Water Buffalos and Economics

If the buyout and subsequent bankruptcy of a century-old gourmet foods delivery business is likened to a happy water buffalo being jumped and crippled by a crazed lion, then economists are the heartless nature documentary guys that film it and then watch it in slow motion from three different angles. Harry & David is the water buffalo, I’m the budding and heartless economist, and producer theory is the angle from which I choose to watch this sucker go down.

Hide yo' business, hide yo' pension fund, cause...

But before I continue pontificating all over the floor, I want to point out that producer theory is the sister principle to consumer theory, which we've already discussed in relation to gas prices and transportation trends (check it, if you haven't read it). Now, I understand producer theory even less than consumer, so bottoms up; this might be a mouthful.

Harry & David, an established luxury and gourmet foods delivery company, declared bankruptcy in late March after several years of financial struggle, according to an article in the LA times.  Looking closely at its decisions and practices during those years offers some interesting case studies for economic producer theory, and how firms try to optimize their operations.

According to the LA times, the financial trouble started when a large amount of debt was “loaded onto the company when it was bought by a New York private equity firm in 2004.” The debt was actually $245 million, with about $20 million per year in interest. Now, defining profits as the difference between total revenue and total costs, it doesn’t take an economist to tell you that dumping a yearly interest payment of $20 million into the equation is going result in decreased profits. But revenue must also be considered when determining whether the ship is sinking or not. Unfortunately for Harry & David, sales on luxury goods took a hard hit during the recession, and the dropping quantity of sales “compounded by debt that has made it harder for the company to make a profit” led to revenues tanking just enough to put profits at a negative. Now, it’s not the end of the world to have negative profits, as long as the marginal revenue remains above average costs. But that wasn’t the case for Harry & David. This ship was sinking.

Now both producer theory and intuition tell us that firms love to adjust selling quantities and capital/labor ratios to maximize their profits. Harry & David, having entered that slippery region where their average total cost was higher than their marginal revenue, was not so free and began minimizing their costs subject to whatever quantity they could sell at. This involved making substitutions between capital and labor. The LA times quotes Harry & David as reallocating “a substantial portion of our cash flow from operations to debt service, reducing the availability of our cash flow to use for other purposes.”  So, which ‘operations’ and ‘other purposes’ are they talking about?  Well, for example, labor costs were reduced when “The company froze its traditional pension plan, then suspended contributions to its 401(k) plan,” or through eliminating yearly raises. Still, wages as a whole were sticky and that meant labor itself had to decrease. The LA times reports “At the end of Jul [2010], Harry & David had 1,026 full-time employees, down from 1,538 in 2005.” Another example of the shift from labor to capital is demonstrated by the outsourcing of jobs previously performed by the company itself. LA times reports that in 2010 “More lower-level workers were let go … and management [had] been farming out to contractors some work that had been done in-house.”

These efforts and adjustments weren’t enough though, and actually may have hindered a company that had previously great management-employee relations.  One of the problems was that Harry & David was a sort of monopsony for labor, being the “largest private employer” in the small town of Medford, Oregon.  When the company started dropping employees and bringing in outsiders to manage operations, the entire town became disgruntled.

In fact, the new management of Harry & David sometimes did NOT operate as economically expected. I mentioned before that labor reductions and decreased benefits allowed reallocation of funds to capital and debt management. But it turns out not all of that money went to capital or into reducing the debt. A large portion went to higher wages for the newly hired corporate inserts. In 2010 the LA times said the new CEO, who refused to relocate to headquarters, “is making $9.7 million this year; his predecessor earned $1.4 million last year.” Well, several large wage increases can easily counteract a lot of labor cuts. This contradicts producer theory and is irrational behavior for a firm.

So, Harry & David limps away, declaring bankruptcy in an effort to minimize losses. They talk about restructuring the company and bouncing back, but if you ask me, this water buffalo is mortally wounded. The investing hyena’s can have their go and whatever liquefied assets remain.