Anatomy of Indian real estate crisis

There are so many articles attributing current Indian real estate crisis to improper financial planning, operation failure and malicious industry practices. But I haven’t read any analysis on their failure of business strategy and its related risk management practices.  So I intend to explore this subject and have penned down my quick thoughts on the topic.

Successful organizations like Amazon base their business strategy with customer at center. Their product offering, go-to-market plan etc are all devised based on clear customer segment identification and their needs. Organization known for innovation also define their research priorities keeping in mind customer preferences. Can we say the same about realtors in India?

Dichotomy of India is that while she houses significant poor population, there also exists handful of super rich families of the world. If population is grouped based on household income, we form famous pyramid with few rich at top; majority poor at bottom and struggling middle tier aspiring to reach the top. Strategic choice for any business in India is to determine whom they want to cater to among this population segment and why. I believe this is where realtors lost their way somewhere post subprime crisis.

Post sub-prime crisis, liquidity taps were opened and rates were slashed to keep economic growth in India. Super low rates to negative rates in developed countries led to flow of capital to risk assets in EM like India. Indian entrepreneurs were taking big bets in the country & abroad and economy seemed to be bouncing back against the fragile developed economies. PE firms entered Indian real estate market; realtors employed marketers who created new segment of super luxury residential complex for super rich & ‘future to be rich’ to meet their high financial return requirements. Initial set of such projects were taken up by rich segment and profit margins were much better than the usual vanilla apartments. Many factors were at work:- high liquidity, low rates, optimistic domestic business outlook, easy avenue to invest black money, NRI investment from abroad and new culture of extravagance display.

Similar to capital markets, I believe any market is broadly composed of hedgers/users(people who need); speculators(traders who want to take bet) and arbitragers(who sells something overvalued and buys undervalued). First set of supply was taken up by high demand from hedgers(super rich looking for extravagance); speculators (expecting growth to continue and burgeoning middle class to become rich) and arbitragers (sell old flat in premium locality to new extravagant flat in less premium locality). In market, when higher returns are available with lower entry barriers, more competition enters and that’s what happened soon with all realtors launching super luxury projects. Arbitragers demand made realtors move away from premium localities to developing new land parcels at outskirts of cities. Soon economic cycle turned, speculators no longer added to their bets; hedgers demand had fallen; arbitragers didn’t see possibility of necessary infrastructure being developed in near future in new localities and thereby put off their plans to move outside premium localities for increased facilities. By mid 2013, liquidity dried up, taper tantrum led to higher rates and impending election led to lower approvals and construction came to standstill. NPA’s started accruing at banks with economy in doldrums; new capital was not available for growth. Then new government came with its tighter vigil on black money and higher focus on cleaning banks balance sheet. Speculators started sale of their real estate asset and book their PnL, banks started fire-sale of mortgaged asset leading to increased supply. Realtors got support from new set of financiers like NBFC which provided them time to survive but at much higher cost. From there on the sector has undergone both time correction and price correction.

During all this time, there was majority of population whose need for housing was not catered to by the industry.  Huge population found it unaffordable to buy house and industry simply ignored their need. Not many realtors business plan focused on innovation to keep cost down/lower margin and make it affordable to this customer segment. There was always a price point wherein flats were easily sold but most realtors simply ignored these hedgers segment at lower bottom of income pyramid for higher returns. We had classic case wherein most wanted to be premium player in the market and market sizing of this segment was based on optimistic assumption by industry players. In simple words, everyone wanted to provide Apple’s iphone and very few saw the need for Micromax in the industry. So along with all the malpractices attributed to sector, somewhere I believe not being able to target right customer segment and their needs is also one of the contributor to the current real estate mess.

It’s easy to comment today knowing the outcome of situation but it is always difficult to act in similar real situation then. Risk management learning - let’s go back and revisit the strategic question as a realtor and see if we could have identified the risk then with sound risk management practices. There were 2 options: - Launch super luxury project with expected returns of say 25% or mass project with expected returns of say 15%. Is it right way to compare? Any investor would look for risk adjusted return so let’s relook with this perspective. Risk primary with super luxury project relates to ability to sell them in reasonable time apart from operation risk that exists in all projects. So scenario analysis should be done on this parameter as variable and risk should be quantified atleast on expert judgment basis, in absence of any data or scientific methodology. Additionally such high value properties are highly illiquid so returns must be adjusted for liquidity risk also. Once adjusted for these risks, would the differential returns be high? Not sure if such risk management practices are followed by the industry and does it make sense to realtors. I certainly believe such quantification should be useful but views are biased.

