I’m working on a short paper explaining the economic approach to evaluating business strategy. But an item in the Wall Street Journal this week highlights one of the key points: a company needs to determine how much of its value creation it will be forced to pass on to workers and vendors.
Classic case: manufacturers of personal computers did not make great profits. The big money went to two key vendors: Microsoft and Intel. Even though sales volumes were rising rapidly in the 1980s and 1990s, the profits were captured at the beginning of the supply chain.
Another good example: airlines. When profits were strong, labor unions would bargain hard, pushing up wages and benefits and job protection rules. When sales slowed down, the high cost structure triggered massive losses.
Now another example: According to a Wall Street Journal article (subscription required) mining giant Rio Tinto announced 14 percent lower net earnings, despite strong demand for the products it mines. The reason: rising costs. It does not seem to be just one vendor. The entire mining industry is running full bore, with companies bidding against each other for specialized equipment. Labor is very location specific. If you are running a mine in Australia, you can’t outsource the digging to India. As a result, a mine is very vulnerable to labor pressure. I don’t see signs of bad management at Rio Tinto, just a company getting caught in an inevitable cost squeeze.
Other companies, as part of their economic contingency planning, should evaluate what their costs are likely to do if their industry booms. It may not be good news.