Learning Curve Effect of Classic Chinese-Filipino Pricing Policy 182.0

Entrepreneur-students of the 1st EDP at AIM help draw an insight

Scholars and analysts often derive their theories after practitioners in the real world have been implementing them successfully for years.

At the first ever Entrepreneurship Development Program (EDP) at the Asian Institute of Management (AIM), my class found a key insight linking the classic Chinese-Filipino pricing practice with innovation theory developed in the western world. The EDP at AIM is a management development program designed for entrepreneurs who are starting to traverse up the the growth phase of the typical venture life cycle.

This theory involves competence-building from DUI-Learning – taken from Kenneth Arrow (for D), Nathan Rosenberg (for U) and Bengt Ake Lundvall (for I) no less – and is one of two legs that interact continuously in a national innovation system.

Note: Click here for a discussion on this western innovation theory and how it has been used as intensive learning in NIEs to evolve national innovation systems.

Entrepreneur class (1). The entrepreneurs in the class were confident and open, aggressive or high-testosterone, and most importantly, great fun! Typically, they did not read much but were intuitive on business and supplemented the learning process with their own experience.

As such the learning potential is high – the real learning will come later when they apply and try out what they learn in the classroom. Learnings from the case method used at AIM are often affirmed and imprinted only in practice.

The insight through Supply Chain Management and the Dupont Model. It is a link between the classic and stereotypical way the older generation of Chinese-Filipino businessmen did their business and Bengt Ake Lundvall’s theory of innovation. And they did this through the decades-old Dupont model.

The Dupont model says that Return on Equity (ROE) is a function of profit margin, asset turnover and leverage (gearing).

Note that, in the Dupont formula, Sales cancels between the first and second terms while Assets also cancel out between the second and third leaving Profit over Equity as equal to Return on Equity.

Profit Margin (PM). In turn, PM can be managed by looking at specific cost items as % of sales preferably in a proforma statement over time for trend analysis. The percent to sales figures can also be benchmark to relevant industry competitors. Typically, this is the metric commonly looked at by business managers.

Asset Turnover (AT). AT is a measure of efficiency and is least looked into. It can be measured by each component of the cash generation cycle as below and as sales over fixed asset ratio.

The cash generation cycle has four components measured in days: receivables, inventory, payables and cash-on-hand.

To determine Receivable days, for example, the total or average accounts receivable balance is divided into sales per day for the period.

Similarly, for Inventory days kept the inventory amount in the balance sheet is divided into average cost of goods sold per day.

Payable days is divided into average purchases per day of the period being considered. Payable days is counted in the negative or as substraction from the other three elements of the cash generation cycle.

Finally, Cash-on-hand days is determined based on average daily cash spend over the relevant period.

The Cash Generation Cycle is the sum of all four (with Payables considered in the negative) and is a measure of efficiency in the use of assets to generate revenues.

The Cycle is best analyzed by comparison over time in a proforma schedule. Comparing against policies on inventory levels, collection and payment terms will also help.

Management of this cycle yields benefits of the second order. In effect, the margin created from PM is multiplied by the efficiency at which assets are used to generate business, effectively transmitted through the vehicle of the turnover rate of Sales over Assets.

Leverage (as Gearing). The mechanism of Assets over Equity – in effect, the effective use of debt – can be managed to extend the return on the equity investment.

In this area, there are essentially two first principles. First, that the cost of borrowing should be less than the expected return on the marginal investment to which it is applied. Second, that the level of debt must not be beyond the level that, perceived or real, does not result into high risk for the firm given that the role of equity is precisely to protect it from variability in the external environment.

Classic Chinese-Filipino Pricing. The classic Chinese-Filipino business pricing policy was low profit margin to drive higher sales turnover.

Traditionally, the benefit from the strategy is only measured in terms of the financial benefit of higher return on equity.

The Link. Learning by Doing-Using-Interacting (DUI) is achieved through the learning curve; for doing using on the volume of experience on the work itself and for interacting with buyers and suppliers over time.

In this sense, achieving a high asset (or sales) turnover de facto increases the pace of learning. In this case, the volume of experience is measured in terms of transactions made over a duration rather than just as absolute time, i.e. a duration of time without transactions does not really result in learning.

Together with other attributes like thrift and opportunity seeking skills, this insight can also account for the Chinese-Filipino success in business especially with the first generation.

Paradigm shift in later generations? Sadly, there are many anecdotal evidence that this original low-price, high-turnover strategy has been less used by the later generations as capital became more available. Then, there would be conceivably lesser learning per peso of sales than in the previous model.

Possibly, the strategy may have come about more from scarcity of capital, i.e. the need to manage or increase the Asset Turnover that is the second term of the Dupont model to get higher profits. Of course, many latter generations still maintain the classic strategy in the family business but have chosen to raise margins in the newer businesses.

Increasing Asset Turnover as business strategy – with low-margin selling as key tactical driver – is much harder work because it requires lower inventory and receivable levels for a given amount of sales. This, in turn, requires continues alertness in many aspects of the business to make sure the whole length of the supply chain stays stocked for business continuity.

Additionally, the avoidance of formal loans – expressed as disdain for hi-fi or high finance (debt) – means that return of equity is achieved also by scrimping and saving on the personal lifestyle. This is also a hallmark of the first generation Chinese-Filipino businessman. The younger and richer generation are more comfortable in the Philippines – many are natural born Filipinos as it became easier for their parents to naturalize after 1975 – and prefer to enjoy the fruits of their work.

Entrepreneur Class (2). Working with the class, this insight popped out during the class on supply chain management where the Dupont model was discussed. Interesting, where insights like this are exposed after a good discussion. Thank you 1st EDP!

Note: I co-teach the AIM EDP with Professor Dickie Gonzales, also an innovation practitioner and adjunct faculty.

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