One thing that jumps out at me when reading FP blogs and discussions is that most people have a very different perspective about how businesses operate than I do. That’s probably not surprising, but it’s been on my mind lately, and today’s (long overdue) post explores a typical mental model, its limitations, and how that model might be improved.
Almost everyone has some framework for thinking about businesses work, what you might call a mental model. These are tools which allow us to understand and analyse: to answer questions like how something happens, what the effects of something will be, or why a business might have made a particular decision. My mental model comes from studying economics andexperiences of working; other people will have a different model, shaped by their own experiences and studies. Regardless of how these models are formed, they are all simplified representations of a complex phenomenon. None of them are perfect, but they are still valuable tools and it can be helpful to think about other models and we might refine our own.
My impression is that many people in the FP community have a mental model of business that is shaped by accounting, which they use this to analyse business behaviour. The model is one where a firm has costs and revenues. When the revenue is greater than the costs, the firm makes a profit. When the costs are greater than the revenue, it makes a loss. It’s a simple model, which isn’t a bad thing: it means the model is easy to use and can provide ready answers to our questions. If a firm puts its prices up, we can use the model to say that maybe they are running at a loss and trying to get profitable. If they later go out of business, the model tells us their costs were still higher than their revenue.
While the model is useful, it is certainly not perfect. Simplicity makes it easy to use but also imposes limits on what the model can tell us. There is nothing in the model about competition or the marketplace, about consumer behaviour, or how costs change. Each of these are complex phenomena in their own right.
This means the model can lead people astray. It sometimes leads people to think that business is a zero-sum game (where a change or a transaction has a winner or loser) or that a business can somehow ‘target’ a particular profit margin (eg 20%). Sometimes having a simple model leads people to think that business is simple, with obvious answers or easy solutions. Each of these conclusions flow logically from the model but they don’t accurately reflect the real world. That doesn’t mean the model is wrong or shouldn’t be used; just that it has limitations which we ought to recognise.
Another limitation is that it doesn’t recognise any constraints on the power of business managers and other decision-makers. It implies that the variables – costs and revenues – can be controlled and tweaked when necessary. Managers have decision-making authority, but this doesn’t mean they can make whatever choice they want. Businesses are complex and interdependent; whenever a decision is made in one space, it can affect lots of other things, in their business and the marketplace, in both good and bad ways. Many of these outcomes won’t (or can’t) be known in advance. Interdependency imposes enormous constraints on business managers, limiting their power, but that doesn’t factor into the model and so it’s a limitation we need to keep in mind.
To illustrate this point, I’m going to explore the three constraints which I see as most important when thinking about the FP industry.
The first constraint, consumer demand, builds on the fact that buyers are intelligent and rational. They know what they’re doing with their money and their goal is to get the greatest possible happiness or satisfaction from their purchases. If you can manufacture a product that people like – something which brings them joy or satisfaction – then those people will be interested in buying it. But whether they actually purchase (or how much they buy of it) ultimately depends on the price.
This means there is a trade-off for firms when setting prices. They can charge a high price, but that means turning off a lot of buyers and not selling very many units. They can charge a low price and sell plenty of units, but each unit won’t bring in very much money. It’s not really possible to charge a high price and sell a lot of products.
Changing prices can be a fraught decision: reducing price necessarily means less revenue for each unit sold. It’s a tactic that only increases the firm’s total revenue if the increase in total sales more than makes up for the lost revenue: if a retailer has a 10% off sale, they have to sell at least 10% more units to break even. Alternatively, putting up prices will increase revenue for each unit, but it also means selling fewer units. If the retailer raises prices by 20%, they have to hope that it doesn’t mean 30% of their buyers go elsewhere.
Our simple model tells us that firms can become more profitable by increasing revenue, which is obviously achieved by changing prices or the number of units sold (output). But firms can’t control both variables: they can control price or they can control output, but they can’t do both. And this means they can’t control their total revenue; they can only influence it indirectly, by changing price or output.
The second constraint is a firm’s own production costs. The model often assumes that unit costs don’t change with output, which is a useful simplification but it’s not a good representation of the real world. In reality, sometimes boosting output leads to higher unit costs and sometimes it means lower costs. It’s typical for them to fall at first until the business reaches a sweet spot where the per-unit cost is minimised, and then they start to rise again (but even this is an unrealistic simplification).
