Finance

Previously we went through how an industry’s changes affect the financial statements of individual companies, including a paper manufacturer and a TV manufacturer. At the beginning of our discussions, we mentioned that any company’s decision making will be affected by the environment it is in, and its own strategic choice. Next we are going to discuss how the strategic choices affect the financials of a company.

Cost Leadership Strategy – Small Profit High Volume

Generally, there are two types of strategic positioning. The first is cost leadership.

What is the cost leadership strategy?

If products of my company are not very different from other products, a very natural way to boost my competitiveness is to lower the costs. I can expand capacity, improve efficiency, or simplify my product design and so on. I will try all kinds of methods to lower my costs.

Once my costs are reduced, i will be in a better position to lower prices, making my products more attractive to customers. In our daily life,

there is a saying describing the cost leadership strategy, which is small profit high volume. This saying perfectly sums up the cost leaderhip strategy.

However, when we say a company employs a “small profit high volume” strategy, what is the profit that we are referring to? Is it gross profit or net profit?

Well, we already know that the reason such company has a small profit is that it purposefully sets the prices low. When it does, a direct result from such as strategy is a relatively lower gross profit ratio. From gross profit to net profit, there might be some expenses subtracted, and some income added. These expense/income items are not only the results from strategy choices, but also managerial performances. In other words, the “profit” in small profit high volume strategy refers to gross profit.

Now lets look at “high volume”. Does “high volume” equal to high revenue? 

If you think about it, it is quite difficult to judge what qualifies as high revenue. The number is drastically different for different companies in different industries. From the literally sense, “high volume” is selling more products. However, we should always set a limit to such claims such as timeframe. In other words, “high volume” should mean selling more products faster than others; so “high volume” actually means rapid sales.

How is high volume represented on financial reports? 

Based on the descriptions above, we got the feeling that a faster sales is better efficiency, or faster turnovers. So “high volume” actually means high turnovers for the company. 

By now we have known that the normal expression of a cost leadership strategy is “small profit high volume”, and the financial expression of it is “low gross profit rapid turnover”. Because the company has low gross profit, it has a low effectiveness. To make up for the low effectiveness, it needs a high efficiency. The cost leadership strategy is a strategy that sacrifices some effectiveness to pursue high efficiency. The cost leadership strategy is winning by efficiency.

Differentiation Strategy – Big Profit Small Volume

Contrary to the cost leadership strategy, differentiation strategy is a strategy that improves product features to differentiate it from other competitors. For example, my company may have the broadest range of products; or my service is well-known in the industry, well above that of other companies; or my deliveries are flexible and on time, etc. This is what we call a differentiation strategy.

In any industry, we can always witness that some companies choose the cost leadership strategy, and some other companies choose the differentiation strategy.

For example, in the retail industry, we can find small convenience stores and large fancy shopping malls. The malls will have better decorations, more comfortable shoppingenvironments, and better services, all contributing to more expensive products sold at the malls. The convenience store, on the other hand, may be located in a rather remote location, provide limited services, but have lower prices for the same products. 

For companies that employ differentiation strategies, the gross profit ratios are normally higher from the higher prices. However, there won’t be too much demand for high-end products, generally speaking. So naturally its turnover rate will be lower.

On financial reports, a company that employs differentiation strategy will show high gross profit ratio and low turnover. Because of the high gross profit ratio, its effectiveness is great, but because its turnover is lower, its efficiency is relatively slow. Therefore, we say differentiation is a strategy that sacrifices efficiency in exchange for effectiveness.

A company normally pursues premium pricing as part of its differentiation strategy. The company already knows its demand will not be as big as the low-end market; however, this is its own choice. We call the differentiation strategy winning by effectiveness.

From the above discussions, we see that different strategies bring different financial performances. However, their goals are the same – to create return on investment. It is the process of creating the desired ROIs that’s different. Some companies choose to win by efficiency, while others by effectiveness. 

Paper Manufacturing Industry

Let’s use the example of the paper manufacturing industry to illustrate how strategy is selected. 

In the paper manufacturing industry, there are a lot of companies adopting the cost leadership strategy. The reason is simple; even a very experienced professional may have a hard time guessing which company produced a specific piece of paper. The final products – paper – are very hard to differentiate. In addition, the paper manufacturing industry is capital-intensive. It requires huge amounts of investments for equipment. To make matters worse, almost every kind of paper needs a different piece of equipment, requiring even more investments if the company wants to expand the product line. 

