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Potato Chip Economics

Everything you need to know about business clearly and concisely explained

John Hunt Publishing Ltd.

CHAPTER 1

The Real World of Raw Materials or "You can't cook a thought."

Or – Why do economics professors rattle on and on about raw materials?

I saw all the people hustling early in the morning to go into the factories and the stores and the office buildings, to do their job, to get their checks. But ultimately, it's not office buildings or jobs that give us our checks. It's the soil. The soil is what gives us the real income that supports us all.

– Ed Begley, Jr.

Introduction: In every basic economics class, we have heard the mantra of raw materials. But I think few students, heck, few adults, really understand the crucial importance of raw materials.

A quick example – when you turn on a light switch, you expect that light switch to work. You give it no further thought. But someone had to dig the coal out of the ground; someone had to transport that coal across thousands of miles, just to deliver it to your local power plant, where they need the coal to make steam, to turn the turbines to produce electricity. The turbines are made out of steel, which is made out of iron ore, which is dug out of the ground. The turbines make electricity, which cruises through the copper wires in your house.

Ah yes, copper to make the wires, copper, which again is dug out of the ground. The point is simple: from the copper wires, to the wood in your house to the steel in your car, to the gas which powers your car, everything must be dug out of the earth somewhere. Lights don't just go on because you flip a switch. Every material involved in that process of bringing you light and power was dug out of the ground at some point.

Let's apply that to the subject of this book. Potato chips. Again raw materials are the most elementary of any manufacturing process. Without a potato you can't make chips. Sounds simple. Dig potatoes out of the ground and make chips. No – it is way more complicated than that; just like every facet of economics, things can go wrong and you must have back-up plans, and relationships and the right potatoes and the right storage ...

And a 'by-the-way moment', the Latin term for potatoes is Solanum tuberosum. And the potato and the sweet potato are not related.

Come on – it's just potatoes!

Quote: Money is the root of all evil, and yet it is such a useful root that we cannot get on without it any more than we can without potatoes.

– Louisa May Alcott

How hard can it be to make potato chips? Buy the potatoes, stick them in the fryer, bag them up, throw them into a box, stick them on a truck and deliver them to the store.

However, as you may suspect by now, this book is intended to teach you how to succeed in the real world of business and how to expect the unexpected and how to deal with it.

Let's look at one of the most basic raw materials that go into making a potato chip. Potatoes. How many potatoes? Golden Flake uses over 100 million pounds of potatoes a year and it takes about four pounds of potatoes to make one bag of chips. (The average American eats five pounds of potato chips a year.)

When you make any food product, it is hard to predict what your costs of raw materials will be. If you make a watch, you can pretty much predict how much it will cost you to buy each component for that watch. And those components do not vary from year to year.

But look at potato chips. They depend on potatoes (okay, I know that is obvious, but bear with me), and a whole range of things can happen to the potato supply ranging from diseases to legislation to bad luck. And that makes it hard to predict each year how much potatoes will cost you.

Oh – those variable costs!

To toss out an economics term, potatoes represent 'variable costs', costs which change from year to year, as opposed to fixed costs, which stay 'fixed' every year. A fixed cost might be the mortgage on your building, the payments you make on your fryers, or a fleet of trucks.

So your challenge becomes trying to control the costs of potatoes, because even if the costs increase, you can't increase the price on a bag of chips; you still have to sell those chips for about two bucks a bag. Of course, you could increase the price of your chips and happily go bankrupt, as your competitors did not get the memo to increase their prices.

How much can the price of potatoes change? In June 2008 they were $10.37 per 100 pounds; a year earlier they were $7.75.

That is an increase of 34%. Can you imagine making a car and the raw materials for the car increase 34%? Yet potato chip manufacturers have to deal with that 34% increase without passing it onto the consumer. Can you imagine if the price of chips went up 34% in a year?

You would have a tough decision to make. Should I put a gallon of gas in my car or buy a bag of chips.

What is going on here? Where are my cheap potatoes?

But why does the price of raw materials, potatoes, fluctuate so much?

A number of factors affect the price of potatoes and many factors are out of the chip maker's control. This means, and this could be the key lesson for any businessperson, that you must adjust, adjust and adjust again. Or as that great American philosopher, Dolly Parton, once said, "We cannot direct the wind, but we can adjust our sails."

Anyway, while we take for granted that we will always have potato chips, let's look at the many factors that snack food companies fight against every day, just to get the potatoes to make the chips.

One key reason for a 34% price increase in potatoes was that flooding destroyed a number of acres of new crop potatoes, up to 50 to 70% in Missouri and other areas.

Hmm – it can't be good when the materials you need to make your product are wiped out by flooding and you still must get chips to the shelf to keep your employees employed and your customers happy.

