Public funds versus private endeavors: catalogs and conflict in Alaska.(Instructor's Note)

Roberts, Wayne A., Jr.

CASE DESCRIPTION

The primary subject matter of this case concerns marketing. Secondary issues include finance, quantitative analysis, and public administration. The case has a level of difficulty of three to five, depending on the depth of analysis. The case is designed to be taught in 1.5 to 2.5 class hours and is expected to require 2-4 hours of outside preparation by students.

CASE SYNOPSIS

Rural Alaska Community Action Program, Inc. (RurAL CAP), an Alaskan nonprofit organization dedicated to serving the economic and welfare needs of rural Alaskans, particularly native Alaskans, launched a new catalog operation in 1993. The catalog had several purposes, one of which was to generate funds to support other social programs. In 1995, after two years of heavy losses and the investment of more than $600,000 ofpublic money through Alaska State administered grant programs, controversy and uncertainty swirled about the contentious new venture. Investors in a private catalog operation, including a leading state politician, were very concerned about competing against a heavily subsidized operation that clearly did not have to make a profit. In addition to competing in the same markets, the two organizations competed for the talents and products of the same producers. RurAL CAP, Inc. argued that the losses were to be expected in a start-up operation, that they needed more time and money to become profitable and further claimed that they did not compete unfairly with private enterprise.

The Department of Community and Regional Affairs, the agency responsible administering the federally funded grant programs, was unsure of what to do. Besides the discomfort associated with giving taxpayer money to an organization that competed against private enterprise, they were concerned about whether the catalog operation represented a wise investment of public money. They wondered whether or not the catalog would ever be profitable, and hired a consultant (the author) to help answer this basic question.

This case can be used to raise and address a number of interesting issues appropriate to classes in public administration, marketing, finance, accounting, and entrepreneurship. In particular, it can be used to demonstrate the power of 'running the numbers.' The teaching note will emphasize marketing and financial issues, including break-even analysis.

INSTRUCTORS' NOTES

1. Do you believe it made sense to forego a detailed feasibility study and instead actually put together a catalog operation, complete with products, contracts with fulfillment houses, etc.? What are the dangers of pursuing such a strategy? What are the benefits? Under what conditions does acting, rather than analysis, make sense? Under what conditions do analysis, prior to acting, make sense?

In general it makes sense to act, rather than pursue information collection, when the optimum course of action is clear, when the costs associated with collecting and analyzing data exceed the costs associated with action, or when alerting competitors through information collecting activities will place the organization at a disadvantage, or when, for other reasons, the window of opportunity may close. In calculating costs one needs to consider opportunity costs, and the costs associated with extracting oneself if the action turns out to be inappropriate.

A real danger in pursuing action before data collection and analysis is that viable alternative courses of action will not get generated or considered. Another danger is that the risks associated with the action will be either undetected or underestimated. For RurAL CAP, it could be argued that they should have devoted some time to generating and considering alternatives. While not clear, it appears an employee generated the catalog project idea, and the decision was simply to forge ahead, without thinking through other ways in which the goals of the catalog could have been achieved.

2. Are there other ways RurAL CAP could achieve the objectives and goals set out for the catalog? In other words, what other marketing strategies could be considered as competitors to a catalog operation? Do you believe that a catalog is the best means for achieving the identified goals?

Clearly there are alternatives. The challenge to students is to think of some. For example, to help develop markets for native arts and crafts RurAL CAP could have focused on acting as a liaison organization for retailers, or could have sponsored shows in urban centers. These actions might have helped retailers, and could have helped insure that rural natives were not underpaid for their wares. Another alternative would be to open their own retail store(s), although this might cause some howling from existing retailers.

With regard to creating value for the subsistence way of life, it is not clear that providing catalog shoppers with subsistence information is the best way to achieve that objective. Are such shoppers interested? Would it impact people other than upscale socially conscious shoppers? What about middle class citizens not interested in cultural collectibles? As an aside, in choosing rental lists for mailings, the ONLY consideration that was used was likely sales levels: the objective of creating value for the subsistence way of life had no impact on decision-making. On the face of it, it would seem that other activities and strategies would be better suited for educating and enlightening people about the subsistence lifestyle.

3. RurAL CAP decided to target individual, upscale, socially conscious consumers. What other target groups could have been chosen or considered?

Again, the challenge is for students to come up with other target groups. They could have targeted retailers, in essence acting as a wholesaler/distributor. They could have targeted the educational market, the museum shop market, tourists in Alaska (including foreigners), and perhaps others.

4. Examine the results for 1993 and 1994 (Tables 1 and 2). Do the results bode well for the catalog operation? What conclusions can you, as an analyst, draw from these data? Does your examination of the pro formas in Table 3 support your expectations?