I would like to end this with an admission that above quick thoughts are novice view of the sector and any alternate views are welcome. Few points to ponder as I end the post:- Do we examine business risk with similar focus as financial risk? Should ERM as an approach resonate with all industry and not only financial services? Do you see similar situation in other industry where there is latent demand for x product but market players are providing only y product which has limited demand but higher returns?

Experiential Learning : Fallacies of Human Mind - I

After having spent significant time of my short career on the quantitative aspects; I was intrigued by behavioral science and so sometime a year back I took course by Prof. Dan Ariely on this subject. I found course to be quite insightful and practical. Since then I have been consciously trying to recognize and overcome common behavioral mistake in my decision making process. I must confess that my success ratio is pathetic but now I am at least aware of my mistakes. As part of my experiential series, I would like to introduce few concepts I learnt during the course with examples from non financial world and then elaborate on my experience from the investment side.

‘Human mind likes to select default option and therefore decision making tends to be more default. This issue is exacerbated as complexity (option) increases. Default option is not always bad or always good. It is just an option which is easy for our brain to select ’. I have always enjoyed solving complex problems and therefore I took time to accept this. But now I am able to appreciate the same over period of time. Marketers exploit this behavior to make us buy stuff which they want us to buy. For example cell phone manufacturer sells phones under different brand name with almost similar specs at similar price that it is difficult for buyer to make rational decision. In such cases, instead of buying based on ones need, buyer tends to buy stuff that is sold to him. This is because mind selects default option instead of choosing right one from the many available options.

On the investment side, this problem is even more difficult to recognize. We spent so much time on selecting right stock/investment so as to beat the market returns but once the investment is made then our behavior moves to default option. Though every trader would agree that once the position is marked to market on previous day, holding on to the existing position is similar to taking fresh position but very few traders put that to practice. We have tendency to continue with default option that is to hold on to existing position. That's the reason of the industry practice of having stop loss; to force the trader to think of his existing position. So many times in past I have exhibited such default behavior while trading and in fact still continue to do. For me, ability to exit an existing position is still a challenge which I continue to face but now I am aware of it and working on it.

This concept applies to the quant world also. Industry still continues to use archaic models that assume normal distribution of returns irrespective of market behavior since it is more familiar to them and hence is their default behavior. VaR continues to dominate risk management world rather than mix of complex stress scenarios which can quantify tail risk also. Management still needs one simple risk metric even though it may be inadequate under stress scenarios. Only change post crisis is recognition that these models may fail. In era of negative interest rate, CAPM still continues to be base model. Inspite of ballooning deficit, US still remains standard for risk free rate. And the list is endless…

This concept also applies to every human being when s/he makes the important decisions of their life. If I look back today to see how the most important decisions of my life were made then I feel lot of them have been influenced by this default option especially when stakes were high. Just take few minutes and ponder how you made your most important decisions of your life. Most of us must have been influenced by this default option. I have currently no standard method or process which helps me avoid this pit fall except that I now recognize the issue. My way of overcoming it is to reduce the available options and then consider default option as unviable and then let my grey cells identify second best option. Then problem is reduced to evaluation between default and second best option just selected. Still it continues to be challenge to ensure rational decision making. Any suggestions to handle the issue better?

New India : Post Demonetization ?

Whether you like him or hate him, you have to laud Mr Modi for his courage to take bold decision that can disrupt the society/nation. There have been many business leaders in recent times who have adopted disruption as model to change the industry dynamics but very political leader have adopted such model for governance.  It is double edged sword and not many are willing to risk so much when the stakes are so high.  Before you carry any impression of this post being the diatribe by one of his staunch followers, I would highlight that I only acknowledged his courage to take such bold decisions. Whether the decision is good or bad that time will only tell us but it will definitely have far reaching impact on our society.  I have attempted to put across my objective assessment of the event and its possible consequences without taking ‘for or against’ view. 

East Asian crisis is said to have imprinted financial crisis fear in minds of the people living in those countries at that time and hence for years later they have preferred to save rather than spend unlike their western counterparts. This fear led these countries to maintain much higher reserves as safety net for any future crisis. Similarly in India, high inflation observed in last decade has led to erosion of wealth for savers in India and this has given rise to new generation of spenders. I believe demonetization has potential to have such behavioral change on our society and therefore have tried to focus such long term effect rather than taking myopic view that focuses only on immediate consequences.

