How do companies fare when demand for their products suddenly drops off? It’s a question many industries could face this year, as inflation continues in a tight labor market. Looking at a past demand shock has some answers, finds new research from the University of Maryland’s Robert H. Smith School of Business.
How well a firm copes with demand shocks depends on how the firm is organized, finds Rajshree Agarwal, the Rudolph Lamone Chair and Professor in Strategy and Entrepreneurship, and director of the Ed Snider Center for Enterprise and Markets. She worked with Smith PhD grads Najoung Lim, now at Melbourne Business School, and Seojin Kim, a postdoc associate at Smith. They looked at the medical diagnostic equipment industry for the research, forthcoming in Strategic Management Journal.
Medical imaging equipment manufacturers sell diagnostic equipment – MRIs, x-rays, nuclear medicine equipment, etc. – to hospitals and diagnostic centers. Demand is usually pretty stable because the equipment is so important for health care. The researchers wanted to see what happened to these companies when they were hit with a demand shock: federal legislation that impacted sales.
In 2005, Congress passed the Deficit Reduction Act to curb the national debt. Because a big chunk of taxpayer dollars is spent on Medicare, the legislation included cuts to reimbursements for certain medical tests, particularly expensive ones like MRIs and other diagnostics that use special equipment (but not mammograms and x-rays). All health insurers, even private ones, use Medicare to set the standards for their own reimbursements, so any changes to the federal health insurance system have big implications.
“As a result, hospitals and diagnostic centers that were used to being able to charge a particular price for a diagnostic test couldn’t charge as much,” Agarwal says. “That pushed those businesses to postpone or cancel their purchases of new diagnostic equipment.”
This caused a drop-off in demand that diagnostic equipment manufacturers hadn’t seen coming but now had to deal with.
“Based on how they were internally structured, some firms were better able to cope with it than other firms,” Agarwal says.
The diagnostic equipment makers tried to stem the bleeding from the drop in demand by reducing costs and reconfiguring their product portfolios. Some firms had outsourced their distribution, and other firms had internally integrated their distribution. For firms that had integrated sales teams, things got a bit tricky, says Agarwal. Reducing costs meant eliminating people from their sales staff. But then they didn’t have enough people to work with hospitals and diagnostic centers directly to try to figure out customized solutions or walk them through making more efficient use of new equipment.
“The firms that had an internal sales force ended up seeing frictions between their demand management and their cost reduction strategies,” Agarwal says.
You can’t cut down your sales force and leverage it at the same time, she says. The firms that didn’t have in-house sales teams didn’t have that problem, and as a result, were less likely to go out of business.
“The firms that were not integrated were able to go after other markets – non U.S. markets, which were not affected by the legislation demand shock, in a much more effective way.”
Having a more streamlined operation without integration allows firms to be more nimble or pivot quicker when a demand shock hits, Agarwal says.
“There are less frictions that you encounter as you are trying to react to a demand shock,” Agarwal says. “You don’t have to worry about the fact that you have to cut down and manage personnel costs. Labor is a huge cost.”
That’s one reason why today’s tight labor market, coupled with near record-high inflation, could cause demand in some industries to take a hit, especially for integrated organizations, she says. So firms in any industry that are less integrated may be more nimble at weathering a demand shock.
“If you are outsourcing more capabilities, then it may be that you have offset your higher labor costs and you’re better able to respond to an adverse demand shock,” Agarwal says.
And while firms can’t always anticipate a demand shock, they can prepare for one, she says.
“For managers: To the extent that you can, really look hard at your organization’s structure to make sure you’re minimizing the frictions.”
Read the research, “Weathering a Demand Shock: The Impact of Prior Vertical Scope on Post-Shock Firm Response,” in Strategic Management Journal.
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