Leslie Pratch on Assessing and Developing Leaders

By Leslie Pratch

When I was getting my M.B.A., I outlined what I considered most useful to digest the curriculum and to help my classmates preparing to interview for consulting firms. Nearly a decade later, I realize these notes may be helpful to first- and second-year M.B.A. students at Chicago Booth (and elsewhere) who are boning up for interviews with consulting firms. I offer them freely and if they are helpful, encourage your use of them, especially if you are pursuing a leadership position in a consulting firm.

When considering new product opportunities, consider four categories of new products:

(1) Existing market; existing product (i.e., enhanced product)

(2) Existing market; new product

(3) New market; existing product

(4) New market; new product

When marketing a new or existing product, remember the four P’s-the four things you can tweak when marketing a product:

(1) Product:

(a) Design/packaging

(b) Bundling of product with other products

(c) Services and warranty

(d) Price/Quantity ratio—how large of a segment is willing to pay for your level of quality

(2) Price

(a) Discounts

(b) Price discrimination (e.g., coupons)

(c) Economic incentives to distribution channels (e.g., commissions)

(3) Promotion

(a) Advertising

(b) Branding/Image

(c) Consumer education (about how to use your product)

(d) Public relations/reputation

(e) Grow the market as a whole

(4) Place (i.e., distribution)

(a) Experiment with channels

(b) Strengthen channels

(c) Focus channels

(d) Decrease costs

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Leslie Pratch, Ph.D. is a clinical psychologist with an M.B.A. in Strategy and Finance and a B.A. in Religion from Williams College. She works with boards of directors and private equity investors to select and develop executives. She can be reached at (312) 464-7919 or email her at leslie@pratchco.com or visit www.pratchco.com.

By Leslie Pratch

When I was getting my M.B.A., I outlined what I considered most useful to digest the curriculum and to help my classmates who were preparing to interview for consulting firms. Nearly a decade later, I realize these notes may be helpful to new M.B.A. students as well as to those in their second year at Chicago Booth who are boning up for interviews with consulting firms. I offer them freely and if they are helpful, encourage your use of them, especially if you are pursuing a leadership position in a consulting firm.

Market Structure

(1) The number and size distribution of the firms in a market

(a) Key determinant:  Magnitude of demand/minimum efficient scale = “natural” number of competitors in the market.

(b) Capital-intensive industries should have fewer firms because economies of scale exist, giving advantages to large firms (George Stigler’s “survivor principle”).

Fixed Costs/Variable Costs

(1) Fixed costs cannot be adjusted in the short term

(2) Variable costs are those that vary directly with the level of production

(3) If fixed costs are high, capacity utilization is the key to success

(4) Fixed costs may jump if capacity can only be added in large chunks

(5) If anticipated volume is low, AC may be minimized by investing in lower fixed costs (e.g., capital) and accepting higher variable costs per unit (e.g., labor)

(i) Examples of Fixed Costs:

(a) R&D Costs

(b) Rent

(c) Administrative salaries

(d) Interest on debt

(e) PP&E depreciation

(ii) Examples of Variable Costs:

(a) Raw materials

(b) Labor

BCG Growth/Share Matrix

Firm plays the role of a banker with cash cows funding Stars and Problem Children early in their product life cycles in order to promote learning economies rapidly.

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Leslie Pratch, Ph.D. is a clinical psychologist with an M.B.A. in Strategy and Finance and a B.A. in Religion from Williams College. She works with boards of directors and private equity investors to select and develop executives. She can be reached at (312) 464-7919 or email her at leslie@pratchco.com or visit www.pratchco.com.

By Leslie Pratch

When I was getting my M.B.A., I outlined what I considered most useful to digest the curriculum and to help my classmates who were preparing to interview for consulting firms. Nearly a decade later, I realize these notes may be helpful to new M.B.A. students as well as to those in their second year at Chicago Booth who are boning up for interviews with consulting firms. I offer them freely and if they are helpful, encourage your use of them, especially if you are pursuing a leadership position in a consulting firm.

Economies of Scope occur when the total cost of producing two goods is less within one company than within separate companies.

Why do economies of scope exist?