Remember, there isn't any revenue if you don't sell any chips.

But hey, despite the occasional flood, what else could happen?

Well, the total US acres of potatoes planted has been reduced by 10% from 2007. Why? The government has mandated that 25% of the entire corn crop must be used to make ethanol and not food.

And if you are a farmer with half a brain and the government is paying you to grow corn and not potatoes, you are going to grow corn.

Opportunity costs – a cool economics term

Quote: Four things come not back – the spoken word, the sped arrow, the past life, and the neglected opportunity.

– Arabian Proverb

Let me sneak in another economics term here – Opportunity Costs. Everything has an opportunity cost. If you watch TV for an hour, you have lost the opportunity to read a book, eat dinner, and play catch with your son.

If you grow corn on your 100 acres of land, you have lost your opportunity to grow potatoes on that same land.

We obviously choose what is more desirable by the choices we make.

You think the opportunity to watch TV for an hour is more profitable than reading a book. You may argue that you don't think that way at all, but you had the opportunity to read a book or watch TV. Your choice, your action to watch TV tells me what you think is more profitable.

All resources are scarce and if you grow corn on your land instead of potatoes, you have chosen the 'opportunity' that offers the best profit. Unfortunately – and this could lead into a long, long discussion of free markets, but – your decision to grow corn was not influenced by what the consumer needs; it was decided by a government program to offer you more money for growing corn. Which kind destroys the basic law of supply and demand.

Which, believe it or not, leads us back to potatoes.

What could happen?

Quote: The only good luck many great men ever had was being born with the ability and determination to overcome bad luck.

– Channing Pollock

So to recap, what can happen to the potatoes you need for your chips?

Hmm, so far the demand for corn has increased, limiting the land available to grow potatoes and there was that flooding which wiped out 70% of the Missouri potato crop.

What else can happen? Well, farmers want to make a profit. What could they be thinking?

And in recent years, the cost of producing potatoes has increased. Think of all the costs associated with growing potatoes, which include higher land, fuel, equipment, fertilizer and storage costs. And the higher cost of everything translates into the higher cost of potatoes, which affects that bag of chips on the shelf.

Think about that. Who thinks about the cost of fertilizer?

Heck, I don't wake up at three in the morning worrying about fertilizer, and I hope you don't either. But every time you eat a bag of chips and every time that bag of chips increases in price, you are paying for the increasing costs of fertilizer.

So if you run a potato chip company, fertilizer must factor into your business thinking. I could say that is no B.S., but that would be a bad pun.

Tariffs and chips – what's the connection?

Quote: Tariffs that save jobs in the steel industry mean higher steel prices, which in turn mean fewer sales of American steel products around the world and losses of far more jobs than are saved.

– Thomas Sowell

Recently Hostess, the maker of Twinkies and other gourmet foods, went out of business. Was it due to bad management? Actually it was due to tariffs. A news item stated:

Economists say high sugar prices tied to US trade tariffs were a big reason Hostess was struggling, but a Mexican company could be a lifeline for Twinkies because it would be able to take advantage of access to lower-priced sugar in Mexico.

Tariffs can also raise the price of potatoes.

American potato farmers sell a lot of potatoes to Mexico. And Mexico and other foreign markets get angry at us. I know, hard to believe that some country might get angry at us, but let's say Mexico does. And they stick a tariff on American-grown potatoes. It has happened and can happen again.

So if you are in Mexico buying potatoes, what are you going to buy? The cheaper Mexican grown potatoes or the ones with the extra tariff tax on them. Of course, you are going to buy the cheaper potatoes.

No big deal, but a Mexican tariff on potatoes can cost American farmers $80 million a year. And if they aren't making that $80 million in Mexico, they will raise prices to Americans.

And that can hurt, especially if you buy millions of pounds a potatoes a year; for instance if you own a potato chip factory, like Golden Flake.

You can thank Congress

Quote: Nothing is better than the unintended humor of reality.

– Steve Allen

Another quick detour, as we return to a favorite theme of this book. How one action leads to another action and affects you as a businessperson.

Mexico did impose a tariff on potatoes and it was not the snack company's fault or the poor guy growing potatoes.

The tariff was imposed, costing potato farmers over $80 million a year, and forcing Golden Flake to face rising potato costs because of some obscure act of Congress.

A news story on what happened might read like this:

Fruits and vegetables – including potatoes – are the most common items on the list of 90 products hit with tariffs as of today, as Mexico retaliated against a US decision to block Mexican trucks from traveling north of a commercial zone along the border.

Potato growers alone could lose an annual market of $80 million.

