Thursday, April 13, 2006
Capacity Utilization Up, Profits Down: Huh?
The recently released commercial printing profits data for the fourth quarter were expected to be down, because industry shipments were so disappointing for that period. Earnings reports from some large printers confirmed the situation. What was surprising is that industry capacity utilization had been increasing steadily for more than a year. How can that be?
Capacity utilization is computed as a fraction: capacity used divided by capacity available. It is often assumed that when capacity utilization is high, profits will be high. When printers get busy, and the capacity used increases, and it is claimed that profits will rise. Decrease the capacity available while keeping sales at the same level, and capacity utilization will rise. All you did was decrease the denominator. It's just simple arithmetic. Everyone knows 1/2 is more that 1/4, even though the 1 in the numerator is the same.
What's happened recently just doesn't make sense: even though capacity has been coming out of the marketplace as plants have gone out of business, profits have headed down. Profits are supposed to be rising. It actually does make sense, and here's how.
In the mid- and late-1990s, capacity utilization was declining, yet total industry profits were more than three times where they are today. In fact, many new presses were being added to the marketplace, increasing the industry's total available capacity. For the last six years, the statistical relationship between capacity and profits has had less forecasting validity than one could get by just flipping a coin.
Keeping presses busy in an expanding market hides a variety of business sins. Riding an industry-wide wave of growth masks managerial and operational inefficiencies and poor pricing strategies. When the tide goes out, the debris left behind becomes plain to see.
The long-held common wisdom of the relationship of capacity utilization and profits is seriously lacking. First, it ignores what the market prices for use of that capacity are. Producing the right things efficiently is essential to creating profits. Being efficient in the manufacture of unprofitable things is deadly.
Second, it ignores the nature of productivity and efficiency. Not all capacity is created equal. During the 1980s, capacity utilization was declining, but the industry was selling printing that had greater value than it did before: it had good quality process color rather than black & white images. It's often hard to remember that prior to the early 1980s having anything printed in color was incredibly expensive. Digital prepress changed the printing landscape forever. Process color exploded in the 1980s, and print buyers shifted to those kinds of higher value printed materials because they were more effective in meeting their communications objectives. While capacity utilization was steadily decreasing, higher selling prices more than made up for it, even when process color demanded investments in new prepress and press equipment, expanding the industry's capacity.
Third, obsession over capacity utilization assumes that only the "cost of goods sold" portion of the income statement is important. Everything is important. How foolish it is to run an efficient pressroom and squander it all on poorly designed administration, distribution, marketing, sales, and finance. Entire companies make profits, not just pressrooms.
Fourth, market access is ignored. The turnaround time and logistics of creating, printing, and delivering work is missing. There is a value to turnaround and other "value added" activities, which is why they're called "value added" in the first place.
Finally, competition is ignored. Industry capacity measurement has always been geographically based. That is, it was always U.S. capacity or North American capacity. Today, the world is connected as never before. All costs and selling prices in one world region are often affected by the characteristics in another. Commodities have had “world prices” for many years. Now, there are world “goods prices” and world “services prices.” Multinational companies have always shifted work between plants of different geographies to achieve their best costs. Today, all industrial buyers are gaining more power over the prices they pay.
So what does it all mean? Having the correct capacity for an individual print business is still essential. But producing profitable things is essential, too. Presstime is not necessarily generic capacity. That capacity must be able to produce the correct sizes, formats, and quantities that the market demands at a particular point in time. When there is a mismatch between the kinds of printed materials needed today and the equipment purchased years ago when the characteristics of those printed products were different, today's prices naturally fall and costs tend to remain the same. Hence, profits are squeezed. Knowing your customers, anticipating what they will need in the future, and knowing what kinds of new customers are likely to emerge in the future are critical elements of all capital investment decisions. Buying equipment requires a depth and breadth of market knowledge greater than just a few years ago. Today's dynamic media marketplace ruthlessly teaches this lesson.