Knowing this, it is not difficult to understand that the major costs of paper productions are fixed costs. Regardless of the actual output, fixed assets will have already been purchased. Therefore, the more paper the company products, the lower the per unit fixed cost will be. This is called economy of scale: if an industry requires siginificant levels of investments, only companies with large enough production outputs can break even by achieving economy of scale. This is why most paper manufacturing companies will choose the cost leadership strategy.

However, it is still possible that some paper manufacturers choose the differentiation strategy.

For example, a company may improve its paper quality and focus on a niche market to achieve differentiation. Here we are going to choose two paper manufacturing companies to illustrate the two strategies.

The first company only produces a particular kind of cigarette paper. The market demand for cigarette paper is really small, but the paper has a relatively high level of profits. The company adopted a differentiation strategy that focuses on making high profit products for only one segment.

The other company produces paper for newspapers. This company is really big, using a cost leadership strategy.

We will find that the company adopting the differentiation strategic position will have higher gross profit rates but lower turnover. By contrast, the company adopting the cost leadership strategy will have lower gross profit rates but higher turnover.

This verified one of our earlier analyses. 

However, we may not always find the desired results. 

Sometime we will find companies using the cost leadership strategy with low gross profit ratio AND low turnover, or companies using the differentiation srtrategy with low turnover AND a not-so-high gross profit ratio.

What might have gone wrong then?

Well, our definition of a strategy is that a company gives up one goal to pursue another goal tactically. However, if the execution of a strategy goes wrong, the company may find that even though it purposefully gives up one thing, it may not necessarily achieve the other. In other words, it may find a decreasing efficiency and effectiveness at the same time, and when it does, we can normally conclude that something has gone wrong with its execution on strategies.

The financials of a company not only bears the mark of its industry, but also show the company’s strategic positioning. In addition, they also show how the strategies are executed by the company.

In the previous episode, we examined the time series analysis of the paper manufacturing company. Along with the development of the industry in the past dozen years, the financial data of the company also changed. Next let’s take a look at what the trend is for the household appliance manufacturer.

Here we list the TV manufacturer’s financial data in 1996, 2002, and 2012. 

1996 to 2002

Gross profit ratio – a signal of industry-wise competition level

In 1996, the company’s gross profit ratio was 27%. In 2002, the gross profit ratio dropped to 15%, a schockingly high rate of decrease in merely six years. 

This drop in gross profit ratio is actually consistent with the competitive environment of the industry. The house appliance industry entered intense competition in a short period of time, causing gross profit ratios of all companies in the industry to decrease significantly. The reason of such drop is simple: as prices in the market got lower and lower, certain costs remained stable, leading to a lower gross profit ratio. 

The decrease of gross profit rate shows that the TV company is losing the ability to demand high market price. When this happens to the majority of industry participants, we say that the market environment has become bad.

Could management be the solution to the drop in gross profit ratio?

When the market environment becomes bad, we may need to rely on management methods. 

How can we use management methods to mitigate the impact from the intensified competition?

Let’s recall a crucial formula we covered in previous episodes: net profit ratio x total asset turnover = return on total asset.

A company’s return on investment is determined by efficiency and effectiveness. From the formula above, we know that there are two ways to improve the return on investment (total asset). One way is to improve the effectiveness, the other is to improve the efficiency. 

Generally speaking, if a company’s gross profit ratio decreases, there is no way that its net profit ratio will increase. In other words, with the decrease of gross profit ratio, the effectiveness of the company will fall.

What do we mean by mitigating the impact of the market through management methods?

There are two approaches. The first approach is to reduce costs and expenses in order to reduce the impact to the decreased net profit ratio. But even so, the room for cost/expense reductions are very limited.

The other is to improve efficiency. In other words, when effectiveness becomes worse and worse, we need to improve total asset turnover to maintain return on investment.

However, efficiency of the TV manufacturer – the total asset turnover ratio – decreased instead. 

This seems a little weird. 

What might be the reason for the decrease of the turnover ratio? Does the company ignore the pressure of the market? Let’s think about it.

For companies in the household appliance industry, a big part of assets will be fixed assets, including equipment and plants, etc. Additionally, as competition in the industry gets worse, accounts receivable and inventory suddenly increase. 