Greed and fear are two emotions which determine large part of people’s behavior when it relates to money management.  Current demonetization of high value currency notes will immediately alter the current equilibrium of these emotions in people. People at large seem to have overcome the fear of corruption/black money and it is the greed that seems to be driving their behavior towards current form of society. Years of inaction against corrupts/black money hoarders has reinforced the moral hazard.  Like all moral hazard problem, everyone knows it exists but don’t know how to avoid the same. Mr Modi seems to believe that his decision will end this moral hazard issue in the society. He is trying to make it difficult for corrupt people/black money hoarders to avoid erosion in their wealth by his policy decision. Hypothesis here could be that the pain such people will go through while losing their wealth which they have always believed to be theirs would be immense and would prevent them from hoarding black money in future. The consequences they will face will serve as deterrent for others in the society to commit on this path of corruption & black money. Also people who have paid their taxes on time will get pleasure of seeing the pain of others who don’t fall in their group and would reinforce their FEAR in future. (In fact it is this pleasure which led to initial positive assessment of his decision). If this succeeds then we may see an end of parallel black economy that has existed for years. It would make it difficult to fund terrorism, bribe officials etc since source & use of funds can be known easily. Already news have been flashing of the difficulties naxals are facing to exchange their loot and they may also see erosion in their wealth. Here FEAR is expected to bring about positive change in people.

Let’s try to take contrarian view about the same event. The high valued notes earned by the people have suddenly become worthless instills FEAR about monetary currency. The current monetary system exists mainly because of the people faith that it will be honored without much hassle.( Of course in current form, one can deposit or exchange currency notes up to certain limit but it is certainly not hassle free.) If people start having doubts about high value currency notes then in future they will not like to accept it or keep it as saving instrument. Would they then prefer gold over them in future since in our society gold’s acceptance has never been questioned yet? Further its global acceptance provides additional comfort for liquidation and removes one’s dependency on nation central bank. This can lead to situation wherein savings would not get channelized into useful development but into gold hoarding. Of course government and central bank may have other means to change this behavior but it would take years to acknowledge and act on the same.  Lot of black money hoarders were believed to have rushed to buy gold, USD post demonetization announcement. Of course they intended to convert black money into gold for future use. But will this immediate gold buying end once these two months are over? Answer could be NO!!! Government would like to believe it will create enough incentive to move people to digital currency. Phew, new disruption model for country where literacy rates are so low; where gullible people have been duped so many times in past that they don’t even trust the banks.

Black money incentives risk taking, discretionary spending among the people. Demonetization will lead to overall decrease in wealth in the society as such and would either strengthen central government or central bank balance sheet. Even if government increases its expenditure, it will take time for this wealth to be accumulated by the society large. Now what do we expect from such society which witnesses mass wealth (legal/illegal) destruction due to act of government? FEAR ? People would spend less, less corporate gains, lower number of new jobs etc. Coupled this with highest population in age of 20-30 years, global slowdown & protectionism and rising terrorism imagine the potential social unrest it can create in huge nation like ours.  In both above cases, FEAR seems to have negative consequences for the society.

The actual consequence of this event may lie in between both the extremes described above.  It is very difficult to gauge people’s behavior and predict the future especially when population is more than billion. But it is certainly one of the exciting times to be in India to experience the same.  Government and its policies will definitely have key role in influencing people behavior. But I firmly believe it is us and our behavior that will shape up the future of this society and government response will be guided by them. So let’s keep our emotions in check; objectively assess situation with open mind post immediate fallout before forming any firm opinion about the event. 

Pricing Woes for Airliners

We saw extensive coverage of Kingfisher Airlines mounting debt for last two weeks and it still continues. I don’t understand whether news are being covered because of its promoters or there is genuine concern about the company and industry. Sometimes it feels similar to ‘run on the bank’ like syndrome and few sadist just waiting to celebrate death of the company. The real problem/concerns for the company/industry seems to be lost in midst of the expert opinion by analyst/leaders.

