A firm at the 90th percentile of the productivity distribution makes almost twice as much output with the same inputs as a firm at the 10th percentile.

Interesting observations from Lessons from “The Profit” by Alex Tabarrok.

I’ve learned a lot about industrial organization watching The Profit, a reality-TV show on CNBC featuring businessman Marcus Lemonis. In each episode Lemonis buys into a failing small-to-medium-sized business and works to turn it around. Lemonis doesn’t invest in a random sample of businesses nor even in a random sample of failing businesses. Nevertheless, the lessons that The Profit teaches are consistent with the new literature on management which has increased my confidence both in the show and the literature.

In the perfectly competitive model, price is equal to average cost and firms operate efficiently at minimum cost. Yet, Syverson finds that in the typical US industry a firm at the 90th percentile of the productivity distribution makes almost twice as much output with the same inputs as a firm at the 10th percentile. It’s not easy to measure inputs or outputs, of course, but even firms producing very uniform products show big productivity differences.

How can firms that use inputs so inefficiently survive? In part, competition is imperfect which gives inefficient firms a cushion because they can charge a price higher than cost even as costs are higher than necessary. Another reason is that small firms eat their costs.

A typical firm on The Profit, for example, has decent revenues, sometimes millions of dollars of revenues, but it has costs that are as high or higher. What happened? Often the firm began with a competitive advantage–a product that took off unexpectedly and so for a time the firm was rolling in profits without having to pay much attention to costs. As competition slowly took hold, however, margins started to decline and the firm found itself bailing. But instead, of going out of business, the firm covers its losses with entrepreneurs and family members who work without pay, with loans which grow ever larger, and by an occasional demand shock which generates enough surplus revenue to just keep going.

The correct metaphor for competition isn’t a boxing match that knocks out the inefficient firm. The correct metaphor is a slow tide. Inefficient firms must scramble for a bit of high ground but as the tide ebbs and flows they can occasionally catch a breath when their head bobs above the profit line. An inefficient firm can survive for years before it inevitably sinks.

Interesting that the observations are coming from a reality show and interesting because this maps to my reading of history and my personal experience in doing business turn-arounds.

The historical piece has to do with the financial overreach all major powers seem to suffer. As their gain power through productivity, in the early phases, they have a shared culture of careful management of money, both among the people and the state. They splash out now and then but they live within a one generation budget. At some point they find ways to overconsume in the present at the expense of accumulating national debt. Britain, France, Spain, Japan, China, India, they have all gone through the same cycle. It is the slow accumulation of debt through consumption that ends up strangling them.

Likewise with businesses. There is an accumulating cost infrastructure inherited from plush days early in the cycle of growth when margins were fat. Expectations of small luxuries are inherited from wealthier times. Painful actions are lazily avoided.

The workout room. The fresh flowers in the office. The lax vacation schedules and work hours. Legions of small luxuries which marshaled together form an army of financial trouble.

At a personal level, the first few months of any turnaround, it is the same set of things I do. Blocking and tackling. Business hygiene. Do the simple things you know should be occurring anyway. Collect outstanding debts. Write-off those that can't be collected. Fire the dead wood that no one wanted the discomfort of firing. Cancel contracts that are not making money and cannot make money. Cancel pursuits on shoot-for-the-moon opportunities. Concentrate resources on a small number of opportunities. Concentrate management attention on a few critical processes (include the people processes), pick a few junior stars to fill the talent pipeline.

There is no pleasure in a drawn out financial strangulation. There are no benefits to be shared when there are no benefits at all. Better to undertake short term pain and disruption to get the enterprise back in financial health.

It is an interesting post worth reading in whole.