The
misalignment in regulation: A conundrum resolved.
By Brian
Newton
Do we need
regulation? Is regulation good or bad? I feel the answer is usually “good” as
long as customer needs are met and company initiatives are aligned.
Additionally, the answer as to whether regulations are good or bad usually
depends on the perspective of the constituent: government, consumer and
company. Each likely has a different view. Regardless of the view, regulations
exist and successful companies can and should deal with them using a solid
business framework and by doing so we can realign business objectives with the regulation
– more or less.
I will
share a brief retrospective of one major regulation and then provide some
thoughts and prescriptions for resolving the misalignment. Consider the Food,
Drug and Cosmetic Act, under which over half of all items purchased in the US
are regulated. (The following 2 paragraphs are drawn largely from the FDA
website.)
The 1938 Food, Drug,
and Cosmetic Act was a watershed in US food policy. Largely through the efforts
of women’s groups which pioneered policies designed to protect the pocketbooks
of consumers, food standards were enacted to ensure the ‘value expected’ by
consumers.
The 1938 Act
eliminated the ‘distinctive name proviso’ and required instead that the label
of a food ‘bear its common or usual name’. The food would be misbranded if it
represented itself as a standardized food unless it conformed to that standard.
The law provided for three kinds of food standards: 1) standards or definitions
of identity, 2) standards of quality, and 3) standards regulating the fill of
container. Regulators had the authority to set standards ‘whenever in the
judgment of the Secretary such action will promote honesty and fair dealing in
the interests of consumers’. That is a
rule under which companies must operate.
The
objective of the FDA is to ensure only quality products that are clearly
described in their labels are available and consumers are thereby able to make
informed decisions as to whether they want to purchase the product. In the case
of drugs, labels also must describe any contraindications as well as possible
side-effects so that the patient and healthcare professional are able to make
an informed decision. What’s not to like about this?
Here’s the
rub. Making quality products costs more. Whether it is high quality ingredients
for foods, drugs, whatever, those ingredients cost more than lower quality
ingredients. And properly labeling any product so that it is possible for the
consumer to make an appropriate purchase decision, costs more than simply
saying the product is, say, bread.
With real
incomes declining in the US over the past 30+ years, the only way for companies
to increase profits has been to reduce costs or provide less content for the
same price (as long as the size was disclosed). Many more tasks have been
automated and machines now perform those tasks. So labor costs have been
reduced. Yet, if the size of the market is not increasing, other input costs
must be reduced for profits to rise. One option: switch to lower quality inputs.
Rather than all meat being used in dog food, one could include “meat
by-products”. Since dogs, and many dog-owners, don’t read labels, the reduced
cost of producing the dog food (without a commensurate price reduction) means
higher profits for the producer. Other options exist that can grow the market
through line extensions, new market development or broadening the eco-system.
Yet many companies don’t consider these options for new routes to revenue and
margin.
Okay, this
is a simple example. However, it draws from an Econ 1 lecture by Prof. Richard
Sutch at UC Berkeley for whom I was a teaching assistant. He was calling into
question the use of price controls that Richard Nixon’s administration had
imposed in the early 1970’s. His example was from a label of the cat food he
had been using up until the price controls were imposed. Once the controls were
in place, his cat stopped eating the food. (No, the cat really did not know
about the regulations nor was he conversant in the rules, but the taste was
different and this was a finicky cat.) Eventually
Prof. Sutch inspected the label. He found that new, lesser quality ingredients were
now part of the cat food! Price increases may be limited and often result in a
reduction in quality in order to increase profits. For human and pet food, as
well as drugs, this is why the FDA exists – i.e., to ensure the foods and drugs
provided for consumers (and their pets) in the US are of appropriate quality.
You may be
wondering why I am writing this at all. After all consistently producing a
quality product is exactly what a firm should do to build and maintain a strong
reputation that consumers will recognize and value, and therefore purchase that
firm’s products. So meeting the regulator’s requirements is simply good
long-term business strategy. This begs the question: What’s missing?
Well, the
management of many firms is often less interested in building and maintaining a
firm’s reputation. Why would I say this? Firms’ managers, especially those in
public companies, are compensated by short term bonus plans. If the firm
increases profits, or more usually earnings per share (EPS), then senior
management is paid a larger bonus. Ah yes, that old, very short-term,
philosophy as emphasized by Wall Street. Indeed, it is not annual numbers but
rather quarterly numbers that are the focus!
You know
that regulations exist and given the explanation above, companies have to
conform. Certainly they do. But let’s take a different view and let me offer
some options that a company can implement to meet their business needs while
aligning with the regulations.
1. Strong leadership building a culture
that keeps companies focused on doing the right things for customers.
2. Company leaders can change the
compensation structures to be more balanced between short term and long term
goals.
3. Keep customers happy, satisfied, and
in the long run the company and consumers both win.
4. Company leaders can set strategies
to grow the market through line extensions, new market development or
broadening the ecosystem.
5. Understand the regulatory
environment and see if there are ways to use the regulations to the company’s
advantage. Sounds simple but often this is not easy to do. Companies must
accept the fact that regulatory constraints exist and focus on those factors
within their control. In doing so, the
companies must effectively manage their risks.
I don’t
have the definitive answer to alignment yet these above prescriptions, among
others, can be used to help companies focus on the right strategies and
tactics. Let’s keep the dialog open and let me know if you have a contrary
view. If your company or organization would like to discuss regulatory effects
on your business and look at palatable options to engender change, please feel
free to contact me at bnewton@clevelpartners.net.