Lot of bullshit has been written on predatory pricing by the players which is killing the industry. But sorry people I beg to differ here. We need to answer simple question here? Who are the competitors? Are the industry players competing among themselves? Or are they replaceable? Let me go back to history. Indian aviation sector became attractive, once the burgeoning middle class started using the service, which was made available through low cost carrier like Deccan. Other important trigger was the growth of the corporates especially in service industry like IT. Let us consider each of this segment and understand their possible action in case there wasn’t predatory pricing by the players as termed by the analyst. Corporates in that case would prefer to use the services of teleconferences/video conferences which are made available at much lower cost. Further most of MNC are already used to such services when interacting with their overseas clients. Also during the recent economic crisis lot of corporates did transition to such services. So increasing price would certainly have negative impact on the volumes in this segment. It may be countered with argument not all cities/towns might have such facility but then do these cities/towns have decent airport and volume to make that routes viable for any airlines? Second important segment was middle class of India which has always been price sensitive.People in this segment still check the fares of second/third AC railway tickets and perform the cost benefit analysis. So here industry players aren’t competing among themselves but with other industry which is highly subsidised and can afford to run in losses since it intends to make up by other services. In such a market dynamics I don’t see any other option for the aviation sector but to keep price low especially in high inflation scenario.

Before applying any futher thoughts on pricing let us analyze the cost structure of airlines.To add to all pricing woes, the most important cost for the sector is aviation fuel whose prices have been volatile and it needs to be imported. The prices are function of the global demand, not the domestic demand and are decided by few countries that have huge resevoirs of oil. No company in industry can decrease this cost by backward integration nor does the law permits them to manage their own imports.So the cost is subject to not only the volatility in commodity market but also foreign exchange market.Further the companies have high fixed operating cost and in case of low volume they lead to high losses. Not to forget the seasonality factor & regulator who seems to keep close watch on the prices. Further weather & operational inefficiency of the security/airport staff also impact the volumes for the industry.Shortage of qualified pilots & skilled cabin crew leads to additional cost for the industry.It is very important to appreciate all these factors because careful assumptions are to be made to determine cost per traveler/seat on the route. Without knowing the cost no pricing strategy can be devised. The complexity in this case is that assumption are not only required on demand/supply side but on aviation fuel, seasonal effect etc. Any variation in these assumption can have huge impact on pricing strategy.

So on the one hand industry is competing with subsidized railways and the new technology which curtails their pricing power and on the other hand the cost structure is dependent on the global economic factors which are beyond the control of the industry. Pricing in such scenario can be very tricky. Aviation industry is known to have used demand pricing strategy across the globe wherein the prices increases as demand increases. However in India regulator has put some caveats in place to avoid cartels. Further globally the industry doesn’t face same challenges as in Indian scenario. Is this time to rethink pricing strategy? What can be learnt from shipping industry/telecom industry? I have no answers to the pricing woes but I bet its one of the most challenging business problems. We have just scratched the issue here with minimal knowledge of the industry. But certainly it has got my grey cells working. In fact next post I would like to focus on the financial woes of industry & KFA especially.Maybe it might throw up some answers then!!

No Change in Pricing Strategy Please!!!

After long break I am back to blogging. It has been one full year now after my graduation and I must confess that graph of my intellectual curiosity is exponentially dipping with time. Unlike academic life, Professional life doesn’t give that luxury to experiment, learn & grow. The daily mundane task eats most of the time. But I have somehow continued my habit of reading universities blogs, business magazines etc which have been helpful to stay somewhat abreast with latest studies/researches, news etc.

Few days back I came across very interesting article in recent edition of HBR. Though I hadn’t been the big fan of HBR during MBA days but these days I do glance through the same. As always I found most of the articles uninteresting except one which caught my eyes. I had experienced the same in past one year. I can’t recollect its exact title but it was something like “Why are business leaders not ready to innovate pricing”. During MBA everyone is taught different methods of pricing (cost based, market based, value based etc.). Phew!! One year away from academics really makes it difficult to recollect all the jargons and methodology (Signs of becoming unemployable :( ).But just try your luck to implement one of them in real world and you will face the resistance. The same experience is narrated by the author.

I have read n number of articles and research in recent times on pricing in the recession etc (of course sources includes mother of all gas content Mckinsey & peers) but my success of implementing those or convincing people to do the same in my company is questionable. So why is this resistance? The fact is no one wants to take hard decision. No one wants to lose competitive edge and innovation can never come without risk of failure. Consider for instance IT outsourcing industry which went through the troubled times during recent crisis. Every CEO, CFO in their quarterly results were cautious and have made statements like we are experiencing pricing pressure and it has affected our margins by x basis points. But none of the analysts have asked them what they are doing to counter the same. Every company fears any change in their methodology might cause them to lose customer. But can’t there be win-win situation? There are such methods but companies are just not trying them. Why? Simply because they can get away easily and isn’t the matter of their survival.