(1) Indivisibility:  Manufacturing multiple products allows firm more fully to utilize plant capacity

(2) Shared inputs can be applied to products produced at different plants

(a) Specific examples of economies of scope:  R&D spillovers

(b) Hub and spoke network economies of scope:

(i) An airline that serves a route such as Indy-Chicago as part of a hub and spoke network in which Chicago is the hub will have a lower average cost than an airline that only serves the Indy-Chicago route point-to-point—more people will travel the Indy-Chicago route because they can get to other destinations in the network.

(3) What Cost Drivers Exist, Independent of Scale, Scope, and Cumulative Experience?

(a) Location

(b) Infrastructure

(c) Coordination

(d) Economies of Density

(i) Focus of production activities (many products versus few products)

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Leslie Pratch, Ph.D. is a clinical psychologist with an M.B.A. in Strategy and Finance and a B.A. in Religion from Williams College. She works with boards of directors and private equity investors to select and develop executives. She can be reached at (312) 464-7919 or email her at leslie@pratchco.com or visit www.pratchco.com.

By Leslie Pratch

When I was getting my M.B.A., I outlined what I considered most useful to digest the curriculum and to help my classmates who were preparing to interview for consulting firms. Nearly a decade later, I realize these notes may be helpful to new M.B.A. students as well as to those in their second year at Chicago Booth who are boning up for interviews with consulting firms. I offer them freely and if they are helpful, encourage your use of them, especially if you are pursuing a leadership position in a consulting firm.

Two ways to evaluate efficiency of vertical relationships

(1) Technical efficiency: Is the relationship such that the least-cost means of production is being employed?

(a) Is the supplier at MES?

(2) Agency efficiency:  Is relationship such that coordination, agency, and transaction costs are minimized?

(a) Coordination: Do activities that protect private information cause inefficiencies?

(b) Do the supplier and producer know each others’ needs (i.e., are not carrying unnecessary inventories on either end)?

(c) Transactions—are we spending time haggling over contracts?

(c) Agency: Is the supplier acting in best interest of producer?

(3) Technical efficiency often increases with outsourcing; 1^st two types of agency efficiency increase with vertical integration; last type with outsourcing.

Market-based evaluations of Vertical Integration

In addition to achieving the optimal balance between technical and agency efficiency, a firm may vertically integrate in order to:

(a) Undo the effects of imperfect competition

(b) Double marginalization:  Each firm sets MC = MR without taking into account the effect of its pricing and production decisions have on the other firm’s profits. Occurs when one party has market power. Profits would be higher if they combined and set MC = MR as a whole.

(c) Price discriminate

(d) Foreclose entry or avoid foreclosure (e.g., integrate backward to lock up scarce input)

(e) Acquire information in incomplete information markets

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Leslie Pratch, Ph.D. is a clinical psychologist with an M.B.A. in Strategy and Finance and a B.A. in Religion from Williams College. She works with boards of directors and private equity investors to select and develop executives. She can be reached at (312) 464-7919 or email her at leslie@pratchco.com or visit www.pratchco.com.

By Leslie Pratch

When I was getting my M.B.A., I recorded  what I considered most useful as a means to digest the curriculum that was new to me and as a way to help my classmates who were preparing to interview for consulting firms. Nearly a decade later, I realize these notes may be helpful to first- and second-year M.B.A. candidates, especially those at Chicago Booth who are boning up for interviews with consulting firms. I offer them freely and if they are helpful, encourage your use of them, especially if you are pursuing a leadership position in a consulting firm.

(1) Firm Specific Investments

Example of rent and quasi-rent. Supplier considering firm (buyer)-specific investment:

Capital investment = $40M

Required return = 5% = $2M/year

Variable production costs = $3M/year

What is ex ante revenue requested for supplier to take investment? = 2+3 = $5M

If ex post next best alternative use of investment yields $3.5M, then quasi rent, the amount buyer can bargain out of seller before seller exits is $5M – $3.5M = $1.5M

(2) Non-Specific Investments

There are no quasi rents because the opportunity cost is $5M (supplier can just sell product on market).

