On Management

Dec. 21, 2004
Beware of 'devastating success' -- your big deal could cost you.

Most companies are very careful in pricing new sales programs. The costs are painstakingly determined. The selling prices are diligently negotiated. Even the mix of products is factored into the calculations. Gross profit margins are figured to three decimal places. If the company has a vigilant financial executive pricing the program, costs for extra payment terms and cash discounts are factored into the profitability analysis. But when a big deal is in the works, all of that careful planning can be sabotaged. If the deal represents a huge volume increase, no one from the CEO on down to the account exec wants to let any last-minute costs sidetrack the big sale. But maybe they should. The company might be on the verge of a "devastating success." The phrase may sound outrageous, but it's something that happens every day. There are cost elements in a deal that traditional measures don't capture. If these costs go unnoticed and unquantified, several months after the big sale the company may find itself doing more volume but making less money. And because it's using more assets, it winds up earning an even worse return. Consider two examples of actual scenarios that cause such catastrophes. The first is a company selling to a major retailer. The second is an industrial business-to-business situation. Both have several things in common: more volume, less profit, and even worse returns on assets. When chasing the big sale, a manufacturer usually is trying to fill excess capacity, but seldom does the new business exactly fit the available capacity. Often, it exceeds it by a wide margin. However, because of the potential revenue impact, the new business takes precedence over old business. Since it involves a volume discount, the new business carries lower prices and longer payment terms than the old business. There also may be a mandate for rapid delivery that requires carrying more inventory. Working-capital requirements rise significantly, and profits decline because so much capacity is tied up with lower-margin business. Moreover, doing business with the big new customer squeezes out volume from older customers -- who paid faster and were less demanding. And we still haven't gotten to the costs required to seal the deal. In a retail setting, there are charges for the buyback (and close-out sales) of competitors' goods currently on the shelf -- in order to make room for yours. There's also the cost of new signage and point-of-purchase display materials, which typically isn't figured into the cost of the deal. And, as the new supplier, you are expected to provide new-store-opening freebies and extra advertising allowances to give the product line a worthy launch. Other costs may creep in, such as increased deductions to correct bugs in the part-numbering systems conversion. Just about this time your competitor may launch a counter-attack -- requiring you to slash prices further to hold onto your new volume. (Are we having fun yet?) Taken together, such expenditures can wipe out all of the first year's profit on the big deal and perhaps eat into year-two profits. The industrial situation may be better -- but don't bet on it. Demanding mega-customers appear in all industries. Besides the working-capital escalation, you may have to agree to an annual 3% cost reduction. Then come the hidden costs: waiving the minimum setup charge or small-quantity premium; tightening the specs just a little. And don't forget the low-volume nuisance items needed to fill out the line. (No one makes money on these dogs.) Add in some expedited delivery costs caused by last-minute production-schedule changes and again any profit is postponed until the second year. The point is that you must anticipate every cost of the deal. In companies I've worked for, we actually developed "cost of the deal" software to make sure we included everything. If you fail to calculate the full cost of the deal, the result, indeed, can be "devastating success." John Mariotti, a former manufacturing CEO, is president of The Enterprise Group (www.shape-shifters.com). He lives in Knoxville. His e-mail address is [email protected].

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