This creates two issues for our mental model. First, firms don’t have absolute power over costs: they can’t simply decide that costs should be lower. Most business managers constantly try to ensure that there are no unnecessary expenses, so there’s nothing lying around waiting for the chop. This means that changing production costs usually requires the firm to change its output. But if the firm is already operating at the sweet spot, changing output will only increase their costs.
And if they aren’t at this point, changing output takes us back to the first constraint. If they increase output to reduce production costs, it requires the business to sell that extra output – which in turn requires a lower price. Costs go down but it will also push revenue down, meaning one part of the business is better off while another part is worse off. Viewed the other way around, dropping prices can increase sales (and possibly revenue) but that also requires increased production and that might push up unit costs.
There’s an interdependency here which means that managers cannot make a decision about one part of the business without it affecting the other. Decisions about price and output cannot be made independently of one another, which imposes a further constraint on business managers, who need to make a joint decision for both parts of the business. That joint decision is typically the level of output (which in turn determines production cost and sales price): they don’t aim to minimise cost or maximise revenue, but to find the point where the difference between the two is largest. That’s the level of output where profit is maximised.
It’s worth pointing out that this is more of an estimate than a decision. This point is determined by forces which are largely beyond the control of a manager; they are just the one responsible for figuring out what it is. Given these constraints, the business manager is not some powerful figure who is free to choose as they please; instead, he or she is virtually powerless.
This interdependency is not part of our mental model. If we ignore the fact that costs and revenues end up influencing one another, we’re going to end up drawing some inaccurate conclusions about how businesses operate or what we think they should be doing. We’re certainly going to end up with the wrong idea about how much power a manager actually wields.
The third constraint is competition: other firms who are trying to attract the same customers with similar products. The most obvious effect of competition is on the prices which a business can charge for their product: the first constraint tells us that no firm can sell a product at a price higher than the value customers receive from it. But competition requires firms to sell at a much lower price, one which reflects the surplus available to buyers from other possible purchases.
Firms also have to take into account the possibility that their choices will affect the choices of other firms. In North America, Pilot recently dropped the price of their Iroshizuku ink from $28/bottle to $20, and I’m certain this is going to influence the thinking of other brands. Other upmarket ink brands like Caran d’Ache ($33.20), Graf von Faber-Castell ($30), and Pelikan ($27.80) will be forced to decide whether they want to follow suit and cut prices or lose sales to Pilot. Whatever they choose will affect Pilot’s business, and it is likely that their potential responses were considered before Pilot made their decision.
Mid-market brands like Aurora ($18), Robert Oster ($17) and Sailor ($18) will have to think about whether Iroshizuku now offers a better value proposition than their own products, and whether they also need to cut price to keep sales going. If some of those brands start to push their prices down, it could lead some of the value brands like Diamine ($15) and Noodlers ($12.50) to assess their own position in the market. In a small market, one firm’s decisions can ripple out and affect every other firm, whose reactions create ripples of their own.
Competitive reactions impose a further set of constraints on businesses, narrowing the range of options which are available to managers. None of this is evident from our mental model, however, so it may not enter the thinking of those who use that model to understand businesses and the marketplace.
We can use Visconti as a case study to explore the mental model and these constraints. Some years ago, they decided to switch from gold to palladium (‘Dreamtouch’) nibs and I have seen a few discussions where, consciously or not, people have used the model to analyse the decision to switch. Usually, it is argued that palladium is a cheaper metal than gold and so therefore it was a way of reducing costs. With lower costs but no change in retail prices, the conclusion is that Visconti were able to make a greater profit from palladium nibs. Often, there is also an implication that consumers have been disadvantaged – even exploited – by the switch.
If you think about this conclusion in terms of the model, the conclusion is entirely logical and reasonable. If the model is reliable and palladium is cheaper than gold, we must accept that this was a profitable move, and one which was at the expense of consumers.
But if you think about the same issue in terms of the constraints faced by firms, things become less clear. The first constraint is about consumer demand: if consumers did indeed feel that the palladium nibs were inferior to gold, then it’s unlikely Visconti could continue to sell the same number of FPs for the same price. An inferior product would require a lower price to maintain sales (or fewer sales for the old price), which would result in decreased revenue.