As competition forces the company to accept more accounts receivable, and as the market becomes more and more crowded, rendering products harder to sell, both accounts receivable turnover and inventory turnover deteriorates. On the other hand, competition requires the company to accept more sales on credit to satisfy its customers’ needs, and the collection period of accounts receivable becomes longer. And more and more products in the warehouse, i.e. inventory, will stay there for quite a long time before they can be sold.

Another result of intensified competition is excess capacity. 

Excess capacity means a surplus of supply compared to demand. When excess capacity happens, how will the financial data of the company be impacted?

Which item reflect capacity in the financial reports? Someone may say it’s inventory. But as we know, inventory is not really capacity. Inventory is the result of such excess capacity. Capacity is the ability to produce – if there is too much equipment, too much land, too many labor forces, etc., there is excess capacity. For example, if all equipment are running at full capacity, they will produce too many products, much more than the actual demand. In situations like this, companies will normally let some of their equipment idle. These are called idle fixed assets. Once this happens, part of the fixed assets are not creating value.

Let’s circle back to a concept called fixed assets turnover. Fixed assets turnover is calculated by dividing revenue by fixed assets. If part of fixed assets are not creating any revenue but still remain on the balance sheet, the whole fixed assets turnover will decrease.

For the TV manufacturer, it is evident that most of its important asset turnover ratios, including those of accounts receivable, inventory, and fixed assets, are deteriorating from 1996 to 2002, leading to a much worse total asset turnover ratio.

Drops in both efficiency and effectiveness will lead to drop in ROI

Although the company has put a lot of effort into improving management, it still can’t fight the trend of the industry. That’s why we don’t see an increase in total asset turnover ratio. As the effectiveness and efficiency of the company drop, its return on investment will drop significantly as a result.

From 1996 to 2002, we saw a very different trend happening compared to the paper manufacturer. As competition intensified, the paper manufacturer’s accounts receivable increased and inventory decreased. However, we can see that for the household appliance company, both its accounts receivable and inventory increased significantly. 

Why isn’t it the same as the paper manufacturer with one increasing and the other decreasing?

When the accounts receivable and the inventory move in opposite directions, it means that the sale of inventory is really sensitive to the accounts receivable policy. When the paper company increases credit sales, the inventory will be sold much faster. If I reduce credit sales, the inventory will move slower. What this means that the credit sales policy can still make a positive impact in the market, leaving different companies some room to maneuver. 

On the contrary, when the accounts receivable and inventory are moving in a same direction, it means even if the company grants more credit sales, products are still not sold. The competition is so intense that whatever the company does, either proactively or passively, nothing is happening. The only result is the increased accounts receivable and inventory taking up a huge portion of the company’s cash.

2002 to 2012

From 2002 to 2012, we can see that the gross profit ratio hardly changed, growing only from 15% to 16%. The competition in the TV industry was basically stable during these ten years.

Under the competitive market dynamics, we see that the total asset turnover ratio has improved from 0.69 to 0.96, and both the accounts receivable and inventory decreased, signaling an exciting positive trend. The number seems to indicate that the company improved its management by a large amount.

Unfortunately, the actual reason of how the turnover ratios increased is not what we expected. 

Shortly after 2002, the company started expanding internationally, and all its international business was conducted via a third-party company. Unfortunately, this company went into full-blown financial crisis and eventually a bankruptcy, leading to the TV company having to write off all accounts receivables owed by the third-party company as bad debt. As a matter of fact, the TV manufacturer wrote off 3.1 billion USD as bad debt once. The consequence of this is that the company’s accounts receivable dropped significantly, but it also had to report losses for several years afterwards.

Additionally, the TV manufacturer, in order to decrease its accounts receivable and inventory levels, sold part of its accounts receivable and inventory to a related company. In other words, their decrease in account receivable and inventory is not through normal operations. Even though on paper, all ratios seemingly have improved throughout the years, such improvement does not reflect an improved business opeations of the company. In fact, the company actually is getting worse, amounting huge sums of losses along the way.

We’ve already compared a paper manufacturing company and a TV manufacturing company under a static situation and saw how an industry’s overall situation affects individual company’s financials in the industry.

But industries are not static; they can undergo drastic changes in a relatively short period of time. How will the companies change with the changes of industries? Let’s look at the paper manufacturing company.

