost bar higher.
- A focus on quality. History and economics tend to look favorably on this strategy. Although at first glance an investment and focus on quality would seem to be no different than investment in feature / function / performance, the famous Faster-Cheaper-Better triad shows that "better" (i.e. quality) has long been differentiated from "faster", with its own value proposition, especially as it relates to brand loyalty and equity.
- De-risking via outsourcing of production. Huge segments of the manufacturing industry have spent the last couple of decades doing just that. If your core competency and primary differentiator is product innovation, this might make sense. Why bother with the risk of building a factory if production efficiency is not your strength? What’s lost in the bargain is operating leverage and some control over your product quality and availability. Should your product become the biggest thing since sliced bread, without the operating leverage you make the same profit on your billionth shipment as on your first.
- Consolidation, coopetition, and secondary markets. Excess and unproductive capacity is often the mother of invention. Getting your facilities back up to 100% utilization can require some creative thinking on your part, from running unrelated products through your plant to developing secondary markets for your primary products.
- The flexible factory. Now we’re talking. You are no longer stuck with being able to run only one product through the production line. Your industrial engineers set you up for long term success with a flexible factory floor design, underpinned by robotics, programmable or soft automation, analytics, and a flexible approach to IT and data management. The key to making this work, however, is “knowing when to fold them”, having the discipline to regularly get out of the commoditized, low margin products in favor of the innovations your design team is bringing forth.
- A focus on the customer, and the customer experience. While you can’t control how much excess production capacity comes onto the market, you can do a lot about your downstream access to the customer – another approach that seems to be highly rewarded by the market. It’s one thing to build it, or even to build it cheaply, and quite another to be able to match that capacity with a paying customer on the other end. This in turn requires knowing your customers, the market, and the distribution channels via customer analytics, understanding the broader market via demand forecasting, and paying attention to the service and aftermarket aspects of your total offering.
Regardless of what the strategic or value discipline approach of any particular firm might be, in the end, if product is going to be made then the capacity has got to be built, and the capital investment committed to. We can’t outsource manufacturing capacity off the planet. Someone with a core competency in production is going to take the risk, and then take the necessary steps to manage and mitigate that risk. This will likely result in higher outsourced versus insourced product costs (once we get past this current phase of global labor arbitrage). While this may be an acceptable outcome for those businesses specializing in only product design / innovation, most of the manufacturing industry will find itself concentrating on some combination of those other key differentiating characteristics mentioned earlier: flexibility, quality, service, information management, analytics and the customer.