1 BUSINESS SIMULATION: COMPETING IN AN OLIGOPOLISTIC MARKET (SIMULATION EXERCISE TO ACCCOMPANY KEAT, YOUNG, AND ERFLE, MANAGERIAL ECONOMICS: ECONOMIC TOOLS FOR TODAY S DECISION MAKERS, PEARSON, 7TH EDITION, 2014 ) Welcome to the world of oligopolistic competition, in which you are the CEO of Angle, Inc. and will run your company for 5 years competing against 2 virtual companies. You will set strategy, execute annual operating plans, analyze financial statements, and judge how your decisions affect the overall health of the company. In the end, you will see your scorecard results and those of your competitors with one of you being declared the winner. As you have learned in this course (in particular, see Chapters 9, 10, and 11 of the Keat, Young, and Erfle text), operating in an oligopoly market can be quite challenging, especially when it involves pricing. In this type of market, it is not simply a matter of finding the optimal price and quantity at which MR= MC. An oligopolistic company must also be very wary of the prices that their competitors are charging as well as how their competitors might respond to any price changes that it decides to make. As shown in Chapter 11, economists even use game theory to try to understand the complexity of this mutual interdependence in pricing. This computer-based exercise gives you a chance to simulate the challenges of finding the optimal price in a market in which the actions and reactions of three competitors determine who is the most profitable. Moreover, each competitor s spending on marketing and development (i.e. operational efficiency) also has an impact on its profit. The Scenario You are the new CEO of Angle, Inc. and will be competing against two companies: Circle and Square. At the start of the simulation, all 3 companies have the same market share and indicators of financial performance. Your decisions on your business model and strategy and skill in executing the strategy (particularly your pricing strategy) over five years will determine who has the best financial performance at the end of this time period and wins the simulation. While the two competitors may be considered virtual in the sense that their actions will be known only to you via the simulation software, they have been programmed in a way that accurately reflects the strategy and tactics of real competition. You will start to know the competitor s goals and year-by-year moves as you play the game.
2 Angle Inc. is a publicly traded firm based in Atlanta, Georgia. It has just completed its fifth year of operation and was founded by Mike Rogers who continues to serve as Chairman and CEO. It designs and manufactures a flagship product called Alpha all over the world. Last year, Angle had $30 million in sales, a Net Profit of $320,000, a market share of 33.3%, and a stock price of $15 per share. The Alpha product and its market are flat with slow growth potential. Circle Inc. is a Chinese company based in Shanghai with aspirations to expand its brand around the world. The CEO is John Li, a second generation Chinese-American with an MBA from a top American university. John spent his first five years as a production quality engineer in a semiconductor manufacturing company and then went back to school for his MBA. He then worked for 3 years in a hedge fund. The booming market in China prompted him to return to his roots. Along with a few of his MBA classmates, he started his own consulting company in Shanghai. However, he longed to get back to the real world of business operations and so quickly accepted the challenge of heading up the China-based Circle Company. Circle sells a product that is just about identical in features and functionality to its major competitors: Angle and Square. Square Inc. is an Italian company based in Milan whose brand is already recognized throughout the world, but whose cost-competitiveness and brand equity are being threatened by growing global competition, particularly from the Asia-Pacific region. CEO: Angela Fiorello, started from the ground up in her family textile business. In her family business, she demonstrated her natural talents in product design and marketing. She received an MBA from SDA Bocconi (Milan), one of Europe s leading business schools. Her family company was bought by an Italian conglomerate, which soon recognized that Angela s natural talents and top education could be put to good use to head up Square, a public company in which they held a minority ownership. With the conglomerate s support, Angela was appointed as the new CEO of Square. Square competes directly with Angle and Circle with a similar product to Alpha.
3 The Market for Alpha Angle and its competitors have been in business for 5 years with all 3 companies selling the same product (Alpha). At the start of the simulation every company is equal which means that the financial results of revenue, profit, inventory, profit margins, and stock price are the same for each company. In fact, market intelligence shows that all 3 companies are also the same in these categories: Price for Alpha: $100 Number of units sold last year: 300,000 units Production capacity: 333,333 units Cost per unit of Alpha: $80.23 Amount spent on Marketing: $4,500,000 Amount spent on Development for manufacturing $300,000 efficiency: Outstanding Loans: $12,000,000 Additional data shows the following about the marketplace: Market size: $90,000,000 Forecasted growth rate: 0% All 3 companies are competing in a fixed market. Note: over time, the market could grow slightly if there is enough price reduction and marketing to simulate industry demand. Two dominant strategies have been used in this market by Square and Circle. Product Differentiation Strategy standout from the competition by investing in marketing and drawing customers in to buy their product. This is the differentiation approach discussed in Chapter 9. Pricing for this type of strategy is based on prestige pricing noted in Chapter 10. Cost Leadership Strategy- standout from the competition with a lower cost per unit. This strategy is also explained in Chapter 9. A company using this strategy succeeds by reducing its costs below its competitors so that it can profit even when prices are low.
