(bare with me guys, this is my day off and I feel like writing up posts. )


This post is intended to glarify things by a simple example.

But first a short introduction

I know this is the way industries like consumer electronics do things (TV’s for example). In the past there used to be only three production lines for television tubes (now we all have flat screens), but we easily had 30 TV brands from which we could choose. Even if we bought a Aristona TV set; at its core was still a Zenith, Sony or Phillips tube. These three companies together controlled 100% of the world market and simply selected the best tubes for their own high flying brandnames and then sold the lesser tubes (various grades) to other companies or created a separate brandname to act as an (undercover) outlet for the tubes that were disguarded for their own high quality brandnames. In fact this is a profitable business model and it is copied by many other industries.

Say we have a single production line were quality control is either limited to say a 30% variation or further improvements in quality control are too expensive to be economically viable. Similar situation are fact quite common. Say each product costs 240 Euro’s to produce and ship (uncorrelated to the quality variation) and the variation among all products is random. Lets assume that the distribution of the variation is uniform; this means that each individual grade occurs about as many times in a single batch. In short, there is no dominance by a single grade or a group of grades. This assumption is made to simplify the example, but the principle explained is still valid for more complex distributions. Lets also assume that each product grade (five in total) is expressed as a weight. These being respectively 7.5 kg or lighter, 7.5 to 8.0 kg, 8.0 to 8.5 kg, 8.5 to 9.0 kg and 9.0 kg or higher. Of course these values are chosen completely arbitrarily !

Summarizing :

240 Euro’s per item fabrication/shipping costs

Five qualities groups

< 7.5 kg
7.5 to 8.0 kg
8.0 to 8.5 kg
8.5 to 9.0 kg
> 9.0 kg

A company like Phillips, Sony or Zenith would then first disguard the true outliers on both sides as these are just to far away from the norm (quality wise) to even be sold to adventurous price-stunters. Some margin of dependability and respectabilty must be maintained; although it is rumoured that Africa is awash with such products. Therefore 40% of the production is disguarded immediately. Leaving 60% of the production to be sold as products of acceptable but varying grades.

The unit cost per approved product has to be raised to compensate for the money lost on disguarded products, thus resulting in a unit cost that is now 400 Euro’s per (approved) item. Now this batch of varying grades is subdivided into quality groups.

The first much sought after group of 7.5 to 8.0 kg weights is given a price tag equal to 3 times 400 Euro’s.
The medium quality group of 8.0 to 8.5 kg weights is then given a price tag of 2 times the 400 Euro’s
The third quality group is of 8.5 to 9.0 kg weights is then given a price tage of a single unit of 400 Euro’s

Now lets assume there is also a handcraft department that makes custom-order-all-carbon products of 6.0 kg weight at a price tag of 3400 Euro’s. The brochure of the company to the customer or business partner will now look like this.

Standard price for a 8.5 to 9.0 kg grade product (= 400 bucks)
+ 400 Euro’s for a 8.0 to 8.5 kg grade product upgrade
+ 800 Euro’s for a 7.5 kg to 8.0 kg grade product upgrade (= top of the production line)
+ 3000 Euro’s for a 6.0 kg hand build carbon product upgrade

The customer can now decide what he feels is the right balance between quality grade and costs for him. Of course the distribution of pricing is such that even when all customers choose to pay for the (top of the line when not hand build) 7.5 to 8.0 kg group that the supplier will never loose any money. Afterall, each customer in that group effectively pays for the other 4 lower graded and disguarded masts as well. These can now be sold as scrap aluminium or be sold under their market price without any loss of investment. When done right the producer can earn even more money that way. The combined earnings (after profits) can then be spend on a new batch of products with the same quality distribution.

If for some reason all customers decide that the standard grade product (8.5 to 9.0 kg) is expensive enough for them then the supplier can always unload the higher grades into that pool without any complaints by the customers. Who will refuse a free of charge upgrade ? A smart company will them make lots of hoopla about how they present a special offer for the next 3 months where they waver the upgrade price if you buy a product now. Thus get some promotional value from their surplus of high quality products (without losing any money on the deal !)

If by expectation the bulk of customers decide for the mid range product (8.0 to 8.5 kg) then the supplier is guaranteed the highest profit margins of all options. For he can sell 67 % of the entire approved batch against double the single unit price and ALSO have some special offer free-of-charge upgrades promo actions. Thus netting him 30% higher profits with additional promo then when all customers decide for either exclusively the top category product or the lowest catagory product.

That is indeed how many companies operate these days.

So why not the F16 class ?


Regards,

Wouter