Here we list the financial data of three fixed time points – 1998, 2002, and 2012.

1998 is when the paper manufacturing company just started its business. In other words, it is the earliest financial data we can obtain. 2002 is the time we used for our previous comparison with the TV manufacturing company. In 2012, the paper manufacturer has been around 14 years into business. 

First, let’s compare 1998 and 2002.

1998 to 2002

Gross Profit Ratio

Let’s look at gross profit ratios first.

In 1998, the gross profit ratio of the paper manufacturer was 32%; however, it decreased to 28% in four years by 2002. 

What does this mean?

The overall competitiveness of the paper industry has probably intensified over the years, from 1998 to 2002. Gross profit ratio reflects an industry’s competitiveness. The more fierce the competition, the lower the profit margins. 

This is consistent with what we saw earlier about the overall development of this industry. In the past 60 years of the industry, the growth rate of investments never stopped increasing. As more and more investment got into the paper industry, the supply side grew significantly, leading to increased competition. On the other hand, demand has been increasing as well, and that was the reason that the gross profit ratio has only decreased by merely 4%, from 32% to 28%. Nonetheless, the decrease of the gross profit ratio does prove that competition began to emerge in the paper manufacturing industry.

Accounts Receivable and Inventory

As an industry becomes more and more competitive, products will not sell as fast as before. The outcome, more often than not, is the increase of inventory. Let’s take a look at the inventory of the company from 1998 to 2002.

What we see is a decrease, not increase, of inventory from 13% to 7%. At the same time, the company’s accounts receivable increased from 10% of total assets to 14%. This is not what we’ve expected.

When a company is facing more and more competition, what can it do to mitigate competition?

The decrease in gross profit ratio reflects a drop in prices. On the other hand, it seems that the paper manufacturing company made the decision to sell more on credit. Granting buyers more accounts receivables could sell products at a faster pace, as evidenced by the decrease of the company’s inventory level. Simultaneously, the drop in inventory coincides with an uptick in accounts receivable level. 

The adoption of agressive credit sales policy is a common practice in competitive markets. For every company, this may be the first strategy companies come up with when they face intense competitions. From a financial perspective, the strategy is actually one that transfers inventory into accounts receivable.

Is this a good thing or bad thing?

Some may think since this strategy helps sell products faster, it should be a good thing. If we can sell our products, we can benefit in many ways. For example, we can grab more market share fairly early. If the products’ market price would decrease in the future, I would have already sold my products.

There is also another direct benefit: Since inventory usually needs warehouses for storage, selling products at a faster pace would save us warehouse costs.

Now that I have sold my products, my inventory becomes accounts receivable, which is closer to becoming cash. Therefore, the overall turnover is also accerlerated.

All of the above are benefits of turning inventory into accounts receivable as fast as possible. However, doing so can also cause some potential problems.

Let’s say if I have sold the inventory, will all the accounts receivable be collectable? There is always risk that some of the accounts receivable will become bad debt. And once accounts receivable becomes bad debt, none of the above benefits will matter: my inventory can be sold for some money regardless of the prices, but my accounts receivable will go down to 0 if it becomes bad debt. It’s essentially the same as having the warehouse looted. 

Now that we’ve seen both these aspects, whether it’s a good or bad thing to turn inventory into accounts receivable is really contingent on whether accounts receivable can be collected. If we can collect the money, obviously turning inventory into accounts receivables will help the product’s sales. But if accounts receivable is not collectable, all benefits we’ve mentioned will be worth nothing.

2002 to 2012

Now let’s take a look at what happened from 2002 to 2012.

Gross Profit Ratio

In 2002, the gross profit ratio was 28%, but it decreased to 15% in 2012. Why was there such a drastic decrease?

Let’s recall what we discussed before about the competitive structure of the paper manufacturing industry. The year of 2008 was a watershed for the paper manufacturing industry, when the Chinese paper manufacturing industry entered the phase of excess capacity. In other words, after 2008 the competition within the industry became significantly more fierce than before. And because of this fierce competitive environment, the gross profit ratio of the paper manufacturing companies dropped significantly.

Accounts Receivable and Inventory

Let’s take a look at the accounts receivable and inventory.

