Sunday, June 22, 2014

Getting 50% profit when 7 in 10 customers don’t pay

June 21


When something seems too good to be true, it usually is. And management techniques, practices and strategies are no different.
 When you read a business book or attend a presentation on a particular management practice, it is a good habit to explicitly ask, “What might it not be good for?” When might it not work; what could be its drawbacks?

If the presenter’s answer is “there are none,” a healthy dose of skepticism is warranted.
 Because that’s unfortunately not how life works, and that’s not how organisations work. It relates to what Michael Porter meant with being “stuck in the middle”: if you try to come up with a strategy that does everything for everyone, you will likely end up achieving nothing. If you focus your strategy on, for instance, achieving low costs, you will likely have to sacrifice delivering superior value on other dimensions, and vice versa.


THE MCDONALDS’ MODEL

Similarly, “doing well by doing good” - enhancing your firm’s financial performance by achieving superior corporate social responsibility - is often easier said than done. When confronted with an ethical decision -for instance, whether to dump toxic waste in a developing country, where it may not be illegal, when all your competitors do so as well - it sometimes costs you (a lot of) money to do the right thing.

Dozens of academic studies have tried to establish a positive link between corporate social performance and profitability, but for every study that finds a (modest) positive correlation, there is one that doesn’t.
 But it seems some organisations do pull it off.


Take the company Aravind Eye Care in India. It was founded in 1976 specifically to provide cataract eye surgery. They modelled their operations on McDonalds: high volume, highly efficient operations, based on division of labour and cost efficiency.

It is a very profitable operation; the company has a gross margin of 50 per cent. Yet the remarkable thing is that they treat 70 percent of their customers for free. The 30 per cent that do pay are relatively affluent people who can afford the operation, but who receive pretty much the same service. In fact, the company goes out of its way to actively recruit nonpaying customers. It goes to look for them systematically in the countryside and transports them to their clinics for free.


This, while the clinical quality of their service - the cataract operation - is second to none.

Similarly, other medical clinics are operating in India - for instance in heart surgery - that combine extremely efficient, low-cost operations, but at very high quality in terms of clinical outcome. To such an extent that various National Health Service hospitals in the United Kingdom are considering sending their patients to India; to save money, while providing them with superior quality treatment.

THOSE WHO PAY BENEFIT FROM THOSE WHO DON’T


How can these organisations combine higher quality with lower costs? How can they combine doing well by doing good, and treat 70 per cent of patients for free at 50 per cent gross margins?

The trick is that their business models are built for the long-term.

Paradoxically, in the long-run, the lower costs enable them to provide better quality.


Ask yourself this: Could Aravind Eye Care make more money if it did not treat the 70 per cent nonpaying patients? Although it may seem that this would save them a lot of costs, in fact, the answer is very likely no.

Every organisation learns with experience. We call this effect “the learning curve.” With experience, firms increase the efficiency and quality of their production. These curves have been documented for airplanes, cars, bottles, pizzas and so on. And cataract eye surgery is no exception.
It is because these clinics treat such very large number of patients, the company runs down its learning curve very quickly, giving it a substantial competitive advantage.

Moreover, the vast number of patients enables it to divide labor to the extreme, creating specialist roles and highly-experienced people in all parts of the procedure. The 70 per cent nonpaying customers form the basis of this advantage. Consequently, the company would likely not be able to attract the 30 per cent paying customers without them.


It is often said that Aravind’s paying customers subsidise the 70 per cent that get the operation for free, yet, in many ways, it is the other way around: Treating the vast numbers of nonpaying patients enables the company to deliver the quality that attracts the ones that do pay.
What enables companies such as Aravind to combine all of these things?

Didn’t I say at the beginning of this piece that “when something seems too good to be true, it usually is?” and that “it is always a good habit to explicitly ask what might it not be good for?” Yes, but that is because there is a second question you should always ask, when considering a particular management technique, practice, or strategy,and that is: “What might its long-term effects be?”


What might seem a good idea in the short-run does not always work in the long term - and vice versa. Unfortunately, most companies make decisions based on their short-term consequences, because that is what they can see and measure.

If, like Aravind, you optimize your business model for the long haul, you might be able to deliver superior quality at lower costs. And even do some good for society in the process.

© 2014 Harvard Business School Publishing Corp

ABOUT THE AUTHOR:

Prof Freek Vermeulen is an associate professor of strategy and entrepreneurship at the London Business School. He is the author of the book “Business Exposed: The Naked Truth about What Really Goes on in the World of Business.”

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