Hold-up problem—redistribution of quasi rents that benefits one party at expense of other; may discourage investment in the first place or result in ex post transaction costs (lawyers to haggle out re-negotiation of contract)

When the self-interested behavior of independent firms jeopardizes the value of these investments, integration is a solution.

Grossman-Hart—ownership of specific assets should be given to entity that has the greatest effect on the overall profitability of the venture. Using its residual rights of ownership, it will use the asset in order to optimize its larger part of the profit pool.

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Leslie Pratch, Ph.D. is a clinical psychologist with an M.B.A. in Strategy and Finance and a B.A. in Religion from Williams College. She works with boards of directors and private equity investors to select and develop executives. She can be reached at (312) 464-7919 or email her at leslie@pratchco.com or visit www.pratchco.com.

By Leslie Pratch

When I was getting my M.B.A., I recorded what I considered most useful to digest the curriculum and to help my classmates who were preparing to interview for consulting firms. Nearly a decade later, I realize these notes may be helpful to new M.B.A. students as well as to those in their second year at Chicago Booth who are boning up for interviews with consulting firms. I offer them freely and if they are helpful, encourage your use of them, especially if you are pursuing a leadership position in a consulting firm.

Diseconomies of scale can occur because:

(1) Rising labor costs resulting in large firms paying higher labor costs (apply Five Forces to see why—firms are large portion of unions’ revenues) although worker turnover is lower at large firms.

(a) Incentive and bureaucracy effects imply that:

(i) It is difficult for large firms to motivate workers

(ii) It is difficult to monitor performance (agency problem)

(iii) It is difficult to communicate with workers

(2) A higher number of managers is required per worker as hierarchy grows.

(a) Spreading of specialized resources:  Chicago’s Michael Foley

(b) Cost of avoiding Department of Justice monopoly hearings.

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Leslie Pratch, Ph.D. is a clinical psychologist with an M.B.A. in Strategy and Finance and a B.A. in Religion from Williams College. She works with boards of directors and private equity investors to select and develop executives. She can be reached at (312) 464-7919 or email her at leslie@pratchco.com or visit www.pratchco.com.

By Leslie Pratch

When I was getting my M.B.A., I recorded what was new to me and as a way to help my classmates who were preparing to interview for consulting firms. Nearly a decade later, I realize these notes may be helpful to first- and second-year M.B.A. candidates, especially those at Chicago Booth, who are boning up for interviews with consulting firms. I offer them freely and if they are helpful, encourage your use of them, especially if you are pursuing a leadership position in a consulting firm.

Why do economies of scale exist?

(1) Indivisibility and the spreading of fixed costs

(a) Economies of scale are more likely when production is capital intensive because this condition implies large numbers of units must be spread over high fixed costs to be at MES.

(2) Increasing productivity of variable input due to specialization and size efficiencies

(a) “The division of labor is limited by the extent of the market” (Adam Smith). That is, as a firm’s scale increases, it can assign workers to increasingly specialized tasks.

(b) Often a twice as big machine does not use twice as much electricity.

(3) Inventories and stock outs—high volume firms need to carry proportionately less inventories than low volume firms to achieve the same level of stock outs (from queuing theory).

(4) Cube-square rule:  Volume of structure increases with CUBE of linear dimensions of vessel; total cost is proportional to surface area of the vessel.

(5) Specific examples of economies of scale:

(a) Spreading advertising costs over larger market

(b) Reputation effects result in need to spend less on advertising

(d) Spreading R&D costs

(d) Purchasing economies

(6) Can limit the number of firms that successfully compete in the market, particularly when consumers are price sensitive. Market share and profitability correlate in many industries.

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Leslie Pratch, Ph.D. is a clinical psychologist with an M.B.A. in Strategy and Finance and a B.A. in Religion from Williams College. She works with boards of directors and private equity investors to select and develop executives. She can be reached at (312) 464-7919 or email her at leslie@pratchco.com or visit www.pratchco.com.

By Leslie Pratch

When I was getting my M.B.A., I recorded what I learned to digest the curriculum and as a way to help my classmates who were preparing to interview for consulting firms. Nearly a decade later, I realize these notes may be helpful to first- and second-year M.B.A. candidates, especially those at Chicago Booth who are boning up for interviews with consulting firms. I offer them freely and if they are helpful, encourage your use of them, especially if you are pursuing a leadership position in a consulting firm.