The fundamental conclusion is that if things don't change, then the operation will be a money loser, and RurAL CAP should consider closing shop. The operation is hemorrhaging money. This should be clearer given the answer to the next questions.

5. Complete the break-even analysis begun in Table 4. In doing so, assume only 2 categories of lists: outside runs (rented names), and House Buyer File names. Further, assume 9 outside run names need to be obtained for every House Buyer File name (this is necessary to replace House Buyer File customers who cease to be interested in the catalog's products). Finally, assume the average sales/book for House Buyer names is $4.14, while the average for rented lists is $1.00. The $4.14 figure represents the sales/book for 1994 for those sent to names in the House Buyers File. The $1.00 figure is admittedly on the high side for the rented names, but will suffice for this exercise.

If we assume 10% of our catalogs are mailed to House Buyer File names with an average sales/book of $4.14, and 90% to rented names with an average sales/book of $1, we can calculate the average sales/book, and the average cost/catalog, as follows:

Average sales/book: (10%)*$4.14 + (90%)*$1.00 = $1.31

Average cost/catalog: (10%)*$.38 + (90%)*$.52 = $.51

Using these numbers, $.51/$1.31= 38.93% represents the percent of sales that goes to producing and sending out catalogs in a mailing. Surprisingly, when we subtract this percentage from the (partial) contribution margin indicated in Table 4, we find that the overall contribution margin is

31.04%--38.93% = -7.89%

Therefore, if they want to maintain the size of their House Buyer File list the contribution margin is negative: The average variable cost/item exceeds the average sales revenue/item!

NOTE: Students may wonder where the 9 rented names/1 House Buyer File name comes from. They can either be asked to figure this out under some assumptions, or shown to them. This reinforces the notion that quantitative analysis provides real value and insight to managers, and it is dangerous to avoid it.

The fundamental relationship is that enough catalogs must be sent to rented names on outside runs to compensate for current House Buyer File customers who are invariably lost over time, because they have moved, died, or just lost interest in the catalog's products.

Let:

HB = number of names in the House Buyer File

R = number of names in outside runs

d = depreciation (or decay) rate among customers listed in the House Buyer File buyers (% that no longer are viable customers after each mailing)

c = conversion rate from outside runs lists (equal to the response rate) Then the relationship is as follows IF the House Buyer File size is to remain constant:

(HB)*d = R*c

If we assume that the house file is a given, then outside run size can be solved for: R = (d/c)*HB

In the Aurora Catalog instance, if the depreciation rate/mailing, every six months, is 10%, which is what the catalog consultants indicated is a typical figure, and the conversion rate (response rate) in outside runs can be increase to 1%, then we have

R = (.10/.01)*HB = 10*HB

This means that 90.91% of the names in a mailing need to be from outside runs, and 9.09% from the House Buyer File list in an equilibrium setting. In the problem this was simplified to 90% and 10%.

It may be helpful to share the following tables with students: Table 5: Relative size of outside runs necessary to maintain a given House Buyer File given different depreciation rates and conversion rates DEPRECIATION (DECAY) RATE 5% 7.50% 10% CONVERSION RATE 0.75% 6.667 10 13.333 1% 5 7.5 10 2% 2.5 3.75 5 2.50% 2 3 4 3% 1.667 2.5 3.333 15% 20% 25% CONVERSION RATE 20 26.667 33.333 15 20 25 7.5 10 12.5 6 8 10 5 6.667 8.333

Clearly, if Aurora Catalog decided to reduce the size of outside runs below the 9 to 1 ratio the size of the House Buyer File would begin to dry up. For a new catalog operation the outside runs need to be higher than this ratio since it is important to build up a good House Buyer File. Presumably investing in building up a House Buyer File represents a positive net present value. That topic is introduced in the following question and answer.

6. A useful analysis is to compute the customer acquisition cost, and the contribution from each customer, over the customer's lifetime. These numbers can be used to generate customer lifetime values. When answering the following ignore all taxes.

a. How much money will The Aurora Catalog lose or make on a mailing to 1000 rented names? How much per acquired customer? Consistent with The Aurora Catalog's experience, assume i) the marginal cost of renting names and mailing a catalog to each person is $.52, ii) the response rate is .9%, iii) the average order size is $76, and iv) the contribution margin is 31.04%.