From 2002 to 2012, the accounts receivable dropped from 14% of the company’s total assets to 8%. Inventory, on the other hand, increased from 7% of total assets to 9%. Why didn’t we see the same trend from 1998 to 2002, the trend that inventory decreased and accounts receivable increased?

The aggressive credit sales strategy that the paper manufacturer employed from 1998 to 2002 is a natural response when companies face fierce competitions. However, by adopting this strategy, companies would have to face the obstacle that some accounts receivable will never be collected. Overall, the credit sales policy is rather a temporary solution than a permanent solution.

As more and more companies adopt the same credit sales policies, the playing field is gradually leveled again, giving no particular company an advantage. At this point, adopting the credit sales policy is rather a passive method than a proactive method, eating out everybody’s profits along the way. And competition is much more fierce than ever. 

Once the phenomenon of granting credit sales to buyers becomes passive, more credit sales won’t necessarily decrease inventory anymore; but it definitely increases the company’s financial risks. The paper manufacturer, which realized this, stopped granting credits recklessly in an attempt to move inventory out. Instead, it switched to a more balanced strategy as a way to mitigate risks.

These are the financial situations of the paper manufactory company across different development stages in dozens of years.

We have already grasped the basics of the paper manufacturing industry and the household appliance industry. Now, let’s look at individual companies from each industry respectively. We want to see if the company’s financial data and the condition of the industry are closely related.

First Look

In both industries, we will choose relatively large companies. Yet since there are lots of different household appliances in this industry, we will choose television as our target product. Now let’s take a look at the financial data of these two companies.

Before we get into the analysis, be aware that the time of the analysis is 2002, i.e. before competition in the paper manufacturing industry becomes too intense. 

Gross Profit Ratio

We can see at this time, the paper manufacturing company’s gross profit ratio is 28%. The TV manufacturing company, on the other hand, only enjoys a gross profit ratio of 15%, around half of the paper manufacturing company. (Forgot how to calculate gross profit ratio? read this.)

Why do the two companies have such different gross profit ratios?

Recall what we have discussed in the last episode, the competition within these two industries was quite different at that time. In 2002,

paper manufacturing industry was in a stage of rapid growth without intense competition. The household appliance industry at that time had

already entered the stage of fierce competition. The different competitive environments made a huge difference in the gross profit gratios in the two companies.

Next we are going to look at four financial numbers, all of which are from the balance sheet. They are accounts receivable, inventory, accounts payable and fixed assets.

By looking at these numbers, we notice that all of them are represented in percentages. These percentages are calculated by common size analysis, aka. structure analysis. Basically what common size analysis does is to help calculate the percentage each asset item occupies relative to the total assets. 

Accounts Receivable and Inventory

First of all, let’s look at the accounts receivable and inventory. The accounts receivable of the paper manufacturing company takes up 14% of its total assets. Inventory takes another 7%. For the TV manufacturing company, Its accounts receivable is 23% of total assets, while its inventory takes up 39% of total assets. The combination of accounts receivable and inventory of the paper manufacturing company is 21%, while that of the TV manufacturing company is 62%.

Why does the TV manufactory company have so many accounts receivable and inventory?

Well, on one hand, the competition in the industry is really intense. With so many companies competing for businesses from just a few buyers, these buyers have accumulated immense bargaining power. The buyers not only are able to press down prices, but they also require longer payment time. As a result, TV manufaturers’ gross profit ratio decrease and their accounts receivables increase, and our TV manufacturer is no exception. And because competition is really intense, the inventory holding period is longer. This is the reason why the company has such a high level of accounts receivable and inventory.

Generally speaking, companies don’t like accounts receivable and inventory, because they take up our cash positions. Having too much accounts receivable is like loaning money to the buyers for free. On the other hand, companies love accounts payables, for the reason that they can use other people’s cash for free with paying interest. 

Accounts Payable

But in the same industry, will larger sized companies or smaller sized companies more likely obtain more credits, i.e. taking up other companies’ cash for free? The answer is obvious – it must be the larger sized company. Large companies, because of their competitive positions in the value chain, can often command credits from both buyers and suppliers alike.

The paper manufacturing company we chose is the largest company in the industry at that time. The TV manufacturing company we chose is not a small company at all, but it is far from being the largest company in its industry. However, from the table above, we see that even the largest paper manufacturing company can only command 8% of cash from its supplier. Yet a relatively less dominant player in the household appliance industry can somehow command 15% cash from its suppliers. Why is this happening?