4 Finally, market research shows that there are 3 types of customers for Alpha: 1. Brand Loyal those customers who will generally continue to buy from the same company independent of price or competitive marketing efforts. However, brand loyal customers will go to competition if they feel the price is unusually high or if they are not marketed sufficiently. 2. Price Sensitive those customers who will shop for the lowest price for Alpha. 3. Marketing Sensitive- those customers who can be lured away with strong marketing (advertising, promotions, customer service, etc.) campaigns. Your Marketing Department has provided you with this chart:
5 Simulation 5-year Cycle You play the simulation for 5-years (rounds) as shown above. Each year you submit your annual plan, analyze the year s results, and submit the next year s plan. Starting and Setting up the Simulation Start the Simulation on your PC and the CEO dashboard will appear. This is where you set your goals, review all your financial reports, launch your annual planning cycle, and see your annual results. CEO Dashboard The Dashboard is divided into 4 areas (click on the Help button for more information about each area) but essentially the areas are:
6 Menu use these buttons to control the simulation, see your score, and review help contents. Action this button runs the setup wizard and inputs your annual operating plans. Reports these buttons display financial and business reports that you may review to help you run your business (reports may also be printed). Status Panel- current stock prices and product prices are displayed for all three companies. Your results against your 5-year goals and year-on-year changes to Revenue and Net Profit are displayed. Note: information is updated at the end of each year. Startup Wizard Playing the Simulation Click on Start Simulation and the simulation startup wizard begins. Follow the instructions on the screen. If this is your 1 st time playing the simulation, we suggest entering the following end game growth targets as follows: Revenue: 2% Net Profit: 1% You have 3 choices on the simulation s difficulty (how the CEO s of Circle and Square compete with Angle): low, medium, and high. If this is your 1st time, we suggest choosing low, but the choice is yours. Click Finish to end the simulation startup. Angle has 2 basic strategies you can employ to meet your goals and win the simulation (both can succeed and win the game.) You execute your strategy by entering 5 Annual Plans. Each plan consists of 6 decision variables: 1. Price of Alpha the selling price for 1 Alpha. 2. Production Plan for Alpha the number of Alphas to produce next year (maximum is 333,333 annually.) 3. Marketing the amount of money to be spent to market to customers. Note: minimal amount you should spend on marketing is 14% of next year s projected revenue. The calculations of projected revenue and minimum marketing amount are: Projected Revenue = (Inventory + Production) x Price. For example: Projected Revenue = (25, ,000) x $100 = $32,500,000
7 Minimum marketing amount = $32,500,000 x 14% = $4,550, Development the amount of money to be spent on manufacturing efficiency. Spending on development will lower your unit cost in the years following the investment. Meaning that funds spent in 2009 will realize unit cost savings in 2010 and beyond. 5. Loan Increase the amount of money you wish to borrow. 6. Loan Repayment- the amount of money you wish to pay back on your loan s principal. Choose your strategy: Cost Leadership or Product Differentiation Cost Leadership - Attain competitive advantage by running Angle so that your cost of producing Alpha is lower than Circle and Square. An example of the implementation of this strategy in the simulation for your first year is: What do I do? Set price for Alpha at the same amount as last year or slightly lower Run production near or at full capacity (Note: take into account the amount of inventory you have from the previous year) Spend the minimum on marketing (14% projected next year s revenue) Start of Simulation What I enter for my first year $100 $99 300, ,000 (Note: there are (will yield 25,000 in inventory 333,333 units that were not sold for sale) last year) $4,500,000 $4,620,000* Spend more on development $300,000 $400,000 Do not increase your loan amount unless you are running short of cash $12,000,000 outstanding loan $0 loan increase (Note: $750,000 is the maximum amount you can increase each year) Pay back some of your loan principal if you have the cash to do so $12,000,000 outstanding loan $500,000
8 If you follow this strategy, you will expect to see the following results yearon-year: Lower Profit Margin (less profit relative to revenue) Inventory low or none * Minimum marketing amount = [(308, ,000) x $99] x.14 = [333,333 x $99] x.14 = $32,967,000 x.14 = $4,620,000 (rounded) Product Differentiation- Attain competitive advantage over Circle and Square by via marketing. An example of the implementation of this strategy in the simulation for your first year is: What do I do? Start of Simulation What I enter for my first year Set for Alpha price at the same amount as last year or slightly higher Run production at less than full capacity (Note: take into account the amount of inventory you have from the previous year) Spend more than the minimum on marketing Spend the same or less on development Do not increase your loan amount unless you are running short of cash Only pay back some of your loan principal if you have the cash to do so $100 $ , ,000 (Note: there are (will yield 25,000 in inventory 325,000 units that were not sold for sale) last year) $4,500,000 $5,500,000 (Note: this is over 16% of projected revenue) $300,000 $300,000 $12,000,000 $0 loan increase outstanding loan (Note: $750,000 is the maximum amount you can increase each year) $12,000,000 $0 loan payback
9 outstanding loan If you follow this strategy, you will expect to see the following results yearon-year: Higher Profit Margin (more profit relative to revenue) Will have some inventory Impact of increasing each decision variable (holding everything else constant) Increase price of Alpha Increase in marketing Increase in development Setting production closer to full capacity Decreases units sold, but also may increase revenue and gross profit margin, depending on how much of units sold declines Increases units sold Decreases unit cost (1 year lag) Lowers unit cost (note there is a risk of more inventory if the demand is not as great as expected) Enter Your First Operational Plan Now that you have chosen your strategy it is time to enter your plan and begin playing the game. Here are step-by-step instructions for entering your 1 st Plan: 1. Start the simulation. 2. Run the Setup Wizard. 3. From the CEO Dashboard, click Plan for 20XX and the planning input screen appears. The planning screen has 3 tabs to enter your decisions (Price & Plan, Expenses, and Financing). You start in the Price & Plan tab.
