The Capacity Trap II
I'm a very competitive guy who generally hates to lose, but sometimes I'm happy to see a competitor walk away with a contract I wanted. That happened a few months ago when a new records-storage company entered the market and undercut my bid on a large city contract. The competitor had offered a monthly rental fee of 13¢ per box, about 40% below my bid. I just laughed. At that price, I didn't want the business. Frankly, I couldn't see why anyone else would want it either.
A couple of weeks later, the guy who won the contract--we'll call him Jerry--came to see me. The owner of his company is a friend of mine and had asked me to give him some pointers. I quickly realized that Jerry was perplexed at how the bidding had gone. "I was surprised you didn't come in lower," he said.
"I'd never bid what you did," I said. "There's no way you can justify 13¢ a box. You're losing money on the deal."
"That's not true," he said.
"Oh, no?" I replied. "Let me show you something."
We sat down, and I took out a pen and paper. I asked Jerry how high his building was and then calculated the number of boxes he could fit from floor to ceiling. Since we knew the total number of boxes involved and the size of each box, we could figure out how much floor space the stored boxes would take up. We also knew the total monthly revenue from those boxes. Dividing the revenue by the floor space, we determined that Jerry would be getting monthly rental income of $6.60 per square foot for storing the boxes. "You could rent that warehouse to another guy for $8 or $9 a square foot, and he would pay the taxes, the heat, and the lighting. With this deal, not only do you get less revenue but you have to cover all those expenses yourself."
"Omigod," said Jerry. "I never thought of it that way."
Now I know some people would argue that Jerry did the right thing. After all, his warehouse was empty at the time. He was already paying the taxes, heat, and lighting, as well as numerous other expenses. Even at 13¢ a box, the city contract would help him cover those expenses. So why shouldn't he have taken what he could get? Something is always better than nothing, right?
The answer is, no. People who don't understand that wind up in what I call the capacity trap. I'm referring here to the common practice of accepting a lower price than usual because you have unused capacity. The extra capacity might take the form of an empty warehouse, or a truck standing idle, or machinery that's used only sporadically, or even the time of, say, a consultant. When an opportunity comes along to sell that capacity at a reduced rate, most people find it hard to refuse. They think only about the money they're going to make on something that would otherwise go to waste. They ignore the problems they'll create if they charge significantly less for their service than it's worth.
I can think of three or four good reasons for insisting on full price even if you have excess capacity. I've already alluded to one reason: the cost of capital. People invest in things like trucks, machinery, and warehouses because they want a better return than they'd get if they did something else with their money. The more you do for a customer, the better return you should expect. Look at Jerry. What sense does it make for him to go to all the trouble and expense of having a records-storage business when he could do better being a landlord? In fact, it should always raise questions if you find that you could earn more money by using your capital another way. Unless you have a clear plan for improving your returns in a specific time frame, you're probably doing something wrong.
Some would argue Jerry did the right thing. After all, something is always better than nothing, right?
Along with capital costs, there's also opportunity cost to consider. Low-margin sales tend to crowd out high-margin sales. Suppose, for example, that you own a small job shop, and business is slow. In order to avoid letting your machinery stand idle, you load up on work at half the normal rate. That seems all right, but then what do you do when a customer comes along ready to pay the full price? Do you even bother looking for full-price customers? You don't have much to offer them if you've used up your capacity on low-margin sales.
But the biggest problem with discounting excess capacity has to do with its effect on your existing customers. Sooner or later, they'll find out that someone else is paying you less than they're paying for the same product or service. You won't have to tell them. Your competitors will. At that point, most customers will have one of two reactions. Some will demand the same discount, threatening to leave if you don't give it to them. Others won't bother to ask for the discount. They'll just take their business elsewhere, convinced that you've been dishonest with them. Either way, you'll erode your margins while alienating the very customers you need to be successful in the long run.
I saw a classic example of this in my industry a few years back. One of my competitors was about to move into a large new warehouse when the sale of his old warehouse fell through. For various reasons, he couldn't line up another buyer, and so he suddenly found himself with a ton of excess capacity. Soon thereafter we began getting calls from our small customers saying that the competitor was offering them rates normally reserved for only the largest accounts. It turned out that he'd hired telemarketers and was soliciting every business in New York City in an attempt to fill his warehouses.