First mover advantages can be based on:

(1) Positioning—first mover can choose to serve the largest, most attractive segments; followers may be confined to niches in order to avoid direct competition.

(2) Learning curve (must be continuous)

(a) The learning curve: Experience curve describes the efficiencies directly related to the level of cumulative output. Does not provide lasting first-mover advantages unless learning produces continual cost reduction, quality increases, et cetera.

(3) Switching costs

(4) Branding (for products where brand is important, second entrant only gets approximately 71% of first entrant’s share)

(5) Barriers to Entry:

(a) Minimum efficient scale—the first ones to reach it will be the survivors because they will have lower cost structure

(b) Legitimate barriers to entry:

(a) Regulation

(d) Patents

(6) When analyzing first-mover strategies, firms must consider substitute products

(a) Firms may want to reduce price in short run, anticipating reduced cost in the long run.

(b) Expectation for reduced future costs effectively reduces cost of current production.

(c) Economies of scale may be large even when learning economies are small:  can producer.

(d) Learning economies may be large even with little economies of scale:  software producer.

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Leslie Pratch, Ph.D. is a clinical psychologist with an M.B.A. in Strategy and Finance and a B.A. in Religion from Williams College. She works with boards of directors and private equity investors to select and develop executives. She can be reached at (312) 464-7919 or email her at leslie@pratchco.com or visit www.pratchco.com.

By Leslie Pratch

When I was getting my M.B.A., I recorded what I considered most useful to digest the curriculum and to help my classmates who were preparing to interview for consulting firms. Nearly a decade later, I realize these notes may be helpful to new M.B.A. students at Chicago Booth as well as to those in their second year who are boning up for interviews with consulting firms. I offer them freely and if they are helpful, encourage your use of them, especially if you are pursuing a leadership position in a consulting firm.

(1) Profit Maximization Production Point/Marginal Cost

(a) Produce at the point where MC = MR.

(b) Sales can go up as profits go down if you are producing beyond the point where MC = MR.

(2) Economies of Scale/Minimum Efficient Scale

(a) Exist when MC < AC

(b) Average cost curves are usually U shaped:

(c) AC typically declines (i.e., MC < AC) as fixed costs are spread over additional units

(d) AC typically increases (i.e., MC > AC) as production runs up against capacity constraints. Typically this occurs because variable costs per unit increase.

(e)  Minimum efficient scale:  Volume of production at the point on the average cost curve where average cost reaches its minimum.

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Leslie Pratch, Ph.D. is a clinical psychologist with an M.B.A. in Strategy and Finance and a B.A. in Religion from Williams College. She works with boards of directors and private equity investors to select and develop executives. She can be reached at (312) 464-7919 or email her at leslie@pratchco.com or visit www.pratchco.com.

By Leslie Pratch

When I was getting my M.B.A., I recorded what I considered most useful as a means to digest the curriculum that was new to me and to help my classmates who were preparing to interview for consulting firms. Nearly a decade later, I realize these notes may be helpful to new M.B.A. students, especially those at Chicago Booth, as well as to those in their second year who are boning up for interviews with consulting firms. I offer them freely and if they are helpful, encourage your use of them, especially if you are pursuing a leadership position in a consulting firm.

In order for a company to sustain an economic profit, four conditions must occur:

(1) Ricardian profits (e.g., due to a limited supply of superior inputs, only a few firms will have the lowest cost structure or will be highly differentiated; these firms will have positive economic profits

(2) Ex ante limits to competition (if there is competition for the superior, limited resources—for example, the best plot of land—then the winner will have to pay all of what would have been its economic profits to acquire the superior resources).

(3) Ex post limits to competition (if others can use your superior resources as well as you can, they will bid to acquire your resource and in so doing, bid away your economic profit.

(4) Imperfect imitability.

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Leslie Pratch, Ph.D. is a clinical psychologist with an M.B.A. in Strategy and Finance and a B.A. in Religion from Williams College. She works with boards of directors and private equity investors to select and develop executives. She can be reached at (312) 464-7919 or email her at leslie@pratchco.com or visit www.pratchco.com.