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Profit maximization (Published in: Business Perspective Vol.9, Jan – June: 41 – 49) Abstract To stay competitive by creating higher value for consumers firms are in constant search for strategies and tactics that will maximize profit. Profits can be maximized by increasing per unit revenue, decreasing unit cost or a mix of both. This study has identified ten different approaches: Innovation, Brand Image, Customization – Mass customization, Customer collaboration, Long tail effect, Operational excellence, Outsourcing, Value engineering, Moving away from unprofitable customers and Reducing quality. Out of these approaches a manager should select the one that fits the situation best. Maximizing profit by reducing quality should be avoided as it threatens long term survival. Key words: Innovation, Customization, Outsourcing, Operational excellence and Brand image Introduction To create higher value for the shareholders, executives are under constant pressure to deliver higher profit. In economics, profit maximization is the process by which a firm determines the price and output level that returns the highest profit. There are several approaches to this problem. The total revenue minus total cost method relies on the fact that profit equals revenue minus cost, and the marginal revenue (MR) less marginal cost (MC) method is based on the fact that total profit in a perfectly competitive market reaches its maximum point where marginal revenue equals marginal cost. A profit-maximizing firm will produce more output when marginal revenue is more than the marginal cost and less output when marginal revenue is less than the marginal cost. If MR = MC, however, the firm has no incentive to produce either more or less output. The firm's profits are maximized at the level of output at which MR = MC. A firm can maximize profit either by increasing per unit revenue or decreasing per unit cost or doing both simultaneously. This study has identified ten different approaches to achieve profit maximization: Innovation, Brand Image, Customization – Mass customization, Customer collaboration, Long tail effect, Operational excellence, Outsourcing, Value engineering, Moving away from unprofitable customers and Reducing 1 Electronic copy available at: http://ssrn.com/abstract=1482609 quality. Some of these are targeted to increase per unit revenue; some are focused on per unit cost reduction, while still others can be classified somewhere in between. 1. Innovation Innovation is the successful exploitation of new ideas. A basic understanding of the subject is essential for all business leaders whatever their current or intended product or service. Innovation should not be confused with technology. Innovation is the only way to stay ahead of the competition. Exploited properly it will improve business survivability and lead to increased profits. Innovation can basically be of three types: Product innovation (e.g. new goods or services put on sale); Process innovation, which changes the way a given good or service is produced or delivered within the firm or across a supply chain; and Behavioural innovation, when an organizational routine is replaced with new ones. Quite often, the innovation turns out to be a mix of all three “pure” categories, as with the case of the introduction of a new product that require new productive competences and changes in the organization. Furthermore, what is a product innovation for a supplier can be a process innovation for a user, as with the case of a new machine which revolutionizes the process of manufacturing and may deliver better quality at a lower cost. In this case, investment is the means to spread innovation across the economy. Besides technology, marketing, finance, organization all can be sources and multipliers of innovation. An innovation can be radical – like KODAK new product development to fight Fuji or incremental – such as Toyota Kaizen, TQM and JIT. As Christensen (1997) has explained an innovation can be disruptive or non-disruptive. Disruptive innovations are those products or systems that create entirely new markets. What minicomputers did to mainframe or PCs to the minis, were disruptive innovations. Similarly, the effect of mobile phones on landlines is disruptive. Market dynamics allow a firm to charge premium price for an innovative product or service because consumers perceive higher value than competitive offers. An innovative 2 Electronic copy available at: http://ssrn.com/abstract=1482609 product also helps in attracting more consumers. Firms 3M and Zara qualify in this category. Innovations could be in generation and delivery of services, IT applications, warehouse management, supply chain management or in any other business processes. Benihana and 100 Yen Sushi restaurants could create a space for themselves in an overcrowded ‘out of home eating’ market in USA due to their innovative style of service delivery. Customers patronized Benihana because they liked the innovative idea of watching their food being cooked in front of their eyes at their respective tables by highly skilled chef to the perfection of a well choreographed piece of dance. The revolving table at Sushi restaurants together with standard menu helped quick turnaround and kept prices down. The use of Internet, digital tools and software are completely redefining the way businesses are run particularly in photography, book distribution, exchange of ideas among similar interest groups of people, movies, music and many others. Firms integrating information technology into their businesses stand to gain by increasing per unit revenue or decreasing per unit cost – maximizing profit. Another disruptive innovation, RFID – radio frequency identification device – gives users complete control over the movement of goods from suppliers to consumers and offers possibility to eliminate latency or delays in the whole process. For the firm this has the potential to reduce cycle times, make more responsive to customer demands and thus may induce more profit. Even cross docking and vendor managed inventory are innovative processes that gave an competitive edge to Wal-Mart in mass merchandising market. 