Consider other industry where the case is not same-Telecom industry. Tata Teleservices came up with pay per second pricing. Was it good for the industry as such? Perhaps not. Was it good for the company? Questionable. Was it good for the customer? Certainly yes. So what was it that made Tata Teleservices to risk a change in pricing which IT outsourcing industry isn’t ready for? It was question of its existence in competitive market. In absence of any differentiation among players price is final weapon which they had and they used it. I am not here to justify their action or strategy but am providing only the situation when company looks for innovation in pricing.

Other situation when company is ready to experiment with pricing is when there is huge gap with demand and supply and its sellers market. Example of this can be realty pricing in Mumbai wherein developers started charging for built-up and super built up area and then it became norm. But such cases are not going to be more in future given nature of competition that exist today & our integration with global economies.

So what am I trying to suggest by these random examples. Put theory aside. In real world 99% of the company would resist any change in implementation of new pricing methodology until it becomes matter of its survival. This is hard truth. But given such situation arises in your industry would your company be able to suddenly come up with new pricing strategy or just wait for competitor to act and then copy if successful. Which one is good strategy? Latter can also lead to case where no one in industry is ready to risk itself causing industry wide slump (Airline industry). So isn’t it advisable to at least have alternate pricing strategies ready and tested so that it can be implemented any time. Isn’t it good idea to have dedicated team to look at innovative pricing models & be ready with its go to market strategy. I believe some more part of the R&D expense should be spent here. There is enough scope to learn from one industry and replicate in other. Why stick to well defined methodologies learnt in B-school or follow the market leader? Innovation in pricing is need of the hour along with product/service innovation. Corporate world please wake up!!!!

Experiential Learning

This post is going to be quite uninteresting because it is about mundane stuff which all of us experience everyday but still make mistakes. It is especially key learning of fresh MBA entering the corporate world. Even though I had previous work experience and knew this very well but still a stint in academic changes the mindset. These are my 3 most important learning in first two months of work:-

1)Expectation Management :-
MBA coming out of from B school working 20 hrs a day, learning a merger and acquisition case study, developing pricing strategy for new product, understanding the impact of globalization, doing industry analysis using Porter framework as part of assignments that too in a day, one can imagine his expectation from the corporate world. He considers himself fully ready equipped with all sort of management ammunition to attack the “bottom of the pyramid” and "creating value for the shareholder". He is waiting for companies to embrace him and ask him to turnaround their company. Don’t get bewildered, this is practically most of the MBA’s expectation to work as management consultant/investment manager/brand manager etc. And please don’t ask about salary and of course there is certainly location preference (after all he is “MBA”).
But wait what he finds in real world? He is not doing the expected work but is simply googling data or making some report for some senior to make presentation and no one is asking his inputs for the company’s future strategy. And what happen to salary it’s not even 50% of what he was suppose to get. Location? ? Are you joking to ask such question in globalized world? Wait didn’t mention most important point he would have landed in wrong industry all together
So you can understand his state of mind. So what should one do? Someone told don’t worry till you are in “right bus” but here there seems to be no vehicle altogether.
Relax this is fact of life and most of people would have experienced the same. It’s called Murphy’s Law. I had read somewhere “career planning = career limiting” and most of us make this mistake. We make ourself too inflexible since we have planned career well from manager to CEO in some record time of 5-6 yrs. We have fixation to profile, industry to such an extent that even if we get better opportunity in other areas we turn blind eye to it. So my only learning is plan career with caveat its never going to be way you intended. Then you may ask y plan career? Simple answer to this is that everyone of us either make gymn schedule or study schedule or take new year resolution sometime or the other knowing fully that we have always failed to follow it but that doesn’t stop us from making them. Same is true with career planning.
This is how I have reconciled myself :).