Mexico acted after Congress inserted in a budget bill a provision to halt funding for a program that let a limited number of Mexican trucks deliver goods throughout the US.

Growing houses, not potatoes

Quote: A lot of people stop short. They don't actually die but they say, "Right I'm old, and I'm going to retire," and then they dwindle into nothing. They go off to Florida and become jolly boring.

– Mary Wesley

Okay, so now we have tariffs, congressional actions, floods, the costs of growing potatoes, better money growing corn, less land to grow potatoes all affecting you, as you sit in your office at Golden Flake, trying to keep the costs of potatoes down, so you can keep selling chips at a two bucks a bag.

Can it get more complicated? Of course it can. That is the challenge of doing business in the real world. Just when you ask, "What could happen?" it happens.

Potato chip makers follow the potato chip market from south to north, which makes sense when you think about it. They aren't growing any potatoes in North Dakota in the winter, but they are growing potatoes in Florida.

So you buy your first crop of potatoes in Florida. But Florida is one of the fastest growing states, and will grow even faster when 75 million baby boomers all cross the Florida border at once. Okay that might be a small exaggeration, but think about this.

To accommodate the growing Florida population, you need more houses, and you need land to build houses on. And the last time we checked, no one is making any more land. There is a limited supply of land (notice how cleverly we snuck in the basic rule of supply and demand). So where do you get the land to build houses on?

Potato farms.

And if you are a potato farmer and someone offers you a million bucks or more for your land and you no longer have to grow potatoes all day, what would you do?

In short, the housing boom in Florida has impacted potato growers and Florida has lost a lot of potato farms.

For every action, another set of reactions. Will this ever end?

Quote: Business, more than any other occupation, is a continual dealing with the future; it is continual calculation, an instinctive exercise in foresight.

– Henry R. Luce

Okay, I know I am repeating myself here, but the beauty of business is that there are so many layers to it and one reaction causes another reaction.

Consider this.

Your neighbor sells his farm and a developer comes in and builds houses. (Notice the concept of opportunity costs here. It is a better opportunity to use the land to grow houses and not potatoes.)

But once your neighbor sells his land, you as a farmer have a whole new set of issues to deal with.

For some reason the new residents want clean water to drink – heck it is not your fault they are so picky – but you must deal with drainage issues and tougher water regulations. Plus chemical applications and spray drifts have to be carefully monitored. Come on, who wants their sweet child playing in the front yard, while toxic chemicals drift through the air, caused by the spraying of potato fields?

Also highway rights have to be worked out, so farmers can move their machinery to other fields on roads that carry more non-farm traffic. In other words, if mom and dad are commuting to the city every day, from their nice new home in the suburbs, the last thing they want is to be stuck behind some yahoo, driving his tractor to the potato fields.

Wait, even more terrible things can happen to potatoes, plus a real short history lesson

Let's think even more about potato farmers and how what happens to them affects Golden Flake and affects what you pay for that bag of chips. Look at Florida for example.

Florida can get freezing temperatures in late February or early March, which can wipe out the potato crop. How about throwing in some heavy rain, which can knock down hilled rows, which can cause root damage and sunburn.

Let's return to basics for a moment here. This book shows that business can be a challenging endeavor and you can't take anything for granted. Most textbooks say 'raw materials' and that is about all they say. But raw materials, in this instance potatoes, are never guaranteed and events can happen that can leave you scrambling to find potatoes to make chips to fill the bags that feed your customers.

But the deeper lesson here is that at times we all forget that our society depends on two acres of top soil to grow everything we eat and to grow cotton for everything we wear.

And even the smartest businessperson is at the mercy of the elements. You can crunch numbers all you want but a flood, tornado, hurricane, drought can wipe out the best-laid plans.

We often forget the potato famine that devastated Ireland. In two years Ireland lost two million people.

A quick history lesson

Quote: True the greater part of the Irish people was close to starvation. The numbers of weakened people dying from disease were rising. So few potatoes had been planted that, even if they escaped blight, they would not be enough to feed the poor folk who relied upon them. More and more of those small tenants and cottagers, besides, were being forced off the The Real World of Raw Materials or "You can't cook a thought." land and into a condition of helpless destitution. Ireland, that is to say, was a country utterly prostrated.

– Edward Rutherfurd

The Irish Potato Famine began in 1845 as leaves on potato plants suddenly turned black and curled, then rotted. An airborne fungus (phytophthora infestans), originally transported in the holds of ships traveling from North America to England, was the culprit.
(Continues...)

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Excerpted from Potato Chip Economics by Philip Theibert, Elizabeth Theibert. Copyright © 2012 Philip Theibert and Elizabeth Theibert. Excerpted by permission of John Hunt Publishing Ltd..
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

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