Unless you’re Google or IBM then Information Management is not your core business, which relegates it to a supporting function like HR or Accounting, and so Information Management only makes sense if it supports your core business and most importantly if the benefits actually exceed the costs. When I advise clients, I spend time first understanding their business model before prescribing an Information Management Strategy.
In the first of this two part blog, I am going to give a practical example of this by looking at the business of retail energy supply. Retail energy supply is characterised by high volumes, low margins, low customer loyalty and intense competition. These factors shape the business, so the logic is valid for other businesses with similar characteristics, like retail insurance. In my next blog, I will present an IM Strategy for such a business model.
|A simplified business model for energy supply|
First of all, let’s look at the financial model. A UK energy supplier will buy gas and electricity on the wholesale market and look to re-sell it to retail customers with a target gross margin of say, 23%. On top of the energy, the customer also pays transport and distribution fees for the delivery of the energy to their home as well as VAT and other taxes. The energy supplier collects these fees and passes them on to the appropriate companies and the treasury without adding any mark-up. In theory these charges are a zero-sum game; the supplier collects the money from the end customer and passes them on to the third party. In practice, zero is the best that the supplier can ever hope to achieve as we shall see.
|Where the money goes|
The supplier also has operating costs to consider. Because the business model is simple, and many processes can be fully automated, most of these costs are fixed costs independent of the size of the business, and a large part of the fixed costs is IT. Variable costs include the cost of sending bills and collecting payments and the cost of running a call centre to handle changes, questions and complaints.
As you can see from the above breakdown, above a 23% gross margin on traded energy quickly ends up becoming a 2% net profit for electricity and 7% for gas. A quick check on a comparison website will show that the differences between the suppliers are more than their net profits. This indicates how competitive the market is; the cheapest suppliers are offering prices that are below the costs of their more expensive competitors. How do they do this?
There are few options available to the energy supplier. The obvious ones are reducing the only input costs over which the supplier has control, namely the wholesale price and the operating costs.
In the wholesale market volume, accuracy and a good hedging strategy are the best way to get the best price. Accuracy is important because energy is ordered in advance on an hourly basis. The volumes ordered are passed on to power stations and gas shippers who will ensure that it is available on the grid. The price paid depends on the energy ordered and the energy actually consumed by your customers, and there are two components. The contracted price is for the ordered volume and the balance price that is paid for the difference between ordered and consumed volumes – it is effectively a penalty for ordering too much or too little energy. To get the best price, you need to minimise the imbalance price. You also get a better price if you order very high volumes through having a large market share.
For operating costs, volume is important again since the fixed costs are so high, but so is customer satisfaction, since happy customers don’t need to call the call centre. Next to that big savings can be made by sending bills electronically and by serving your customers with a good website. Intuitively it would seem that one way of increasing volume and keeping customers happy is to reduce your selling price. After all, rational customers will choose the supplier with the lowest price, and knowing that they are paying the lowest price will make them happy. In practice it’s not that simple. Customers expect predictability and customer service just as much as they expect a fair price. There is a saying in the market that "customers come for the price, but they stay for the service." Replacing lost customers with new customers is very expensive; it costs less to keep the customers you have happy. Getting the balance right enables you to offer a competitive price, retain customers and still make a small margin.
|Happy customers are loyal customers|
However, there is bigger problem that needs to be addressed – unpaid consumption. When consumption is not paid for, the supplier is still liable for the wholesale energy costs, transport and distribution costs and the taxes. When net margins are so slim, they are quickly eroded unpaid consumption. For every £100 of electricity that is not paid for, the supplier needs to bill and collect £5,000 of electricity consumption just to recover the losses.
So optimising the business of energy supply means:
- Ensuring that the energy that you supply is paid for
- Keeping operating costs low by having a large market share and happy customers
- Keeping wholesale energy costs low by having a large market share and accurate forecasts
I’ll come back to those aspects and how Information Management can help them in my next blog.