2)People Management:-
Recollect your OB lectures when everyone was sleeping wondering why one has course such as this in their program. However after an MBA, in just few months one would realize that Kotler’s and Damodaran is of not much of use nor the Peffer’s ,Prahlads and Ghemavat. You don’t need to read “Talent is never enough” by John Maxwell since you experience it. You can see very talented MBA from best of Bschool reporting to someone who is hardly graduate and this fresh from B school starts complaining about company not being able to give its employee due worth. These examples help him to reinforce his belief that company has not given right profile/money. But the fact is intellectual capability is not of much importance if person cannot drive the behavior in organization. Best of strategies are of no use if they cannot be implemented. Sales manager who cannot motivate his team to achieve their target is of no use even if he has fool proof strategy. The same is true with all the other functions of business. Everyone has a supervisor and the other fact is everyone finds his/her supervisor as biggest fool on the Earth. Moreover this is true for fresh MBA who was taught “Managing with Power” and was never taught how to work without power. It’s very important to pursue ones viewpoint rather than reconciling to the belief that the other person is fool. It requires lot of courage, persuasion power, negotiation skill and understanding of OB to get one’s work done without “power”.

3)Don’t miss forest for trees:-
Completely frustrated MBA in wrong place under fool considers his work very trivial. He fails most of the time how this trivial work of his fits in bigger picture of the organization. This may be because he is too dejected that he doesn’t even want to put an effort to visualize the big picture. This is big trap and if one falls in it then it can act as a “tipping point” after which there would be steep descent in his career. So ensure you have big picture in mind and work towards it with hope that it would be rewarded and you would get better opportunities in future.

This has been my experiential learning till now. Some of the things I have experienced and some are my opinions/belief and its quite difficult for me to separate one from other.
Quite big and boring post and it’s in my interest to stop gyaan before I loose subscribers to my blogs.

Value based pricing ??????

I am just wondering how many theories backed by case study which you one learns in B-school have no relevance in real world. Or is it that I have not understood them properly so finding it difficult to relate to problems in corporate world or is it due to my inexperience. I sincerely wish that second reason should turn out to be true.

Value based pricing was one the most abused word in all my marketing lectures. Every professor would provide “gyaan” that customer is willing to pay upon the perceived value of the product/service and not based on the cost aspect. It is duty of the marketer to create this value perception. They told us it is difficult for company to move from cost based pricing to value based pricing. The examples of Pepsi, FMCG products etc were standard. So it became mantra for us that wherever we work we must ensure that gradually we adopt value based pricing by educating the customer. But in real life situation is totally different. Consider for example entire outsourcing industry which came to existence due to cost factor. Now Indian players as outsourcing center played cost card to their advantage and gain competitive edge over other MNC. As Indian players matured the cost of employees in India increased manifold though nothing compared to US and Europe still. Further the new cost centers like China, Brazil, and Philippines etc emerged. Also most of the MNC established there delivery center in India and such places and have removed cost as differentiator. In this given industry landscape, there is no doubt that service providers would enjoy benefit if they go for value based pricing. But how can one make transition to such pricing strategy when you are never sure whether other player would adopt such strategy or not. It could be serious loss of business if industry as whole does not adopt it. Further how do you educate customer when entire industry came to existence because of the cost arbitrage. What about the competition arising from other parts of the world? So here the service provider can only succeed if it is adopted industry wide. But that is very difficult to achieve in fragmented market where there are large number of players. So this is one more theory learnt in B-school which I have found it difficult to implement due to real world constraints. In fact I was wondering in this era of globalization where buyers are well educated and connected across the globe how difficult is to sustain value based pricing for players in other industry too?

So my marketing friends pour your views, counter arguments on this supported by as much “gas” as possible.

Derivatives in IT decision making

Doesn’t topic look strange? Yes I am referring to using derivatives in selecting IT solution. I haven’t got crazy working in IT industry after MBA finance but the fact is it relates. I read an amazing article from an analyst of Forrestor who had proposed this concept and I have highest respect for his knowledge and conceptual clarity of both the worlds – IT and Finance. So the credit for this post goes to him. I am trying in this post to explain my understanding of the report in simple words for benefit of non-IT guys.

Let me start with simple question – what does a business looks for from its IT? I know it may mean different to different businesses but in very crude terms we can say that IT must at very basic level facilitate the business to grow and thereby achieve its objective. Now the question for CIO is when business looks forward to IT for some solution to business problems he needs to select best from variety of alternatives available. This is very subjective since it has to take into consideration variety of constraints like budget, available skill set and future business outlook. But do all the necessary factors are factored in while making such decision? How is the cost-benefit done for each option? More often than not CIO would determine cost of implementation and the value of direct benefits from it and then select one which gives maximum value for given cost which should be within the budget. But is this the best way to take such decision? I will give simple example. Given business problem say introducing online shopping can be solved by solution A and solution B. Cost of solution A is say Rs 1 lakh while of solution B say 1.2 lakh which provides same functionality but with flexibility to add auction feature within a year. Now given above method of decision making CIO would select solution A since there is no way to factor the value of limited (time bounded) flexibility that solution B offers. So here if CIO is able to find the value of flexibility then he can make better decision. Then how to find its value?

