Slope
Analysis
Another tool that helps provide insight when reviewing
business trends and performance comes from a suite of tools coined "Slope Analysis." Slope analysis is
based on graphing trends of key variables over time (in the above case, unit
price and unit cost), based on actual data, and then extrapolating those slopes
to future periods. Such a slope analysis for the IXC market would have
indicated, several years before AT&T and MCI proclaimed an understanding of
this relationship, that the IXC business model was dead, or at least severely
challenged, as currently constructed. That is, the slope analysis would have indicated that gross revenue per minute
was degrading significantly faster than corresponding costs. When such a
relationship comes to be, it indicates through extrapolation that at some point
in the probable not too distant future, gross revenue will not provide the
margins required to cover costs, let alone make a profit.
The wireless narrowband market may be trending in a similar
fashion to the IXC market relative to gross revenue per minute price
degradation, as seen in Figure
7.
What is not known at this time is what the wireless carriers are
experiencing on a cost per minute basis.
Nevertheless, such a trending, even with estimates, may provide a
leading indicator that a business case may shortly no longer be sustainable, and
that a market exit or fundamental change in the business case may be
required.
Converging/Diverging Gross Margin Analysis
Another powerful form of slope analysis involves what is
known as "Converging/Diverging Gross
Margin Analysis." Gross margin is simply the difference between net sales
and cost of goods (or services) sold. It is a measure of operational efficiency.
Gross margin may be the single most important
metric in any business.
In a converging/diverging gross margin analysis, we try to
determine if the gross margin is increasing as a percent, or decreasing as a
percent, of net revenue over time. If we determine that gross margins are
increasing as a percent of net revenue over time (converging = a
good thing), this indicates that each successive sale is more profitable
operationally than those that preceded it.
And conversely, if we see a decreasing gross margin as a percent of net revenue
over time (diverging = a bad thing), this indicates that each
successive sale is operationally less profitable than the sales preceding it (Figure 8).
Diverging gross margins indicate a serious
deteriorating operational condition. It is important to discern the
underlying reasons for a convergence or divergence of gross margins as soon as
possible. Understanding why margins are converging may allow one to improve
business even further.
Conversely, understanding why gross margins are diverging should
highlight fundamental problems as early as possible. These margins may be
measured as often as monthly. Seasonal businesses will have to be aware of
variations due to the unique natures of their businesses. Important Note: Converging gross margins indicate increasing
operational efficiencies, as each successive sale is more profitable than the
one that preceded it. And conversely, diverging gross margins indicate
impairment in the operational efficiency of the enterprise with each successive
sale. Diverging gross margins are a matter of
the utmost importance!
In order to plot these converging or diverging margins, we simply
need to capture data from past income statements. A recent 1997 example of this
condition was seen when AT&T spun out its wireless business unit. A careful
reading of that entity's financials at the time would have indicated that the
wireless unit experienced a serious decline in its gross margin—a whooping
diverging gross margin in a single year. The importance of this diverging gross
margin was shortly felt by shareholders who
bought shares at the IPO price, as soon thereafter, the AT&T Wireless share
price dropped precipitously.
Here, we see that the gross margin analysis does not
necessarily tell us "why" operations are becoming less efficient, only that they
are. Had we drilled down on the AT&T Wireless entity after determining it
had a diverging gross margin, we would have seen that this condition arose
because of "off-net" or roaming charges paid to other carriers. That is,
AT&T marketing and sales organizations introduced a widely accepted calling
plan into the market long before AT&T had sufficient infrastructure to
complete calls nationally on its own wireless network under its "Digital One
Rate Plan." This required AT&T to originate and terminate calls on other
carrier's networks at a relatively high cost. This determination of a diverging
gross margin in AT&T's case would have further indicated a continuing and
relatively large capital requirement in order to build out its network
infrastructure in order to bring off-net traffic on-net. And this understanding
would have highlighted an impending cash crisis, when viewed in terms of the
network buildout required to become operationally cost effective. Hence, a
simple converging/diverging gross margin analysis would have led us to better
understand the current and continuing issues facing AT&T and AT&T
Wireless before others became aware of the
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