2. Brand Image Senior executives increasingly recognize the importance of their company’s brands in driving customer loyalty, price premiums, revenue growth and, consequently, enhanced shareholder value. Executives are pushing for not only stronger brands but are also demanding that they be built and maintained better, faster and cheaper. This demand presents a real challenge. In this competitive world consumers are displaying ‘crossover’ buying behaviour and producers are facing ‘cross category’ competition. In the product and service space 3 commoditization and convergence are dominant and choices are exploding – resulting in decreased level of customer loyalty. Brands are exposed to increasing number of touch points, consumers are more aware, positive and negative experiences with the brand are quickly getting converted into word of mouth referrals. In this environment some stellar brands have flourished, like LG, Park Avenue, Lux, Colgate, Maruti - but many more such as Kelvinator, Stencil, Hamam, Babool, Ambassador – have fallen on hard times. Consumer-based brand equity goes far beyond just the trigger communication. It comprises the long-term market benefits for the company from customer satisfaction and brand loyalty perspectives and offers opportunity to earn higher profit by unlocking the value of the brand. 3. Customization – Mass Customization In this competitive environment, Internet and information technology have shrunk distances, overcome the difference in time zones, eliminated the advantages of scale of operations, broken down the barriers and, the best of these, propelled the “market of one” – mass customization. No company can ignore the present day mantra of customer satisfaction ‘I want what I want’. For firms it is not sufficient to pursue single point focus. Successful firms have to harmonize focus on multiple issues as customers are more demanding and are reasonably sure that some supplier will be able to match their expectations. Mass Customization is defined by Bain & Company (www.bain.com) as "the large-scale production of personalized goods and services. To succeed at it, companies must harness technologies that revamp their speed, flexibility and efficiency at minimum expense. Combined with organizational changes to focus firms on the unique needs of very small customer segments, these technologies help companies affordably deliver custom versions of their offerings to profitable niche markets." According to a survey of product and service companies in North America and Europe conducted by Booz Allen Hamilton (Leslie Moeller, Matthew Egol, and Karla Martin, 2003), firms that can more effectively balance the values that customization brings to their customers with the complexity costs it can impose, generate organic sales growth and profit margins significantly higher than their industry average. 4 The study, which benchmarked business units with sales from $1 billion to more than $20 billion at 50 companies, found striking differences between companies that adapted and aligned their customer strategies and fulfillment operations, and those that constructed more ad hoc responses to customer demands. The research encompassed such industries as consumer goods, chemicals, telecommunications, media, and financial services. The study revealed a two-to-one performance gap between “smart customizers” and “simple customizers.” Later Keith Oliver, Leslie H. Moeller, and Bill Lakenan (2004) in the article ‘Smart Customization: Profitable Growth Through Tailored Business Streams’ cautioned that few companies are successfully trading off the values of mass customization with the cost of complexities that it imposes. Companies should be careful in deciding what will differentiate from competitors, do customers perceive extra value in them, can the extra cost be justified, and may be it is necessary to realign delivery processes for different segments. Consider LEGO factory, a very advanced toolkit for user (kid) innovation and co-design. With this new business unit, Lego combines its original mass customization pilots, which were able to pick an individual assortment of Lego bricks according to one customer's order, with its strong software and interaction skills. Children can not only create their own unique designs, and order the corresponding bricks in a customized set with the help of their father's credit card, but can also submit these designs to the company. Lego may then produce an extraordinary design as a mass product for other children as well. Amazon.com offers readers the possibility to customize books from various publishers. Building on its "Search Inside the Book" technology, which allows customers to search the complete interior text of hundreds of thousands of books, the company is currently developing two new programs that will enable