The answer to this problem is call option from finance industry. This case is similar to concept of the call option which gives the buyer of the option a right to buy the underlying at strike price before expiry date of the option. Here also solution B offers CIO a right to implement auction functionality at certain determined cost within a year. The call options have value for the right they provide and similarly this flexibility should also have value. Call options price is found using Black Scholes option pricing formula:-

c= s*f(d1) –xe-rt f(d2)
d1={log(s/x) + (r + v2 /2)t}/v*sqrt(t)
d2 = d1 – v*sqrt(t)

where ,
s= price of underlying
x= strike price
r= risk free rate of interest
t= time duration for expiration of option
v = volatility for stock
f= standard normal cumulative distribution function.

We can use same formula to find value of the flexibility to make more informed decision since the concept is same. In our case

c= value of the flexibility provided
s= return on implementation of auction feature
x = cost of implementation of auction feature
t = 1 year here i.e. time available to avail the flexibility
v= volatility of industry can be used to predict volatility of business and hence technology usage.

So using this above option we can find value of this flexibility and that value can be deducted from option B to make it comparable with option A. This would enable better decision making for CIO than obvious methods that are used today. Further it provides him an opportunity to deliberate on future features that might be required and may facilitate him to provide more objective explanation to CFO for budgetary approval of flexible IT solution that may help business in longer term.
I know you may question lot of assumption like that of volatility and usage of normal distribution and most important the assumption made by Black-Scholes in pricing model etc. But this post is meant to bring to your knowledge entire new dimension of using the financial knowledge in IT decision making. We can always debate out the viewpoint and criticize the shortcoming of any model but at same time I think we should appreciate the new perspective.

Other side of Google Story

Before you start reading this blog I want to make you aware that I am big fan of Google like many of you but I am playing the devil advocate to fuel debate. I am in minority group who though being an ardent reader didn’t like the book Google Story because I perceived the book to be one of the marketing techniques of Google rather than its true story. There were only positives about Google and that is what I see is the perception of most of the people. People have been made to believe that Google stands for philanthropy, they want to make life of people better by providing them access to vast amount of information at low cost. At same time Microsoft is being perceived as giant monopoly crushing any opponents in the industry with only aim to earn huge profits. Every computer science graduate dreams to be in Google and brand Google now stands for innovation, noble cause. There are ample of articles and cases that document work culture at Google, their success story and their noble intention. People are speculating that there is nothing that can stop Google’s growth. But there are few people who have raised doubts on Google. Most famous being by Dr. Benjamin Edelman, assistant Professor at Harvard Business School, whose article in HBR about how Google’s Ad deal with Yahoo is nothing sort of monopoly was really alarming. This blog has been inspired, in fact most of points have copied from famous article ‘Google Engima’, published by Booz Allen and I am just putting my interpretation of that. So credit goes to them for these insights which I think we should know before we try to emulate Google in our business.

Let’s first see the Google’s claim of providing information for free as no noble vision but rather perfect business strategy. It is similar to Microsoft strategy of providing Internet Explorer for free to destroy Netscape. However Microsoft was criticized for its action while Google actions are being considered as noble. That’s strength of good marketing communication. I know many of you won’t agree on this so let’s get some clarity. If anyone looks at Google revenue stream then it would be crystal clear that online advertisement business is its cash cow which generates more than 80-90% of its revenue. Now answer simple question when would online advertising industry thrive? Only when there are more users online i.e. using Internet. So who are the competitors of Google? Anyone who provides users with utility that doesn’t require user to use Internet. So if Google provides those utility online and with reduced cost in fact for free and similar or better performance then users would prefer online version then offline one. Thus it is a direct competition for Microsoft. It is very famous strategy of using complements to drive the main product. Google by its support to open source, developer group is doing nothing but reducing the cost of complements. Now look at all the product that Google gives out for free like Blogger, Google Docs, Maps etc and you will this why they are free. Because they make people connect to Internet and moreover by using Google products they get more information about the user preferences which turn helps it search engine. In fact the success of search engine lies with heavy usage of Google by people. Microsoft office suite is expensive and offline utility so Google came with its online suite. Gmail provides Google with one more avenue to earn through advertisement. So get out of philanthropy its business and Google derives its strength from this strategy which acts as big barrier of others. Let’s understand that now.

