Viewpoint -- The Wheat, The Chaff And The Crunch Of The Cereal

Dec. 21, 2004
Discovering and leveraging sources of true profitability is a practice that many managers misunderstand.

The key to a wholesome, crunchy cereal is proper separation of the wheat from the chaff. The key to proper separation is knowing which is which. In my experience I have seen dozens of underperforming companies confuse the wheat and the chaff. In other words, they aren't sure what the real source of profitability is within their companies. While many companies have successfully increased revenues over recent years, they're surprised to find a stagnation or even reduction of EBITDA (earnings before interest, taxes, depreciation and amortization) and cash flow. Yesterday's hard charging economy has given way to today's recession. And like farmers separating the nourishment from the husk, managers of underperforming companies must discover, separate and leverage sources of true profitability within their companies. Fortunately there are basic pragmatic steps managers can take to understand product and customer complexities and associated profitabilities. Through this understanding and with a portfolio mindset, managers of underperforming and distressed companies can positively affect the outcome. All Revenue Is Not Good Revenue Traditional cost systems can mislead managers. Accountants developed these systems for other accountants. In fact, they were developed for the SEC. Although they're compliant with generally accepted accounting principles (GAAP), these systems fail to provide accurate and insightful information into the true economics of the business. In other words, the products that are made, the services that are provided and the preferences customers choose aren't reflected. Traditional cost systems focus on direct materials and direct labor, arbitrarily allocating manufacturing overhead to products and failing to associate engineering, selling, service and distribution costs to anything at all. That was fine in Alfred P. Sloan Jr.'s day (Sloan served as CEO of General Motors from 1923-1946), when virtually all costs were direct material and hands-on-chassis labor. But given the complexities of business today, indirect costs are a much larger part of the business, often 50% or more. Decades-old activity-based costing concepts have enabled us to better associate indirect costs to products, services and customers on a cause-and-effect basis. These concepts have successfully demonstrated that while all products and services sold contribute to revenue, they don't all necessarily contribute to profitability. Not only that, wide swings can be found in the reported profits of individual products using better cost systems compared with those of traditional cost systems. As insightful managers assimilate this new "true" profitability information, they realize that their products, services or customers can typically be segregated into three primary categories:

