Economics Jim Hargrove, CEO Excess Inventory Neptune

Economics

Jim Hargrove, CEO

Excess inventory

Neptune has over 60 days' worth of inventory and is faced with some interesting solutions to address this issue. This memo will analyze the issue and the proposals put forth by the management team. The memo will conclude with a recommendation for action.

New fishing rules and new technology investments have allowed Neptune to take bigger catches. Despite record sales, the company is still accumulating inventory. There are two proposals on the table for addressing the inventory issue: launching a budget brand and decreasing fleet size.

Analysis of Underlying Issues: The solution should reflect the underlying problem. The company has increased its fleet with new additions. This increase in capacity is permanent. The government's new regulations are also pushing us into richer fishing grounds, again representing a permanent increase in capacity. Other firms in the industry are also facing a long-term increase in capacity.

Recommendation: The company should decrease the size of its fleet, rather than launching a budget brand. A price war is not sustainable and there is no evidence to support that price reductions will dramatically increase consumption, particularly if those reductions are matched by other firms within the industry.

Supporting Documentation.

The two main factors affecting supply have both been discussed. Each of these factors can be considered to be a long-run issue, and will be shared by other firms within the industry. The industry is characterized by monopolistic competition, so the price is expected to decrease somewhat, to a new equilibrium point. In order to maintain a higher price, the industry as a whole must cut production. Demand is impacted in part by the price of fish, but also in part by the desirability of fish products in the marketplace (consumer habits and preferences). Recent evidence shows a social trend towards healthier eating, but this has not had a significant impact on fish sales. Fish is typically a premium-priced source of protein and many consumers have responded by simply not incorporating fish into their diets.

The market is characterized by monopolistic competition. Many competitors are not differentiated, however, choosing instead to compete as cost leaders. These firms sell a mix of house and private label brands. Neptune competes as a differentiated producer and has made significant investments in production technology to support that position. The claim by one manager that these investments are sunk costs is not entirely accurate -- some of the process such as rapid deep-freezing are variable costs and therefore will continue to provide Neptune with a higher-than-average cost structure over the long run. It is expected that any move by Neptune to lower prices will be matched by the company's competitors.

The applicable branch of game theory is general equilibrium theory. Price and quantity are related. In this scenario, the quantity produced has increased, and this can be expected to push the price down. This is going to be the case until the price falls far enough to spur demand to meet the level of supply. For Neptune, this creates two problems. The first is that the new equilibrium level may not be high enough to cover the company's fixed costs -- the new ships may be a sunk cost for cash purposes but their depreciation expense still shows on the income statement. This would have the company lose money and there is some indication that starting a discount brand would cause the company to sell at a loss. The second problem is that the company is attempting to compete as a differentiated producer. It is seeking a part of the demand curve that is generally less price elastic. Neptune has made heavy investments to build this brand image and to erode that brand image would not only squander those investments (many of which are sunk costs, albeit) but would also make it difficult to raise prices later. The company has built its business on consumers that are not price sensitive, so the last thing it wants to do is introduce price sensitivity to that segment of the market. There is no guarantee that new consumers attracted by the low prices would follow the prices back up -- no new long-term demand would be created as the price moves up and down the demand curve. This invalidates one of the main arguments in favor of a budget brand.

The competitive environment is another consideration in that the other firms will lower their prices to compete with Neptune. As most already compete as cost leaders, they probably have lower costs of production than Neptune. Thus, they would undercut Neptune, meaning that any market share gains on the part of Neptune are likely to be short-lived. The pricing power of Neptune within the industry is relatively high only because of its differentiation. If it loses that, the company renders itself susceptible to response from competitors, all of whom have high exit costs that will result in a sharp reply to any price move Neptune makes.

1. I would identify cost and supply side factors on the basis of previous experience. The company has data that it can analyze, as does the industry association, to determine elasticities of demand. Neptune will have internal cost forecasts and understands its supply drivers.

2. I would utilize industry and internal information to determine demand-side factors as well. The company is aware of the substitutes issue, but as this is a concern it should poll consumers to better determine what the elasticities for fish products are, because a move to gain new customers with low prices is only useful if those customers remain fish-eaters when the prices move back up.