Late Night Discussions
Number 10

by Dr. Eliyahu M. Goldratt

The minute we sit ourselves down, I say to Jonah, "If you don't mind, I would like to go back to our open subject."

"Which is?"

"Companies facing a market downturn." I answer firmly.

"What about them?" he asks, as if our previous long discussion had never taken place. With some effort I control my impatience and calmly say, "What should a company facing a market downturn do, if it doesn't want to suffer the devastating consequences of having to layoff many of its employees?"

"Exactly what any company, under any circumstances, should do. Not to allow artificial barriers to stand in its way."

Tonight it won't be easy, not when Jonah is in this aloof mood.

"Jonah!" I slightly raise my voice. "Can you be somewhat more specific?!"

He raises his eyes from the fire and smiles at me. "Alex, judging from your impatience, I take it that you didn't bother to follow the clues that we mentioned last time. Are we falling back to the mode of 'give me the answers!'? What happened to our decision to search for answers ourselves?"

"I'm all for searching for the answers, I'm simply against unclear general statements or even worse, unclear clues."

"You have a point," Jonah calmly says, "let's do it your way." He pauses to light his cigar and continues, "What do you think determines the market price for products?"

I sigh in relief; at last the discussion is starting to move. "Market prices," I answer confidently, "are determined by the market perception of the product value and its availability."

"Should the market be regarded as one entity? Is the perception of the market, on the product's value, uniform?" he asks.

"Definitely not," I answer. "Different segments of the market might have different perceptions of the value of the same, or almost the same, product. Very frequently a company has the opportunity to sell its products in a segment of the market for a price that is considerably different, alas usually lower, than it is currently sold for in another segment."

Jonah nods his head, puffs once more and says, "Alex, you have used twice the term market segment, can you define it for me?"

Defining terms is not easy, but Jonah is right, if key terms are not defined the end result is usually confusion. "The market is not uniform," I slowly start, "at least not in the way it assigns value to specific products. So market segments exist for sure. But how am I going to answer your question? What might be a good definition for a market segment?" I'm stuck.

"Why won't you try to first define 'segmentation'?" comes Jonah's suggestion. Good idea. "Two sections of the market will be called segmented from each other if changes in product price in one section do not cause any corresponding price change in the other section. The segmentation can be caused by many reasons: geographical distances, different guarantees given by the manufacturer, different packaging, different service levels, etc. What is important to realize is that price does not cause segmentation, it is a measure of whether or not segmentation exists."

"Carry on," he encourages me.

With more confidence I summarize, "A section of the market will be called a market segment if changes in product price done in this section will not cause price changes in the rest of the market.

Jonah nods his head in approval and asks, "And you claim that for most companies market segments exist?"

"Yes, definitely."

After some more thought I add, "Provided that they will be careful, when they do business in those segments, to stress those ingredients that guarantee the segmentation. But Jonah, as I said before, most of those segments are for lower prices than the segments in which the company already operates. Many times even lower than the product's cost. How can it help a company in trouble?"

"We are talking about a company facing a market downturn, a company whose sales have dropped," Jonah reminds me. "Does such a company have excess capacity?"

"Yes, of course. Most companies under normal situations have excess capacity on some of their product lines, but a company in a market downturn has, by definition, a lot of excess capacity. For such companies, satisfying a market segment's need does not require almost any increase in operating expenses. As long as the price offered in the segmented market is higher than the totally-variable cost of the products, it will definitely increase the company's bottom line and improve its cash."

"Alex, are you sure that if the price offered in that market segment is below the 'product cost', nevertheless profit and cash will be improved?"

I'm looking for the catch but cannot find any. The company already has the machines, the building, the know-how. The company doesn't want to write off its major investments in its employees by laying them off. The reduced prices offered in the segmented market do not affect prices in the markets in which the company is currently operating. "Jonah, I'm convinced that only benefits will result. Profit will definitely go up, and more importantly, cash will improve. You know, come to think about it, most companies don't usually consider those segments as viable and thus grossly underestimate their size. In my opinion, considering the vast, open opportunities hiding in those unearthed segments and the fact that most companies have considerable excess capacity, the impact on the company's bottom line might be much more than we usually estimate. It can easily swing them into the black."

This idea captures me. From the work I've done in my plant, I came to appreciate the magnitude of excess capacity that exists even in a well run plant. I also learned by how much this capacity can be increased if a company is willing to hire some more direct labor, to man the third shift, etc. Increasing expenses by a few percent can easily increase available capacity by more than thirty percent. Now, let's suppose that a company will not just eagerly try to search for the existing market segments but actively work to create segmentation. By small innovative changes in the existing products combined with changes in the way they are offered to the market, most companies can easily create many new segments.

Jonah, examining the expression on my face, bursts out in laughter. That irritates me a little. "Don't you think that..."

"Hold your horses," he calms me down. "Before you dive into developing a company's strategy based on market segmentation, don't you think that it will behoove us to examine what blocks companies from doing it today?"

"Good idea. But Jonah, I frankly cannot see any logical reason to prevent companies from embarking on this path."

"What about illogical reasons?" comes the cynical response.

I raise my hands in despair. "How can I figure out an illogical reason?"

"Quite easily," he says. "What we call an illogical reason is not intrinsically illogical, it is simply the case where the starting point of the logical argument is erroneous, usually founded on a fact that no longer exists."

Since this doesn't help much, I wait for him to continue.

"Alex, we have to remember that the notion of 'product cost' is accepted to the extent that most managers have already forgotten that it is nothing more than a numerical phantom, a result of some allocation games. What is the almost instinctive reaction of managers when you suggest to them to sell a product below its calculated 'product cost'?"

"They will be convinced that this action will cause them to lose money, at least in the long run."

"You see. You have just proven that under very common conditions the exact opposite exists, but the erroneous notion of 'product cost' is blocking most managers from realizing it." When I nod my head, he continues, "But the bigger stumbling block that your suggestion is facing comes from the notion of a 'uniform product price'. You see, since most managers fully accept the notions of 'product cost' and 'product margin,' for them product price is just the summation of those two. How do you think they will react to your suggestion to sell the same product, at the same time, for two considerably different prices?"

"They will probably claim that it's unfair. Hey, wait a minute, isn't that exactly what the Japanese are doing?"

This "Late Night Discussion" is Copyright © 1992 Dr. Eliyahu M. Goldratt