Is your business losing money in spite of strong volume? How to make money without becoming slave to volume?

Over the past 20 years I have been involved in a number of businesses many in various stages of turnarounds. I have seen or executed both successful and unsuccessful turnarounds. Often the failures taught me more than successes did. By sharing this methodology and lessons learned I hope to make it easier for today’s leaders to tackle such situations. [AY1] 

I am sharing a simple process that analyzes profitability of products, and lays out specific steps to improve profitability through a combination of culling, margin improvement and volume growth.

The paradox of too much volume

Often sites or companies are in a difficult situation where no matter how much they increase the volume their profits do not go up. Reducing fixed costs also has little effect. The company is also short on availability of working capital. This results in either high cost of borrowing money for working capital or not having enough cash to fund safety inventory to enable smooth operations.

To identify if we have a margin spread problem, we start with a product profitability analysis. This example is for a manufacturing business. It can be applied to service delivery business as well except a majority of the costs will be for labor. For those who are unaccustomed to the financial terms please refer to the Profitability Basics and Glossary section at the end of the blog.

Collecting the necessary data

For an accurate analysis it is important to have good data. Most accounting systems (if kept up) should have this data that the company or site accounting or business finance group should be able to provide. You can typically use the last twelve month of data or a more recent period (say last 2 quarters) if there has been a big change in profitability. Specifically:

Volume and Price of products sold

Revenue from products

Actual raw material consumed per unit of product (not standard but from usage)

Average raw material cost (RMC)

Variable labor allocated for each unit of product

Labor rate fully burdened

Total plant or allocated fixed costs for the line  

Analyzing the data for profitability

The first test of profitability is: Are we generating sufficient variable margin to cover the fixed costs? Let us say the plant produces 6 different products with varying variable margin as in Table I below:

Table 1: Initial data set for profitability analysis

We do some data manipulation calculating variable margin generated by each product and also calculating VM % or Variable Margin as a % of Revenue. As long as the cumulative variable margin (18,700) is greater than the plant fixed costs the business should have positive gross margin. For the business to be truly profitable the gross margin should exceed the SG&A expenses. Next we sort the data with descending order of variable margin%.

Table 2: Re-sorted data with cum. margin and volume

Note the entire data set is sorted with VM% as the key, declining from 23% to -31%. We next calculate the cumulative volume and cumulative Variable Margin and plot Cumulative Variable Margin vs. Cumulative Volume. The results are show in Fig. 1.

C

 

Figure 1; Initial Product profitability Curve

The variable margin to volume curve can be divided into three sections.

Section A is the healthy margin section. With increase in volume variable margin goes up. So by bringing additional volume you will generate additional variable margin thus covering more of your fixed costs.

Section B is the low to flat growth section. With every additional volume you get very little increase in variable margin. While the overall impact of these products is positive given the low variable margin these products are not very attractive.

Section C is the negative variable margin section. The products do not have positive variable margin and you lose more money as you sell more. These products are the biggest opportunity for improving overall profitability of the business.

Key actions to improve profitability

Now that we have identified the profitability of various products and ‘leakage’ of profits due to certain products, it is time to deal with the ‘problem children.’

Fix or fire the underperformers

There are two ways to deal with these types of products (section C). Either you raise prices, or if customers are not willing to accept the price increase, stop making those products. If you go to your customers and tell them that you are losing money (cash not profits) over these products you will get a sympathetic ear. If customer sees value in this product they will (grudgingly) accept a price increase for these products, especially if you make an effort to take some cost out of the product. If the customers are not taking a price increase then give them 3-6 months (at a higher price) to reformulate, redesign or find equivalent parts elsewhere. Never cut off a customer with too short a notice. They will remember you and make sure you don’t get new business in the future

Enhance the profitability of low margin products

Once you got rid of (or straightened) the tail, your next step is to improve the profitability of the middle section (section B). By looking at raw materials reformulation, using cheaper alternatives, or finding alternate suppliers you can improve profitability. Some targeted and reasonable price increases, while difficult, are not impossible to get.  Next review the yield/defect rates for these parts and work with quality and manufacturing functions to improve yields for low yield products. Often the low profitability is due to high labor costs or high raw material costs.

Disproportionate resources for high margin products

Once you have addressed the low margin and negative margin products you are left with mostly products that show good margin growth with increasing volume. Your goal is to try to grow business by targeting customers and regions where we have low share for these products compared to elsewhere in the market. Invest disproportionate sales and marketing resources in selling these products for the low share customers and regions. The more you sell these products with high profitability, the more variable margin you will generate. This results in better fixed cost absorption and improved gross margin.

An example case study

Let’s take the above example and implement the steps describe above. First we look at section C. Let’s say we were not able to raise those prices sufficiently and decided to stop making the two products: ‘prod5’ and ‘prod6. We then look at products in section B and successfully raise the price by 5%. In the near term we leave the highly profitable products in section A as they are. The net results of these changes are shown in the Table 3 below.

Table 3: product data after pricing actions

The impact on variable margin is dramatic. The cumulative variable margin increases from 18,700 to 23,875 an increase of 27% with only a single price increase of 5% and eliminating the negative margin products. The higher margin is coming from 21.5% lower volume. This lower volume would also mean the business needs less cash to operate due to lower inventory and receivables and generates more margin. What’s not to like?! The new profitability curve is shown in Fig. 2:

Figure 2: Improved profitability curve

Key takeaways and recap

 Profitability is the number one measure of the health of an enterprise. Businesses that have low profitability cannot attract capital, are often working capital intensive, and do not generate enough margin to justify future investments in plant, technology and process improvement. A simple methodology is presented that calculates product profitability,

• .     Raise prices or stop selling negative variable margin products.
  
  
• .     Improve profitability of low margin products through a combination of raw material cost reduction, improved yield and price adjustments.
• .     Invest disproportionate resources in promoting and selling high margin products in customers and regions where you have low share.

The results can be quite dramatic and lead to significant improvement in profitability. Thus for the same receivables and inventory you generate disproportionate cash allowing you to pay down debt and invest in your business. Ultimately it results in sound sleep for the owner and job security for the employees.

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Profitability basics

Those who don't have a financial or business background below I have defined some terms and lay out the basic math of profitability.

The profitability of a manufacturing operation at the plant or site level is measured as the gross margin in the Income Statement. It is defined by.

Gross Margin = Volume x (Unit Price – Raw material cost – variable labor) – (Fixed labor + Depreciation + fixed manufacturing costs).

If we group the terms together:

Gross Margin =( Volume x Price – Volume x variable cost) – Fixed cost

The first term in the right is often referred to as ‘variable margin,’ ‘margin spread’ or ‘contribution margin’.  We will abbreviate it as “VM”.

Gross Margin = Variable Margin – Fixed costs

Glossary

           

Volume	Number of Units Produced
Price	Net Price per unit after rebates and discounts
Revenue	Volume x Price
Raw Material Costs	Variable cost per unit of raw materials used
	Labor hours per unit x labor cost/hr * (1+benefit rate)
Fixed labor	Fully burdened Variable labor labor costs  including ovhd labor, supervision
Fixed Plant cost	Plant utilities, insurance, maintenance cost and labor etc.