To boost profitability, break down your costs like your golf game.
Can a golf coach tell you what’s wrong with your game, just by knowing your handicap? Of course not. While your handicap can shed some light on your overall ability, your coach must break down your game — evaluating your putting, driving, chipping and more — before pinpointing problems and making corrections.
Like a handicap, a company’s profitability is an indication of overall performance — and it is equally useless as a diagnostic tool. Overall profitability is expressed by the fundamental business equation: Revenues – Costs = Profit. But because your level of profitability represents an aggregate of all your company’s business activities, it cannot point to specific opportunities for improvement. To do that, you must take the approach of a good golf teacher, evaluating one element at a time — in this case, one product at a time.
This product-by-product approach makes sense because it’s consistent with how your business truly operates. You quote one product at a time to your customers, schedule one product at a time on the production line, and so on. Each of your products contributes to — or perhaps detracts from — your profitability to a different degree. So it makes sense to measure your performance and identify improvement opportunities one product at a time.
This means you should evaluate your business with a different equation: Pricen – Costsn = Profitn, with n representing each of the different products you manufacture.
Your success in affecting profits depends on your ability to control revenue and cost levels. In golf, you can’t control the speed of the greens or the direction of the wind, but you can control your putting stroke and your club selection. Trying to control the uncontrollables in business is just as fruitless. Instead, you must focus attention only on the parts of the profit equation you can influence.
Let’s look at price first. In the automotive business today, the price for a given product is fixed over the short-term. You can’t raise your prices. In fact, you most likely have an annual percent give-back “bogey” you must meet or risk the business being awarded to your competition.
This wasn’t true in the past when manufacturers could exercise a form of arbitrage if their customers lacked sophistication and knowledge of the marketplace. But today, regardless of what you may believe, the automotive products you produce are commodities. That’s because automobiles themselves have become more or less commodities. Today, most parts suppliers are manufacturing essentially the same product.
At the same time, the combination of the internet and global sourcing has firmly established the market price for the products you produce. Price today is like the par score on the golf course — it’s non-negotiable.
I would argue that profit is also fixed over the long-term. Your company’s profit requirements have been established by the capital markets and are based upon the risk-adjusted return on investment for the shareholders who have placed their assets with your company.
They expect a certain return for their investment. And if their investment is considered risky, they expect even higher returns. In years passed, automobile supply was considered a “blue chip” industry. Once a contract was signed, the machinery pumped out part after part, month after month. Volumes were high and complexities were low.
That era has ended. Products are increasingly more complex, contracts are more numerous and harder to secure, production runs are shorter and competition is far more severe. Because of all this, automotive supply has become a much riskier business, which has put upward pressure on the profit side of our equation. If the point is reached where the financial returns are no longer attractive, your business will liquidate as your investors and lenders put their money elsewhere. This is the cold, hard reality of capital markets.
So, returning to our golf analogy, here’s what we in the auto industry are facing today. The golf course is more difficult (profit requirements) but par hasn’t changed (price). Yet we still must find a way to navigate 18 holes as efficiently as possible. That brings us to cost, which is the only part of the equation that can be controlled in the short-term.
Tightly managing costs will allow you to offer the most competitive prices possible while still remaining profitable, but there are other less obvious advantages to good cost management. Cost data can be extremely useful in pinpointing the areas of your operation that can quickly generate the greatest cost reduction. It’s like your golf instructor focusing first on your putting, because that’s where your greatest opportunity for improvement lies.
Cost management can tell you which of your products are most profitably made, information that can help target the efforts of your sales force. On the flip side, this information may identify inefficient elements of your operation that could be outsourced (a viable option for business, but sadly, not for golf).
Cost data also may reveal a special capability that will allow you to simply outrun your competition within your current industry. Or it may be useful in uncovering product niches which, if fully exploited, would diminish your customers’ supply options and may even allow you to raise prices for lack of competition.
All our clients agree that cost management is both good and necessary. Yet most of the calls we receive from financially distressed manufacturers relate directly to inadequate cost management practices. How can this be? The answer can be traced to bad cost data.
Many companies simply have poor cost reporting systems — cost data is inaccurate, out of date, non existent or insufficient to enable analysis and proactive control. We once had a client who told us he was operating at a 10 percent scrap level, which he admitted was excessive but still not enough to explain the distress his company was experiencing. Our analysis revealed that he indeed had 10 percent scrap: 10 percent in Department A, 10 percent in Department B and 10 percent in Department C, for a total of 27 percent company wide. He was like a golfer who had to guess his final shot total because he failed to record his score for each hole.
Another cause of bad cost data: some companies continue to collect this data in aggregate, rather than on a product-by-product basis, which prevents them from identifying specific opportunities for savings.
But the most common issue is poor cost allocation. Many years ago, manufacturing costs were made up mostly of materials and labor, with only a fraction going to overhead. Today’s cost structure is far more complex, extending well beyond the production floor to engineering systems and design, engineering updates, utilities consumption, compliance reporting, MRP/ERP systems, maintenance, supplier management, quality reporting and product launches, to name a few. At the same time, costs directly attributable to specific products, such as set-up, launch and inbound freight, are often lumped into overhead budgets.
All this makes cost tracking far more complicated and challenging — your company could be losing money on certain products and you may never know it. The solution we recommend is Activity Based Costing, designed to apply costs to the specific products that consume them, vastly improving your ability to track and manage cost data.
In summary, cost is the only part of your “game” that you can control. By breaking down your costs like the elements of your golf game, managing the cost of each product, and implementing some basic data tracking and accounting initiatives, you may find that improving your company’s performance is easier than lowering your handicap.
Dan Ploger is managing director of Plante & Moran AFME, a manufacturing consulting firm in Nashville.
To boost profitability, break down your costs like your golf game.