Profit Pools

Strategic consulting has a rich history, from Frederick Taylor’s foundational concept of ‘Scientific Management’ a century ago to the heyday of the 1990s spurred by globalization. In recent years, COVID-19, deglobalization, sustainability, digitization, and artificial intelligence have emerged as hot topics, presenting the industry with fresh opportunities to advise clients.

As the industry seeks additional ways to add relevance to its clients, I propose a material upgrade to market forecasts, a consulting specialty. More than a suggestion, it is, frankly, a plea.

A usual market analysis starts with volume trends. How many gigawatts? How many shipments? How many procedures or pieces of equipment? These are then converted into nominal terms (e.g., euros or US dollars) to highlight the size of the opportunity over a five to ten-year horizon.

There are two issues with this approach.

First, little, if anything at all, is generally said about supply behavior and its impact on pricing. Yet, supply typically follows a greed-induced cycle (from under- to over-capacity and back), with immediate implications for price and demand as microeconomic forces work their magic. Forecasts presented as straight trend lines fail to account for human nature and its fondness for a good cycle.

The second issue is more damaging. Firms do not allocate capital based on future demand or revenue. What they require are projections about the future profit pool. And that data is typically unavailable.

Take the energy mix, for example. There is an abundance of charts displaying an exciting rise in electricity generated by wind and solar power in terawatt-hours up to 2050. Does this make renewable energy an attractive investment opportunity?

No. Indeed, in nominal terms, the picture is already less appealing, due to structural deflation. Moreover, from a profit perspective, the opportunity is bleak. Many industry participants remain structurally unprofitable, squeezed by commodity cycles, policy volatility, technological change, and global competition.

But could there be more profit in 2030, and, if so, under what assumptions? Given the potential evolution of Porter’s five forces, is there a chance to eventually earn abnormal returns?

Without profit, or, at minimum, the expectation of profit, there is no visibility on the future return on capital. Consequently, forecasted growth may prove illusory as firms refrain from investing to supply certain markets, despite their growth potential.

Therefore, to be both credible and useful, a market analysis should include a forecast based on an anticipated industry profit pool, accompanied by transparent underlying assumptions for discussion.

Frederick Taylor stated: ‘The principal object of management should be to secure the maximum prosperity for the employer, coupled with the maximum prosperity for each employee.’ 

Strategic consultants, please help your clients focus on wealth accumulation through the bottom line.