customers to purchase online access to any page, section, or chapter of a book, as well as the book in its entirety. Amazon thus is finally offering on a retail level what innovative publishers like MetaText, Cinado.com, Symposion or Addison Wesley have done since years: Providing readers the opportunity to purchase just the pages they really need. What might be not a good idea for novels, is great for edited books or also many trade books, where often the first and last chapter are giving you 80% of the information you want to know. 5 Adidas Mi (http://www.miadidas.com): Six shoes (running, soccer, tennis, indoor, basketball) with three areas of customization; fit (length and width of each foot), performance (outsole and midsole options and seasonal upper materials) and design (choosing from over 100 color combinations and embroidered lettering). All of which has to be done in person at select Adidas store locations. Similarly, Nike iD (http://www.nikeid.com/), Puma Mongolian BBQ (www.puma.com/) and Land's End (http://landsend.com) offer customers fairly high degree of customization even at a high volume of sale. 4. Customer collaboration To deliver mass customized products the vendor either exercises full control on the delivery process or shares the control with customers. In the latter instance the customer can play any one of the two roles: Co-producer or Innovator. Consider Asian Paints. Customer needs to visit one of the showrooms with a sample shade of the paint that she wishes to buy. The vendor trained person will mix the pastel colour base paint and the correct amount of tint of colour to produce the desired shade. Customer has no role to play except approve the shade if she finds acceptable. In contrast to this situation, in a mall the consumer herself decides the item, brand, quantity, quality, picks them up and passes through the payment aisle acting as a coproducer for the service. Similar situation is witnessed at petrol pumps, buffet lunch and salad bars. By co-producing the service the customers are helping the vendor to lower the cost of delivery. Now consider toolkits for user innovation and design. This innovative method of new product development (NDP) shifts the design task to the customer by making use of recent developments in IT, media, and production technologies. The customer, in turn, gets a product that perfectly suits his/her needs. This new approach challenges the timeconsuming and costly traditional approach of screening the market for new product needs which are then converted into novel or adapted products. Toolkits allow producers to outsource certain design tasks to customers. In this way, products can be developed much more quickly and at lower cost. Customers, in turn, get exactly what they want – a custom product that suits their individual needs precisely. This approach allows manufacturers to serve ‘markets of one’ and to handle large and small 6 customers in the same way. This new approach has only been adopted in few industries so far. Peter A. Gloor and Scott M. Cooper (2007) observed that throughout history many valuable innovations have come not by the sole effort of a bright mind but by ‘collective efforts of team of people’. Often individuals in these groups are devoted to the idea and to the collaborative process of working with others toward a common goal. They know that their reward might be nothing more than the positive feeling of success at the end. They do not work for financial gain but rather for the challenge to solve a problem. The resulting collaboration benefits those involved and sometimes the society as a whole. The swarming of bees is an archetype this business. Best manifestation of this new principle of Swarm Creativity is seen in development of World Wide Web and Linux. Firms such as Microsoft has been able to reduce cost of development and testing and reduce the time to market by involving large number of users (beta sites) to volunteer for testing software during its pre-launch stage. 5. Long tail effect Product variety is an important component of consumer welfare, yet many markets have historically been dominated by a small number of best-selling products. The Pareto Principle, also known as the 80/20 rule, describes this common pattern of sales concentration. However, by greatly lowering search costs, information technology in general and Internet markets in particular have the potential to substantially increase the collective share of niche products, thereby creating a longer tail in the distribution of sales. The trend was first detected by Chris Anderson (2006) in his book The Long Tail: Why the Future of Business is Selling Less of More. The 80/20 rule applies to all businesses. A manufacturer may have eighty percent of retailers contributing very little; Music company may have a large number of songs that were favourites at one point of time but almost no demand today; Book publishers and distributors may face similar dilemma with many titles and so on. It is not that there is no demand for such products but the demands are so small that it is expensive to carry in the physical formats of selling – largely constrained 7 by limitations of shelf space, lack attention of the seller and high cost of slow moving inventory. The "long-tail effect" is all about profitable niche businesses replacing the traditional mass market. Internet and cost effective options of search and storage have reduced the dependency on a few blockbuster movies, best selling books or hot favourite songs for