Friday, May 11, 2012

Ratios Can Mislead

Clayton Christensen, a giant among business school professors, likes to tell an interesting story about American steel companies. Fifty years ago, there was really only one way to produce steel commercially: through large, expensive integrated mills. In the 1960s, a new innovation came along: mini mills. These mini mills were able to produce steel at a lower cost (20% lower, in fact) than the big integrated mills because they used a cheap input, scrap metal. The only problem with the steel was that it was low quality. Despite this, there was a big market for the steel in the building industry. (Builders weren’t overly concerned about the quality and specifications of the steel “rebar” because it would be buried in concrete anyway.) The owners of the integrated mills had a decision to make: Would they compete for business in the rebar market or would they get out of the low-end market altogether? The managers looked at their margins on this low-grade steel and tried to remember what their MBA textbooks had taught them. In business school, there is a lot of focus put on ratios. The goal of ratio analysis is to spot business opportunities in high-margin markets. The managers of the integrated mills made, what appeared at the time, to be a sensible business decision: They ceded control of the rebar market to the mini mills and focused their scarce capital on higher margin steel products, like sheet metal. At the time, Wall Street applauded the choice. You might be able to guess what happened next. After rebar became a commodity, margins dropped to near zero and those once highly profitable mini mills had to look for new opportunities. Naturally, they looked upstream to the more profitable steel products. Eventually, (after thirty years or so) mini mills were competitive in producing every steel product. So, a basic question now has to be answered: Why didn’t the owners of the integrated steel mills build mini mills themselves? The answer is the owners only wanted to focus on high-margin businesses. By the time the owners realized that a lot of their business was going to be taken from them by these smaller competitors, it was really too late too late to start a mini mill business from scratch. (Instead, some of the large steel companies bought out established mini mills.) Today, mini mills control about 60% of the market for steel products and all but one of the large American integrated steel mills have gone bankrupt.
- Read more about it here: The New Yorker