The Hidden Cost of Regulations

 

Regulations begin with an honorable purpose.  A problem is identified and governments or large corporations feel compelled to address it because “the people” want it fixed.  As solutions are kicked around, decision makers eventually decide between a few alternatives.  Will they use public funds to research, implement findings, educate the population, and ultimately change human behavior?  Or will they give the problem to corporations and insist that they find a solution and suffer penalties if they don’t?  The second choice is often used because it doesn’t involve a direct raid on the treasury.

 

We need to be reminded that society ends up paying for regulations through higher product and service costs.  In effect, it becomes an added sales tax.  In this article, we explore how the costs are determined.

 

To get started, let’s talk about the nature of business.  Businesses get started because astute people observe that a need exists in the market.  The need might be for innovation, bringing a particular product or service to a new locality, reduction of price by leveraging global markets, accommodating changing consumer preferences, or many other things.  As people, we become passionate about our mission to make a difference or succeed in various markets.  We care about the why.

 

Another fundamental part of the nature of business is competition.  If someone offers the same total package at a lower price, they will usually win.  In actual practice, not all businesses offer the same total package of bundled goods and services.  Many differentiations around quantity, delivery, service, location, and experience exist.  But the total package must come at a competitive price for the business to survive.  Businesses do not just compete against each other for the best combination of price and value.  They also compete with other ways that the consumer could spend their money.

 

Next, we should talk about managing costs.  A business cannot arbitrarily set prices low to attract large amounts of revenue.  It also needs to keep prices high enough to cover costs and provide a return on investment.  Some costs are common to all competitors and the consumer is willing to pay for them.  Every airline must pay for airplanes, pilots, and fuel.  A traveler can expect to pay for these costs in the price of their ticket although there will be some differences in how those costs are managed between airlines.  When faced with an additional requirement, businesses must either limit the cost of implementation or pass on a higher price.

 

Let’s get back to regulations.  Governments tell businesses that they must comply with a new requirement.  The expectations and the penalties are (sometimes) clearly communicated.  The companies must dig in and find solutions even though 1) it is not part of why they are in business, 2) the consumer may not want to pay any additional costs, 3) competitors may figure out how to absorb the cost without raising prices, and 4) some markets may not be subject to the regulation and won’t pay for it.  As a result, companies are forced to give attention to problems that are not naturally a core part of their business and for which no funding is provided.  Local governments refer to these as unfunded mandates.

 

We should be clear that not only governments regulate.  Big corporations dream up initiatives that they perceive are important to their shareholders or customers.  These become requirements of companies who do business with them.  A common feature is the lack of resources made available to help solve the problems.  Usually just a requirement and a deadline.  Most companies have to start by researching the expectations.  Then comes the formulation of a plan to comply that doesn’t break the bank.  That usually involves time to innovate and develop systems.  Remember that deadlines to comply are often only two to four weeks away even though it may take a year to do the work.

 

Supplier companies have to absorb the cost of compliance in the beginning.  Or just walk away from the business opportunity.  In that case, the consumer may have to pay an immediately higher price because no one is willing to comply without raising prices.  Companies figure out ways to comply that have the lowest cost structure.  The long-term cost of compliance will be worked into the pricing model.  Since corporations generally insist on the lowest price, the company who does the best job of managing the cost of compliance will win.  But that cost is now included.  The same thing works up and down the chain so that the cheapest way to comply is now included in the consumer price.

 

At the end of the day, the consumer will decide if they want to pay the new regulation “tax”.  If they decide they would rather spend their money another way, whole markets can be crippled by regulations or corporate initiatives.  While it is enticing to spend corporate rather than public money, individual citizens make the ultimate determination whether they are willing to pay the “tax”.  They can always move to a location without the regulation in effect.

 

As an example, we look at Conflict Minerals regulations.  The US Congress decided that it would like to influence events in Africa through corporate regulations.  They forbid the use of several commoditized materials (including gold) that were mined in specific locations and used to fund war.  The industry has struggled to identify the source of all materials and make sure that no illicit commodities show up in the supply chain.  Over the course of ten years, the electronics industry has gotten a grip on the problem after spending around a billion dollars.  Since there is now no cheaper way to comply, the cost of compliance is fully borne by consumers.

 

We will close with a few thoughts about how this could be better managed by large corporations.  Acknowledge that there is tension between cost and speed.  Immediate implementation is going to cost money.  If the corporation has delayed to the point that they need speed to eliminate penalties, they should make money available to the supply chain to pay for expediting.  The best solutions are going to take time.  No regulations should be implemented with a deadline of less than 12 months without additional funding or temporary permission to raise prices.