making profit. Now, due to amazingly low cost searching power of the Amazons and Googles, the entire inventory - mainly comprising the previously ignored niche titles - is available to choose from. And because there are so many of them, collectively they may be worth more than the blockbusters themselves. The "long-tail phenomenon" is well documented: Amazon.com makes significant profits selling many low-volume books. Long-tail enthusiasts claim that low-demand books, CDs, and movies, which are not available in brick-and-mortar stores, will collectively take up a majority share of the market over time. 6. Operational excellence Operational Excellence results in world-class quality, productivity and delivery of goods and services to customers, at prices that are competitive. In today's marketplace where forces such as technological innovation, outsourcing, e-business and global competition are prevalent, it is becoming increasingly important for companies pursue operational excellence. Operational excellence is demonstrated by results that reflect sustained improvement over time, improvement in all areas of importance, and performance at a level that is at, or superior to, ‘best in class’ organizations. Common areas of importance for a cost center are safety, quality, people, and cost. Common segments within each performance area include employee groups, facilities, departments, and external customer types. It can be achieved by benchmarking processes of the firm with the best in the class processes in companies across all industries. Xerox regained the lost market share in photocopying business by achieving operational excellence through extensive benchmarking of 241 different processes. They had tried unsuccessfully to match the cost of producing small copiers of Canon by following the path of value engineering. Success could not be achieved because the processes were not world class and were inflexible. 8 Firms have to demonstrate operational excellence in all processes that are directly or indirectly creating and delivering value for the customers. Manufacturing excellence may symbolize lean manufacturing, implementing TQM, Activity Based Costing, Focused factory, Using enterprise software, Implementing standard processes and similar initiatives. Toyota, GM, Flextronics are representatives of this class. For excellence in service delivery firms can learn a lesson or two by understanding the processes of Shouldice Hospital, Benihana Restaurant, Mumbai Dabbawallah, Southwest Airlines and Starbucks. Operational excellence in supply chain management is to turn it into a value chain. It is more than simply boosting efficiency. The cornerstone of a value chain transformation is establishing a differentiated customer offering. By serving customers or customer segments based on their unique requirements and aligning the value chain accordingly, companies are able to increase efficiency and, ultimately, take the enterprise to another level of performance and profitability. Dell Computers have perfected the art of value chain management for the personal computer industry. Failure to transform into a value chain had forced IBM – the pioneer in the personal computer industry – to lose control on the value creation and finally exit the industry. Motivated and empowered employees are corner stones of operational excellence in human resource management area. Business strategies that will defeat the competition must be supported by excellence in execution at every opportunity. Whether the business strategy is to win through customer intimacy, through product/service innovation or through low prices, the enterprise’s business processes must consistently meet the customer’s requirements with the most effective use of resources. 7. Outsourcing Outsourcing is the act of moving some of firm’s internal activities and decision responsibilities to outside providers. A value chain consists of many varied activities. A firm may not have competencies in all of them. Any activity that is not a part of firm’s core competency can be outsourced. In present business scenario there are many firms providing specialized services. Hence it is possible to outsource. Even large firms like Nike do not own any manufacturing facility. They carry out functions such as product 9 development, brand building, R&D & customer service themselves, and rest is outsourced. Dell Computers also follow similar business model. The reasons to outsource vary greatly. Other than cost or investment reduction and generating cash by transferring assets, the reason to outsource could be driven by many other non finance considerations. These are: Requirement of the organization to enhance flexibility and effectiveness, Get access to some improved processes, Increase revenue, and employee need driven. Some of the motivations of outsourcing are: Economies of scale, Risk pooling, Reduced capital investment, Focus on core competency and Increased flexibility. Major risks are Loss of competitive knowledge and Conflicting objectives. The outsourcing partner should be chosen such that the activity to be outsourced must be the partner’s core competency. Only such a combination holds the potential to reduce cost – maximize profit. 