As we’ve covered in the previous episode, the Chinese paper manufacturing industry is short on raw materials. A lot of raw materials such as wood pulp must be imported. As a result, these companies, including the largest in the industry, lack bargaining power against their suppliers. In other words, suppliers are in a stronger position.

On one hand, the stronger position gives suppliers the ability to increase the price, and on the other hand, it impacts accounts payable. Suppliers are less willing to extend credits to paper manufacturers when they purchase raw materials. In the household appliance industry, however, we haven’t witnessed similar bargaining power from suppliers.

Fixed Assets

For the paper manufacturing company, 62% of total assets are fixed assets. For the TV manufacturer, however, only 14% are fixed assets. Even though both companies are in asset-heavy industries, the level of fixed asset investment is still vastly different.

What is the reason for such a big difference?

The paper manufacturing industry is a capital intensive industry. For every 10,000 tons of paper manufactured, it requires 14 million dollars of investment, which is mainly spent on equipment. This is why a large proportion of assets are fixed assets. 

Total Asset Turnover Ratio

At a high percentage level of 62%, the paper manufacturing company’s assets are mainly fixed assets. The TV manufacturing company’s largest asset category, on the other hand, is current asset; when we combine accounts receivable and inventory, we get the total percentage of current asset for the TV manufacturer at 62%. Of these two companies, which one do you think have a faster asset turnover?

Apparently, it should be the TV manufacturer, since current assets have faster turnover than fixed assets. In other words, we’d expect that the asset turnover ratio of the TV manufacturer to be much higher than that of the paper manufacturer. But if we look at the two companies’ actual asset turnover ratios, we will find that the differences are not so significant. 

What’s the reason that the household appliance company didn’t show higher assets turnover ratio like what we’ve expected?

A likely reason is that the current assets of the household appliance manufacturer have similar asset turnover ratio as the fixed assets of the paper manufacturing industry. In other words, the turnover of its current assets – accounts receivable and inventory – is really slow. 

This could mean its accounts receivable may not be collected for a long period of time. Its inventory may not be sold for a long time, and just stays in the warehouses.

This could be bad news for the TV manufacturer. Since TVs are products that update really fast, the value of the inventory could easily depreciate. On the other hand, if its accounts receivable cannot be collected for a really long time, it’s quite possible that it may become a bad debt.

Another look

Now let’s go back and take another look.

The six financial numbers and their respective ratios clearly describe the industry characteristic of the two industries. 

Gross profit rate reflects the competitiveness of the industries.

Accounts receivable and inventory reflect the bargaining power between the companies and their downstream partners, i.e. the buyers.

Accounts payable reflects the bargaining power between the companies and their upstream partners, i.e. the suppliers.

The proportion of fixed assets reflects the demand on cash of the industry.

And last but not least, asset turnover ratio helps us get a basic understanding of how companies are managed. 

We can see that financial data is a really efficient language. With just some simple financial data, we can clearly have a birds-eye view on an industry’s condition. We can also see how any company in a certain industry sort of carries characteristics of that industry. The financial statements will inevitably reflect such traits. 

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What we see now is just a static situation. However, industries are changing all the time, and the internal and external environments of industries vary dramatically across different timeframes. How are these changes reflected on companies’ financial statements in different industries? We will further explore in the next several episodes. Stay tuned. 

Previously we’ve talked about Porter’s Five Forces and how they impact industry profitabilities. In this episode, let’s pick two completely different industries and see how the different industry dynamics impact financial performances of companies in each industry.

The two industries we chose are paper manufacturing industry and household appliance industry. To facilitate a better understanding of our discussion, let’s first establish some basic understandings of these two industries.

Paper Manufacturing Industry

The paper manufacturing industry is not unfamiliar with most people. Almost everybody is a consumer of the paper manufacturing industry. For example, we may read newspaper, use notebooks, read magzines, etc., all of which are different kinds of paper products. In our daily lives, we may also use tissue, toilet paper, etc., and both belong to the household paper products. In addition, every day we buy all kinds of products, and they usually come in packaging, which of course is a type of paper. Therefore, everyone is a consumer of the paper manufacturing industry, but generally speaking, we don’t go to a paper manufactory to buy paper ourselves. By purchasing other kinds of products, we become consumers of paper indirectly. This may also be the reason why we don’t know that much about the paper manufacturing industry.