So what happened? While he went after our small-volume customers, we went after his large-volume customers. He was charging his big accounts--those with 10,000 boxes or more--the same rate he was giving to accounts with 500 boxes. As a result, we were able to take some of his big customers away. Meanwhile, we bided our time, knowing that the competitor would have to raise the small clients' rates drastically when the initial contracts expired. Sure enough, he did, and the clients weren't happy about it. We're signing up a lot of them right now.
Of course, there are exceptions to every rule, and this one is no different, as I've come to appreciate since I last wrote about the capacity trap (see Street Smarts, August 1996). Back then, I said it was always a bad idea to sell unused capacity at a discount, but I have to admit that the practice does make sense occasionally, as long as two conditions are met: First, you and the customer must agree upfront on the duration of the discount and what will happen when it expires. Second, you must be able to explain the deal to other customers who raise questions about it. They need to feel that you've been fair.
Earlier this year, for example, I used some of my excess capacity to take a 200,000-box account away from my largest competitor. The customer had discovered that it was paying above-market rates, thanks to a series of automatic price increases, and had begun looking for another vendor. We proposed a 10-year contract with the first two years heavily discounted. We could make that offer because we temporarily had a lot of extra space in one of our warehouses. In the third year of the contract--when the customer would start paying normal rates--the new warehouse we plan to build would be finished; we'd replace our construction loan with a mortgage; and the increase in revenue from that one account would cover the monthly mortgage payments.
So the customer knew in advance exactly what the deal was. And if other customers ask me about it, I can point out that we gave all of them discounts in the beginning as well. I can even offer them the same deal we've given our new customer--provided they're willing to sign a new 10-year contract for 200,000 boxes.
That's an unusual situation, however. In general, it's a bad idea to discount excess capacity, as I think Jerry now understands. Recently I bid against him for another contract. He didn't get it--neither did I--but the price he bid would have given him a better return than he could have gotten by renting the place out. So at least he can take comfort knowing that he wouldn't have hurt himself if he'd won.
Ask Norm Redux
I got some great feedback to the October "Ask Norm" column, and I thought I'd share with you two e-mail messages that shed additional light on the issues I addressed. Mike, who owns a business in southern California, said he got a kick out of my advice to the company owner facing competition from an ex-employee. I had told the owner to forget about it and focus on his business. "As an employer of over 350 people in the collection business, I faced a similar situation, except that there were not one but three key employees who quit to compete," Mike wrote. "I had no problem with the quitting part, but they crapped on my bankers and decided to take customer records as well as proprietary software on their way out. Suppressing my urge to crush their new venture with hundreds of thousands of dollars in legal fees, I did nothing and stayed focused. Within two years, they had all sued one another; their business had failed; and--here is the best part--their investor had sued them and turned the judgment over to me for collection. Indeed, revenge is a dish best served cold."
I can understand how sweet that must be for Mike, but revenge isn't always on the menu. Sometimes your ex-employees are going to succeed, as much as you might wish that they would fail. The point is to stay focused on your own business no matter what.
Douglas Bristow of the Project Reports in Marietta, Ga., was interested in the executive who worked for a Fortune 50 company and was looking for a start-up he could donate his time to. "I have had exactly the opposite problem," wrote Doug-las, who had been a big-company executive before leaving to start his business almost 25 years ago. "Because of my lack of sales and marketing skills, I have not been able to grow the company to anywhere near its potential. I would gladly have given partial ownership to a big-company executive who could have provided the expertise I needed. Of course, there's an inherent problem with using big-company executives as small-company advisers: They often have a hard time adjusting their thinking to the small-company level. I remember my own difficulty understanding the value of a penny as opposed to a dollar when I went out on my own. Starting or running a small company can be a humbling experience for people coming from a large corporate environment. On the other hand, I have never been sorry that I took the plunge."
I agree that it can be a challenge for big-company executives to adjust to small-company circumstances. Many of them aren't used to working in an environment in which resources are scarce. That said, it's always worthwhile to get advice from experienced business people. You have to evaluate the advice and decide for yourself what to do with it, but if you have the opportunity to hear the voice of experience, you should listen.
Norm Brodsky (email@example.com) is a veteran entrepreneur whose six businesses include a three-time Inc. 500 company. His co-author is editor-at-large Bo Burlingham.
NORM BRODSKY | Columnist
Street Smarts columnist and senior contributing editor Norm Brodsky is a veteran entrepreneur who has founded and expanded six businesses.