10 4. Enter the price you wish to charge for Alpha in the Enter your price for 20XX box. 5. Enter the amount of Alpha you wish to manufacture in the Enter your plan for 20XX box. This amount will be manufactured and added to your existing inventory. 6. Click Next to move to the Expenses tab. The screen changes to: 7. Enter the amount you wish to spend on marketing in the Marketing box. 8. Enter the amount you wish to spend on development in the Development box. Note: if you wish to go back and change your price or production levels, simply click on its tab. 9. Click Next to move to the Financing tab. The screen changes to: 10. If you wish to increase your loan (limit of $750,000 per year), enter the amount in the Enter your loan increase box. 11. If you wish to repay a portion of your loan s principal, enter the amount in the Enter your repayment amount box. 12. If you are happy with your plan, click Submit Plan and the simulation runs. If you wish to change any of your decisions, click on any of the tabs and make your changes. If you do not want to submit this plan, click Close or close the window by clicking on the X in the upper right.
11 How to Analyze the Results The simulation is rich in data and there are numerous steps and sequences you could use to analyze what happened and why the results vary. Here is one possible sequence. 1. How were sales? a. How many units did you sell? Check the Supply Report. b. What happened to your inventory? Did it go up, down, or stay relatively the same? Check the Supply Report. c. How many units did Circle and Square sell? This is easy to calculate. Divide their Revenue by their Price. Revenue is found in the Income Statement and their sales price is on the CEO Dashboard. d. Determine what caused results. Possible reasons to investigate: (1) your price compared to Circle and Square s prices and (2) the amount you spent on marketing. 2. What was the price elasticity? a. What was the percentage change in the quantity demanded of my product relative the percentage change in my price? b. What impact might my levels of spending on marketing have had on my quantity demanded? c. Is there a cross-elasticity factor involved? Did my competitors change their prices and if so, how might that have affected the quantity demanded for my product? 3. How was my income? a. What are your revenue, gross profit, operating profit, and net profit? Check the Income Statement. b. What were the gross profit, operating profit, and net profit for Circle and Square? Check the Income Statement. c. What are the reasons for your results relative to theirs? Possible reasons to investigate: (1) your price compared to Circle and Square s prices and (2) your spending on marketing, development, and your unit cost. ********************************************************** Note: the following questions are optional. These types of questions are covered more in courses in finance and accounting, but every business student should be familiar with them.
12 What should you do next? 4. How are my financial ratios? a. What are your Gross Profit Margin, Operating Profit Margin, and Net Profit Margin? Check the Financial Ratios Report. b. What trend are you seeing in your ratios year-on-year? c. What are Circle and Square s Gross Profit Margin, Operating Profit Margin, and Net Profit Margin? What is their trend? How do they compare to your trend? 5. What is going on with inventory levels? a. You know your inventory level from step 1. b. What are the inventory levels of Circle and Square? Check the Balance Sheet Report. Why are they different? Possible reason: The company who charged the highest price, probably has the highest level of inventory. Once you have analyzed the results, you can follow 1 of 3 possible strategies for the next year. 1. Stick with your current strategy (low cost or differentiation) 2. Switch to the other strategy 3. Experiment with a blend of both business models Quick Check on Your Understanding of What to Do Next: Suppose in the first year you chose the cost leadership strategy as shown above. Which of the following indicates that you decided to continue with this strategy in the second year of your operation? 1 How to Win A. Price: $100 Marketing: $525,000 Development: $300,000 B. Price: $99 Marketing: $300,000 Development: $400,000 C. Price: $98 Marketing: $500,000 Development: $450,000 When you complete your 5 years as CEO, you will receive an appraisal of your performance based upon Angle s performance against Circle and Square. One of the 3 companies Angle, Circle, or Square will be declared the simulation winner based upon a balanced scorecard approach.
13 Anytime during the simulation, you can view your score by clicking the Score button from the Dashboard. Consult the help menu for details on the scorecard calculations.