Put it in another way, the paper manufacturing industry has several different customer bases, i.e. buyers, such as newspaper and press, individual consumers, manufacturing companies, etc. 

Where do the raw materials of paper manufacturing come from? A really important material is wood. Most paper is produced using wood pulp. One example is toilet paper. We always see on toilet paper packaging saying “made of 100% original wood pulp”. This means the raw material of the toilet paper is wood pulp, which comes from wood.

As we know, forest resources are pretty limited worldwide. Therefore, sometimes we may not only use original wood pulp, but also recycled wood pulp, like recycled paper. It also matches the concept of being environmentally friendly. Additionally, the paper manufacturing industry worldwide also uses straw pulp or other non-wood pulp in production. 

The paper manufacturing industry is a capital-intensive industry. To build a paper manufacturing factory, every 10,000 tons of paper production capacity requires about 14 million dollars of investment. For a typical paper factory, the industry standard can reach hundreds of thousands of tonnage, resulting in a total investment of several hundreds of millions of dollars. This is why the paper manufacturing industry needs large amounts of capital.

Now let’s use the five forces model to check the paper manufacturing industry’s overall environment. 

First, we are going to look at two things, the competitiveness of the industry and the threat of new entrants. The threat of substitute products will be discussed later.

Now let’s look at this graph, which describes how the paper manufacturing industry progresses in the past 60 years in China. From this graph, we can see that the output is relatively stable from 1950 to 1990, but starts to climb really fast from 1990 to 2008, especially between 2000 and 2008. After 2008, the growth rate starts to slow down.

Even though this graph is about output in the paper manufacturing industry, it actually also shows a similar trend of investment into the industry for the reason that output comes from additional investment. So investment in the paper manufacturing industry is really hot between 1990 and 2010.

But why is there a turning point in 2008?

Well in 2008, Chinese paper manufacturing entered the phase of excess capacity. Excess capacity happens when the production capacity of the industry exceeds its demands, and when it happenss, the competition will be brutal.

Now let’s take a look at this table. The table lists the cost structure of raw materials and labor to produce one ton of paper in different area in the world. 

Producing one ton of paper in different areas across the world can have drastically different costs. In some areas, raw materials are relatively more expensive, and labors in some others. Remarkably, China is a rare exception. We can see that the labor cost in China is really low; but this is consistent with our commonsense – China is still developing and labor costs are relatively low compared with other developed countries. However, raw material cost is really high in China, or about three to four times the price of those of other developed countries. 

Why is that?

Well we mentioned which raw materials the paper manufacturing industry need. First of all, we need wood. Forest resources in China are relatively scarce compared to a lot of countries. For example, the forest coverage rate in certain countries can reach 80%. But in China, it’s less than 30%. Because of this, the Chinese paper manufactory companies have to import wood pulp from other countries.

On the other hand, companies also try to use some substitute materials, such as non-wood plants, or straw pulp. However, producing straw pulp is a serious cause for pollution, and the government has put down serious restrictions on such method. Another source is recycled papers. Since recycled paper are from waste paper, and the paper manufacturers in China have to rely on waste paper import from other developed countries, which will inevitably increase prices. 

Knowing all these, we can come to the conclusion that Chinese paper manufactories have to face suppliers with stronger bargaining power. For a really long period, competition in the industry wasn’t intense. However, it lacks bargaining power against its suppliers, or its upstream.

Household Appliance Industry

The household appliance industry refers to house appliance manufacturers for things like TV, air conditioner, or washing machine, etc. It is one of the first industries to enter into intense competition in China. As competition becomes more and more fierce, we can imgaine that profit margins will become lower and lower. Therefore, the household appliance industry possesses relatively weak bargaining power against its buyers.

Another feature for the Chinese household appliance industry is that for a very long time, the industry has a really specialized sales channel. This channel is centralized under two or three companies’ control, aka. a high market concentration. This gives buyers even stronger bargaining power. Therefore, the household appliance industry is very different from the paper manufacturing industry, as it lacks bargaining power against its buyers, or downstream.

These are the basic conditions of the paper manufacturing industry and the household appliance industry. Understanding this, we will further explore how companies in these two industries perform financially.