8. Value Engineering Value engineering is an approach to productivity improvement that attempts to increase the value obtained by a customer of a product by offering the same level of functionality at a lower cost. Value engineering is sometimes used to apply to this process of cost reduction prior to manufacture, while "value analysis" applies the process to products currently being manufactured. Both attempt to eliminate costs that do not contribute to the value and performance of the product (or service, but the approach is more common in manufacturing). VE originated in General Electric (under Lawrence Miles) during the Second World War. They were seeking ways to make the most efficient use of war-limited funds and raw materials. They found in most cases alternative materials and processes performed at least as well and often better in terms of both specification and cost. This led them to formalise the approach and devise a team-oriented technique that determines the 'value' of each part and each product. Value engineering, thus, critically examines the contribution made to product value by each feature of a design. It then looks to deliver the same contribution at lower cost. 10 VE is defined as "an analysis of the functions of a program, project, system, product, part of equipment, building, facility, service, or supply of an executive agency, performed by qualified agency or contractor personnel, directed at improving performance, reliability, quality, safety, and life cycle costs." 9. Moving away from unprofitable customers - Life Time Value (LTV) of customers Not all customers are created equal. Twenty percent of customers often provide eighty percent of a firm’s profits. The firm breaks even—or loses money—on the rest. The best usage of customer relationship management (CRM) is to enhance the experience for profitable customers, and bring down costs by automating unprofitable ones. This requires an enterprise-wide commitment to sharing customer data, and the reinvention of how every department in the company interacts with customers. A number of leading firms believe they've found a Competitive Advantage – Focus on profitable customers. And move away from unprofitable customers. Selden and Colvin (2002) have shown that truly customer-centric companies--including Dell Computer, Toronto-based Royal Bank of Canada, Fidelity Investments, and Canada's Hudson Bay Co.--are getting a grip on their customer portfolio and managing it to lengthen their lead over competitors. Firms could not focus on their profitable customers earlier because until recently trying to calculate the profitability of individual customers or even customer segments was too hard an information technology task for big companies to handle. Now the technology, which is getting more powerful and less expensive by the day, is finally up to the job. Here's a mind-boggling fact: Royal Bank calculates the profitability of every one of its ten million customers every month. Customer value management is managing each customer relationship with the goal of achieving maximum lifetime profit from the entire customer base. Customer value management enables companies to take full advantage of the economics of loyalty by increasing retention, reducing risk, and amortizing acquisition costs over a longer and more profitable period of engagement. This is more applicable for firms operating in mature markets. 11 A firm that can manage to move away from unprofitable customers will improve its bottom line. The resources thus freed up can be utilized to build and nurture value enhancing relationship with profitable customers. 10. Reducing quality The insatiable greed for maximizing profit gets easily manifested into strategies leading to cutting cost. Managers possess better clarity about cutting cost than increasing revenue. They are more confident that their cost cutting strategies will yield results than their revenue increasing strategies. Often too much of cost saving may lead to decline in product performance, non conformance to stated specifications and reduced reliability – render them unfit for use. The Pulitzer Prize–winning historian Barbara Tuchman asserted in her article ‘The Decline of Quality’ in the New York Times Magazine (Nov 1980) that the quality of civilization was going downhill. Mass production had rendered the devices and luxuries of the good life — furniture, watches, clothes, toys — more plentiful than ever. But these products were not as durable, as reliable, or as pleasing as their handmade pre-industrial counterparts. Her article was fiercely passionate. After investments made during Quality decade of 80s it appeared that quality of products will keep on improving and quality of life will get better and better. American producers initially faced competition from high quality Japanese firms followed by cheap Chinese counterpart. Today companies in industrialized countries face tough competition from low-wage countries and high price-cutting pressure from global retailers. For the past few years, it has appeared that U.S. corporations are once again employing strategies that emphasize short-term gains from the production of cheaply made, junky products. Kitchen appliances, power tools, cell phones, computer printers, DVD players, toys, and many other consumer goods are increasingly conceived and sold as disposable commodities. Although these products have more features and capabilities every year, their durability and longevity are rapidly dwindling. This may also be called planned obsolescence – products are designed such that they need to be replaced quickly. There is an evidence of declining product quality. American Customer Satisfaction Index (ACSI) conducted every year since 1994 shows that over all satisfaction index of 12 manufactured products have held