The second constraint was production costs. I’m not at all sure that palladium nibs would be cheaper than gold: certainly, it seems that the raw material was (and is) cheaper. But that’s not the only cost with nibs. Using an unusual (perhaps even unique, nowadays) material requires an R&D investment as well as specialist skills to produce and polish the nibs; it means forgoing the considerable economies of scale available to gold and steel nibs; and it also seems that palladium nibs have a higher rate of repairs and servicing, as the palladium nibs seem prone to damage and sprung tines. Each of these push up costs, offsetting at least some of the cost benefits from a cheaper material. We can’t know for sure whether the overall effect would be an increase or a decrease in Visconti’s nib costs.
These two constraints challenge the conclusion offered by the model. We can’t say that revenue would have stayed the same and we can’t say that costs would have gone down. That uncertainty makes it difficult to accept the conclusion that the change must have led to higher profit. But working through the third constraint presents us with an alternative explanation for their decision.
In any competitive marketplace, the worst position for a firm is trying to sell a product that is virtually indistinguishable from the competition. If consumers don’t see any differences between your product and someone else’s, they are going to buy on price alone. And that forces every firm in the market to cut prices until they’re basically selling at cost.
In order to have a successful, profitable business, firms have to avoid selling at cost. They do that by differentiating themselves from the competitors, creating some difference between their products and everyone else’s that consumers value. If the difference is slight, customers probably won’t value it highly and won’t pay much of a premium. But if the difference is significantly valuable in some way, some buyers will be willing to pay a much larger premium. As long as the price premium exceeds the extra costs of differentiation, the firm can start to earn a profit.
I think Visconti recognise this and have always had a strategy of trying to set their products apart. Whether you like the differences or not, it’s undeniable that the brand today has differentiated their products in pretty much every way: the design, materials, shape, capping mechanism, filling system (for better or for worse), and the nib performance. Most of this differentiation has been done in a way where it’s extremely difficult for competitors to copy them: the Homo Sapiens has been hugely popular because of its unique material, but no other brand has attempted to make their own lava pen. The same is true of the hook capping mechanism, which is hands-down the best on the market. This has allowed Visconti to maintain their differentiation and to charge a premium price for their products.
Viewed in isolation, the decision to switch from gold to palladium nibs seems unusual and the idea that it was done to cut costs can be persuasive. But viewed in the context of competition and business strategy, it would be strange indeed if every aspect of the pen was unique except for the nib. We can’t say for certain whether this was Visconti’s motivation but it seems like a credible alternative explanation: not necessarily the true explanation, of course, but one which might be true.
So while our simple model is useful and can answer some of our questions, we also need to bear in mind its limitations. Once we go beyond the simplicity and add in some real-world complications, it can challenge the easy conclusions of the model. However, it can also provide us with alternative explanations, ones which tell us more about firm behaviour and which might lead us to a more accurate understanding of decision-making in our industry.
There’s nothing inherently wrong with the mental model that was discussed in this post. It’s simple, easy to use, and is generally a reliable framework for understanding aspects of the FP business. But, like any other model, it is a simplified representation of reality and has limitations which we need to keep in mind. If we ignore those limitations, the model will lead us to conclusions which aren’t reliable.
We should also keep in mind that this model is completely alien to the experience of business managers. Theirs is a world where decisions are complex, interdependent, and highly uncertain, which is quite different to that presented by our model. Trying to use this model to mimic their decision-making can lead us astray in our thinking. Instead of being a tool which helps managers determine how to increase their firm’s profitability, it’s a tool which can help managers determine why their profitability increased or decreased. That’s the space where this model originated and it’s where there are the fewest limitations on its use.
Recognising that we depend on mental models – and understanding that these models are both flawed and limited – can help us to remain intellectually humble. Of course, it’s not easy to practice this consistently but, without such humility, we can become stubborn or dogmatic and miss out on the insights offered by alternative perspectives. It’s hard to see much intellectual humility in the public space nowadays, but it is as important as it ever was, and I’m endeavouring to do better. I hope this post gets you thinking about it too.