Lot has been written about 20% time which Google employees are given to work on areas of their interest and the liberty they enjoy. People have concluded this has been reason of Google being highly innovative and ahead of everyone. This strategy works for Google because the cost of failure of its new product is much cheaper for them. This is because Google normally introduces half developed product as Beta version in market and entire Google devoted fan club starts using it and promoting it. It provides them revenue from that stage itself through advertising and also provides important data on customer behavior. Other fact is that range of the compliments that can be developed are also huge. So any work done by its employees in those 20% time doesn’t go wasted. In fact it provides lot of learning which is most essential in knowledge industry, satisfaction to employees (which implies low attrition and low cost of attracting new talent) and huge marketing for the Google. If any product is developed successfully then more revenue is generated for itself. However that is not the case for others since cost of failure is too high for them. In fact closer analysis would suggest that this initiative also has complete business sense.

Now next point of contention is Google success because of all this practices or are this practices are being used by management guru’s to be cause for its success. Is there cost-effect relationship? If you consider most of the successful products in Google bouquet have been acquired. Google video was failure but Youtube an acquired entity is success. Other examples are Google Earth, Blogger, Feedburner, Orkut, wiki developer JotSpot are nothing but acquisition. So where is its innovation? Rather it spots and buys innovation and reinforces its own brand as innovator. In fact even the concept of bidding for advertisement was taken from GoTo by Google and it perfected the process later. It was also not its creation.Hey Google fans don’t swear at me I am just providing other side of story which is neither publicized nor communicated. All those fight against copyright restriction for free information is for their business. Ask any student how much dependent he is on Google for code, papers, forums, assignments etc. Google has been involved in battle against copyright material, privacy issues time and again and every time it gets away because it has been able to create an image of a noble organization working in larger interest of society. Its ties with academic world have also help to create this perception. So now answer is Google a case study for innovation or its marketing strategy?

As I told you all before I am big fan of Google and this blog is just one side of tale which is never thought of by anyone. At end of day Google is one the most successful business venture and there is huge learning for every one of us and I sincerely believe that.

Ways to Profitability

This is one of the lecture of my last course in marketing to which I had paid attention and it was worth it. The theme of the lecture was different strategy to increase profitability for the company. The measure for profitability that was considered was return on investment (ROI).Though I am not convinced whether we can consider ROI as true measure of profitability but still I consider the strategies are worth mentioning. There are four techniques which are employed by the companies namely:-

1) Cost Efficiency: - I don’t think this strategy needs much explanation. Entire outsourcing is based on this fundamental. We reduce the cost and thereby boost profits and thus ROI increases. South West Airlines is very good example of this strategy.

2) Premium pricing: - This is very common point reiterated in all marketing lectures. It is always taught that company should differentiate itself and charge premium for the same. This strategy has been successfully employed by Sony in the past and now Apple.

3) Increase Turnover: - This strategy needs some explanation. Above two are very common and it is very easy to find their implementation. Let us consider very simple example where in I manufacture a pen for Rs 10. I sell a dozen in week at Rs 15 each. So one week ROI is 0.5. Now instead of that now I sell a dozen in half week at same price. Then at end of the one week my profits would be twice at same level of investment. Thus now my ROI has increase to 1. Here we have assumed that you manufacture again by investing amount received by selling first dozen and have ignored time value of money of extra profits earned (Rs 60). So in nutshell this strategy suggests to increase working capital turnover and thereby increase ROI. Note there is no correlation between profit margin and ROI here. Most of the FMCG companies have implemented this strategy successfully.

4) Cash management: - This also needs very detailed understanding. Very good example of this is DELL. One can sell goods lower than the cost price and still have positive ROI if it implements this strategy. Here you charge your customers upfront and provide service/goods later i.e. receivables upfront and payables are delayed. You actually have negative working capital. So now for people weak in finance might wonder how could this increase your ROI and many would be startled by having negative working capital. But we you pay closer look you are using your receivables to fund your company thereby decreasing the investment required so net result ROI increases. DELL successfully employed this strategy and changed entire competitive landscape of its industry. So if someone asks you that can you make profit by selling lower than cost? Think twice before you answered that question.

I wonder I can still remember the stuffs. That’s great.