  • Profitable Stuff: Often only one-quarter to one-third of a company's products, services or customers are truly profitable. These are the ones to nourish, learn from, extend and leverage.
  • Marginal Stuff: One-third to one-half of products, services and customers are marginally profitable or marginally unprofitable. This is typically the largest category, which requires the lion's share of management's attention for very little, if any, return. Products and services in this group are candidates for design simplification or price increases.
  • Unprofitable Stuff: Often a surprise to the management team, one-quarter to one-third of the business is truly unprofitable. These areas are candidates for rationalization or significant contract renegotiation. Unprofitable customers are candidates for a "plain vanilla" customer-service approach. Obviously the unprofitable category should get the most immediate attention from managers of underperforming companies, though all these categories offer exciting opportunities. For example, one troubled manufacturer of totes and bags recently segregated products by true profitability. It found that less than 20% of its 1,000 products contribute to profits; fully 80% detracted. Looking into the details, the management team uncovered plenty of rationalization, simplification (e.g., design for manufacturability) and customer-negotiation opportunities upon which to focus its turnaround effort. As a typical example, it found one marginal product selling for $92, but losing more than $3 for each item sold. The reason: a high number of sales discounts, warranty replacements and procurement issues associated with its 100-plus components. By now you won't be surprised to know that the company's traditional cost system incorrectly indicated this product to be a successful and very profitable one. The more accurate cost and profitability information became the foundation for the company's product-rationalization efforts. Theoretically if a company were to eliminate the unprofitable category in its entirety, the company would realize an immediate 20%-50% increase in profits. That's theory. In practice it doesn't work out that way. In any rationalization exercise you need to actively plan for and manage away the costs. To do that you need to know where the costs are coming from -- what resources are being consumed by the undesirable products, services, or customers. The practical manager of an underperforming company will therefore manage a rationalization effort in chunks. For example:
    • Identify as many targeted products to be eliminated as possible (chunks of products).
    • Understand, through your new cost information, what resources are being used to design, make, sell and distribute those products to your customers (chunks of costs).
    • Understand other implications of these potential eliminations.
    • Plan and complete the simultaneous elimination of both products and costs.
    Unless costs are managed away in conjunction with unprofitable products, the only thing the manager of an underperforming company has done is thrown him or herself into a virtual death spiral of eliminating products, transferring costs to remaining products and finding more unprofitable products to rationalize. Defend Against Negative Implications Managers need to consider portfolio theory. By that I mean they need to recognize that the entire company consists of a series of customer portfolios. And each customer portfolio consists of a product portfolio as well as a service portfolio. In other words, the profitability of each customer depends directly upon the portfolio (or mix) of products that customer purchases and the portfolio of services you provide to maintain that customer relationship. Companies can do two things to improve customer -- and ultimately company -- profitability. First, modify the mix of products each customer purchases to a more profitable blend. Secondly, improve the relationship -- the ways in which you interact -- with that customer. For example, say the customer buys five products of varying profitability that are supported by five services -- five key things we do for that customer as part of our relationship. This customer tends to have a high cost-to-serve when it comes to distribution. For instance, the company might require us to ship to a number of retail locations rather than to a single centralized warehouse. Additionally, its specialty engineering service costs are high. Perhaps the company requires us to modify standard products for it. Inventory management costs for this customer are high as well. Perhaps it provides us with poor or changing forecasts, resulting in our stockpiling product for the company "just in case." To improve the profitability of this marginal customer, we can do a number of things. First consider the product portfolio:
    • Convince the customer to substitute unprofitable Product E with some other similar product with higher margins.
    • Redesign Product E through design-for-manufacturability or design-for-assembly techniques.
    • Raise the sales price of Product E.
    • Focus on increasing the customer's purchase volumes of other products by helping it locate new relevant applications or markets.
    Now consider the service portfolio:
    • Work with the customer to improve forecasts.
    • Consider charging an engineering change fee for significant modifications to standard products.
    • Work with the customer on reducing the number of "ship-to" locations.
    Enhanced cost accounting and profitability reporting has enabled this insight. In fact, through better profitability modeling tools we can extend this historical profitability insight and "play what-if" to analyze and quantify potential results of the initiatives described above. Once you understand true product profitability, true customer profitability and the economics of the portfolio of products and services associated with each customer, then you understand that you can't simply eliminate unprofitable products, services and customers. Consider the last example. Say, for instance, this customer absolutely needs Product E, but Product E happens to fall near the end of your cumulative product profitability curve. It's a big loser. Without understanding customer portfolios, you might have eliminated Product E. Now that you understand Product E is a must-have to an important (high revenue), profitable (though marginal) customer portfolio, you'll be less likely to eliminate it. Rather, armed with a full understanding of the economics of your relationship with this customer, you endeavor to maximize the total profit contribution that this customer provides to the company -- warts and all. Pragmatism Is A Good Word Even when companies begin to realize they're slipping down the distress continuum, and so begin to look for insight to EBITDA improvement, many mistakenly believe they cannot afford to improve their cost and profitability reporting systems. They're concerned that the task is too difficult, expensive and time-consuming. Determining true profitability may sound intimidating, but it doesn't need to be a lengthy or expensive exercise. Don't worry about the "correct" approach, because with management reporting such as this there is no single correct way. The process itself is useful for learning more about your products and customers. Here are some practical tips to get you started:
  • Use Available Data: Fill in the gaps with estimates. For example, if you want to associate your high warehousing costs to products based on square footage consumed -- rather than on traditional machine hours -- but don't have it, work with the warehousing manager to get estimated storage bins by product.
  • Get A Handle On Big Cost Areas First: These have the greatest impact. The old materiality concept should be alive and well here. Take iterations; learn as you go.
  • Don't Waste Precious Resources: You're an underperforming company. You're right to be hesitant to spend the money and time on a new system now. Use simple PC tools already at your disposal (e.g., a spreadsheet), and get that hungry new industrial engineer to lead the charge.
  • Don't Worry About A Sustainable System: Get the information to help you influence the troubled situation now. If you do it right, there'll be plenty of time to build that expensive sustainable cost management system later. Bad Things Happen When. . . Bad things happen when managers of distressed companies don't take the time and effort to discover and leverage the sources of true profitability in their company. Never weeding the garden for fear of making mistakes or blindly accepting all new work "as long as it contributes to revenue" leads to an unmanageable portfolio of unprofitable products and customers. The bottom line is that managers need to be good farmers. Good farmers are careful to separate the wheat from the husk, but they know they will need to accept a bit of chaff. After all, it's the chaff that provides that satisfying crunch. Tom Anderson is a senior associate with the management consulting business of Jay Alix & Associates, a turnaround and restructuring firm based in Southfield, Mich.
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