With a .9% response rate, 9 out of the 1000 recipients will, on average, become a customer and purchase an average of $76 worth of goods. The cost of the mailing will be 1000*$.52, or $520. With a contribution margin of 31.04% we get the following: Table 7: Acquisition cost calculations: 1000 rented names Number of new customers (1000*.009)9 Revenues (9*$76) $684.00 Variable costs before mailing expenses ((1-.3104)*$684) $471.69 Gross Margin (.3104*$684) $212.31 Less mailing costs ($.52*1000) $520.00 Net Profit/9 names ($307.69) Cost/acquired customer $34.19 Aurora Catalog will lose $307.69 by renting and mailing a catalog to 1000 names. They will acquire 9 customers, at a cost/customer of $34.19.

b. Once a person becomes a customer costs go down and response rates and sales/book go up. Compute how much money RurAL CAP will make or lose, on average, the next time they send customers acquired from the initial list of 1000 a catalog, assuming i) the cost of sending a catalog to each customer is $.38 (note the cost is lower because the names are not rented), ii) the response rate is 4% (that is, there is a 4% chance each customer will buy), and iii) the average order size is $102. Further, assume that the contribution margin remains 31.04%. These figures, of course reflect The Aurora Catalog's experience. Determine how much RurAL CAP will net on this mailing, as well as how much they will net per acquired customer.

On a subsequent mailing the 9 customers will be sent a catalog, and there is a 4% chance they will spend $102 on goods. With a contribution margin of 31.04% and a cost of mailing a catalog, we have the following results: Table 8: Net revenues in subsequent mailings for customers acquired through renting 1000 names Revenues (9*.04*$102) $36.72 Variable costs before mailing expenses ((1-.3104)*$36.72) $25.32 Gross Margin (.3104*$36.72) $11.40 Less mailing costs ($.38*9) $3.42 Profit/mailing to 9 customers $7.98 Profit/customer $.89

Using these assumptions subsequent mailings will be profitable, but not largely so.

c. If we assume that the 4% response rate will be good for 2.5 years (5 mailings), and that the average order size remains at $102), compute the net present value of renting a list of 1000 names using a discount rate of 5%/half year. Under the assumptions implied in this analysis, is renting names a good investment strategy for The Aurora Catalog?

The net present value is the present value of $7.98 cash flows every 6 months discounted at 5%, or $34.55, less the cost of the first mailing of $307.69, or a negative $273.14. Clearly renting names has not been a good investment strategy so far.

7. In addition to the quantitative analyses relating to RurAL CAP's experience, what else would you want to know before making a judgment as to whether this catalog has a chance of becoming profitable? If you were part of RurAL CAP's management team, what would you recommend?

A very important consideration, in fact the overwhelming one, is what RurAL CAP is planning to do given the results so far. What alternatives have they considered, and what are they going to do? Another critical concern is how well informed they are about how they are doing. Do they realize that given their results the more they sell the more they lose? How much analysis did they do, or plan to do, to analyze their results to date? Other issues concern the expertise they have in-house, how they would manage for growth (given their projections, the scale of operations were expected to increase rapidly, which could outstrip the ability of the rural community to supply product, and the ability of the employees to manage the business). Recommendations from students can be quite varied and generate a lot of discussion.

8. When do you think public money should be used to support for-profit forays by nonprofits? Should DCRA continue to support the catalog? Under what conditions? If you were the Commissioner of the Department of Community and Regional Affairs what would you recommend?

This is a thought question with no 'correct' answer. Clearly it is exasperating for an operation like The Great Alaska Catalog to have to compete with an organization like RurAL CAP. From one perspective, the private citizens are being taxed to finance competitors with no bottom line responsibility. Before getting too carried away with this, students should be reminded that special programs exist for private firms. The entire U.S. Small Business Administration focuses on helping small private businesses, which compete with larger businesses, for example. Or consider the special loans that have been extended to firms like Chrysler, or special rental rates cities and states give to large companies. Also, think about the government help provided to J. P. Morgan Chase to swallow Bear Stearns and Co. The list of programs and instances of bailouts and other help is quite extensive. The fundamental question is, what is the role of the government, which represents all citizens, in the private sector?

Another interesting perspective is from the standpoint of the natives. What if the expertise and the abilities of the private firm(s) are not adequate? Should they suffer simply because the firm(s) is private? What if prices, due to a lack of competition, are held low? When, and how, might a non-profit funded through grants help the situation?

Wayne A. Roberts, Jr., Southern Utah University Table 6: Percent of a mailing that must be to outside names in order to maintain the House Buyer File for different depreciation and conversion rates. DEPRECIATION (DECAY) RATE CONVERSION RATE 5% 7.50% 10% 0.75% 86.96% 90.91% 93.02% 1% 83.33% 88.24% 90.91% 2% 71.43% 78.95% 83.33% 2.50% 66.67% 75.00% 80.00% 3% 62.50% 71.43% 76.92% CONVERSION RATE 15% 20% 25% 95.24% 96.39% 97.09% 93.75% 95.24% 96.15% 88.24% 90.91% 92.59% 85.71% 88.89% 90.91% 83.33% 86.96% 89.29%