steady over time. But exceptional companies such as AT&T (7.9%), 1-800-FLOWERS.COM (11.6%), Amazon.com (3.6%), AOL LLC (32.1%), Apple Computers (7.8%), Ask.com (14.5%), AT & T Mobility (7.9%), barnesandnoble.com (14.3%), Best Buy (5.6%), Dell (8.3%), Dominos (11.9%), E*Trade (12.1%), Hyundai Motors(23.5%) skew the results. If these companies are taken out of the list then the over satisfaction rating has declined. Even most revered firms could not show improvement on the customer satisfaction front. There are many examples: Samsung (-4.1%), American Airlines (-14.3%), AT & T (17.6%), Delta Airlines (-23.4%), HP – Compaq (-7.7%), NIKE (-12.2%), United Airlines (-21.1%), Home Depot (-6.7%) and Time Warner Cable (-7.9%). (A full table of company data can be found at www.theacsi.org.) In the end, only one conclusion seems to fit: In every product category, a few good brands continue to improve their durability and reliability. The good get better and the rest get worse. One may find that shorter warranty periods, rising rate of product returns, increasing revenues from post warranty services, easy acceptance of extended warranties all seem to suggest, though without valid evidence, that consumers’ tolerance level towards poor quality is also rising. Other than blatantly copying a successful product – which is outright unethical and no firm has succeeded in the long run - some of the tactics firms are surreptitiously employing to deceive consumers on quality are: 1. Create strong brand pull, reduce quality gradually while maintaining same price. 2. Remove or reduce the quantity of the costliest component or replace it with cheaper one, even if it reduces functionality. 3. Limit the function of the product or split in two different products. 4. Discontinue the fastest selling model. Replace it with almost similar model which is less costly to produce. 13 Has quality really declined? Are firms using such dubious tactics? Evidences are mostly anecdotal. But these have been collected over past five years by asking following three questions to consumers, mostly housewives, who are regular repeat buyers of household products: 1. Can you name some brands that you have been using for more than two years and buy replenishment stocks regularly? 2. Do you think the quality is consistent? 3. If the quality is on the decline, what could be the reason? Well known brands of liquid to clean floor and toilet no longer give shine; detergents leave woolen garments very hard, for fluffy feeling another product is to be used; shampoos are devoid of conditioners; incense sticks do not spread fragrance also they burn out quickly; perfumes leave stains on clothes, particularly white clothes; naphthalene balls leave scars on woolens; and so on. Sometime back a well known brand of glucose biscuit increased the price of the pack of 100 gms from Rs. 10 to Rs. 11 – this is fine so long the brand value can sustain the market share. But recently they reduced the quantity from 100 gms to 90 gms; examples are many. Wristwatches and clocks do not last for more than few years; window air conditioners need refilling of refrigerant gas every year because the copper tubes used are so thin that they develop cracks; timing chain in a car wear out faster because these are no longer made of steel; and so on. A prominent brand of footwear manufacturer often withdraws a highly successful fast selling design and replaces it with almost similar design. Critical comparison may reveal that metal buckles have been replaced by Velcro straps, leather has been replaced by synthetic material, the bounce in the sole has vanished – all focused on reducing cost; such examples are abundant. There is no argument over the fact that reducing quality is not a sustainable tactic for profit maximization, but still firms follow it. In the short run such tactic can shore up the 14 bottom line but if the firm wishes to be around for longer period implementing such a tactic may threaten the very existence of the brand and perhaps the firm. Conclusion Managers have many options to maximize profit. Some of these are directed to enhancing per unit revenue, some enable to cut per unit cost, while still others focus on mixing the two. The type of product or service, extent of market presence, stages of product life cycle, competitive environment and firm’s internal capabilities will determine which option to exercise. References Anderson, Chris (2006). The Long Tail: Why the Future of Business is Selling Less of More, Hyperion Clayton Christensen (1997). The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail, Harvard Business School Press Gloor, Peter A. and Cooper, Scott M. (2007). “The New Principles of a Swarm Business,” MIT Sloan Management Review, 48(3), 81 – 84. Keith Oliver, Leslie H. Moeller, and Bill Lakenan (2004). “Smart Customization: Profitable Growth Through Tailored Business Streams” Strategy + Business, Spring Issue (http://www.strategy-business.com/press/article/04104?pg=all) Leslie Moeller, Matthew Egol, and Karla Martin (2003). “Smart Customization: Profitable Growth Through Tailored Business Streams,” Strategy + Business, Resilience Report, 18th Nov (http://www.strategy-business.com/resiliencereport/resilience/rr00001) Selden, Larry and Colvin, Geoffrey (2002). “Will This Customer Sink Your Stock? Here's the newest way to grab competitive advantage: Figure out how profitable your customers really are,” Fortune, September (http://money.cnn.com/magazines/fortune/fortune_archive/2002/09/30/329272/index.htm) 15