You raise the same question as you did the quarter before, and in fact have done for three quarters in a row: “How come our sales are up by several percent, while our profit has remained at the same level?” When you press the team to give reasons for the declining profit margin, an intense debate ensues with a plethora of arguments like “all my products are duly priced”, or “we have recently reviewed our cost allocation principles for all product groups – and made a few minor adjustments, so I can ensure you that they are up-to-date”. As the debate fades out, you present your conclusion – “We don’t have a clue, do we?”
This is not an unfamiliar situation in many organisations. A once profitable and growing business has kept growing, but the profitability has somehow deteriorated. Why has that happened, as no significant changes have taken place? Well, only a few more products have been added to the range – some slight product variations for your most valued customers – and yes, there have been some rush orders when your competitor failed to deliver and you helped out the customer – as you did with that new customer who required bespoke transport arrangements, or that other one who insisted that you keep safety stock… and so the list goes on. None of these in isolation would have made any particular impact on your profitability, but over the years there have been quite a few of them.
No matter whether you are the CEO of the company, or merely involved in sales and operations, these questions are fully relevant for you: “Where did it go wrong?” or “What can we do about it?” or, if things aren’t that bad yet, “How can we ensure that we stay profitable?”
If you only knew the true profitability or economic contribution of each product and service, you could make rational choices on how to best serve your customers and manage your suppliers, you would know how to plan and develop your offering and product range, and you would understand the trade-off between customer service, cost and profit. Knowing this, you could take concrete action to adjust prices and terms, impact the cost base and realise savings where you have identified them.
…you would know how to improve it!
In order to know the true economic contribution of your products, or of your customers or even of a single customer order, you first need to get a thorough understanding of your end-to-end supply chain cost. You need to understand how your supplier terms impact your profitability; e.g. how larger order sizes for a certain component on the one hand reduce your purchasing price, but on the other hand increase your warehousing cost, your capital cost for inventories, and eventually your Cost of Goods Sold due to inventories becoming obsolete. You need to understand how your product customisation increases your sourcing cost for that different-shaped side panel, for example, and how much more time it will require to fit the panel in assembly – or which orders should carry the extra cost for that direct truck delivery you needed in order to handle the rush order you accepted – or, in fact, all orders related to that truck delivery.
Getting to the economic contribution…
The economic contribution is the amount of economic profit a revenue-generating asset contributes to the value of the company.
The formula for determining your economic contribution is:
- Economic contribution = Net profit – Capital charge
- Net profit = Gross margin – Attributable operating cost
- Capital charge = Attributable working capital x Cost of capital %
The gross margin is calculated by adjusting the net sales for each SKU, e.g. for markdowns and promotions, and by reducing the cost of goods sold. The attributable operating cost is the value of all other of your operating costs that can be directly attributed to suppliers, categories, products, customers and channels throughout the value chain. They may include freight costs, distribution labour, returns handling, marketing & advertising, damaged goods, rebate processing, commissions, etc.
The attributable working capital is the value of the working capital required that can be directly allocated to your products and channels. It will include e.g. days payable outstanding, days receivable outstanding and days of inventory on hand. The cost of capital % is e.g. the internal Weighed Average Cost of Capital (WACC) as defined by your CFO, or it can also be the target value for the Return on Capital Employed (ROCE) that your board has set for your company.
To get to the true profitability of your products, you will have to do a thorough analysis of your supply chain. You will need to convert your unstructured and scattered data into a structured format. You will need to get to the transactional data, join different datasets, allocate the attributable cost, and make assumptions and allocation decisions where there is no straightforward allocation rationale. You will need to check the data for consistency and issues, and solve these issues. Depending on the amount of transactional data, you will need to choose an appropriate tool for your cost model. If you have very much data, you may need more advanced tools and more calculation power than an ordinary spreadsheet program can offer.
Having determined the economic contribution for each SKU, you should identify the outliers at both extremes: SKUs with a low or negative contribution may lead to customers cherry-picking these SKUs, and not buying other SKUs in the range, while SKUs with a very high contribution may prevent the SKU reaching overall high sales due to an excessively high price. In addition to isolated SKUs suffering from a low contribution, you should furthermore identify any areas of concern: do all the SKUs in a particular product group have a low contribution, or does it concern all SKUs passing a certain process step in production, etc.? You would then need to go further into the root causes of the low contribution.
…and taking action for improvement
To determine improvement actions and the impact of your alternative actions, you should cluster the SKUs into groups, based on your analysis, and run a few scenarios. If you terminate this group of clearly unprofitable SKUs, how much will your cost drop? If you increase the price for that group of SKUs, how much will your sales drop? If you reduce the price for these SKUs, how much more will you sell, and how will your contribution eventually be impacted? Based on the results of the scenarios, you can create an action plan to improve your profitability.
The actions you need to take depend on the conclusions you make, based on your analysis. It may mean terminating a recently introduced product, swapping to a supplier with a higher price but more flexible terms, increasing the price for an SKU knowing it will mean reduced sales, or telling your key customer that this particular SKU will no longer be available in two days from stock, but in two weeks made to order.
Having done this exercise, you have increased your insight into your key profitability drivers. You have created a method, and even a tool, for updating the contribution on the SKU level, and most importantly, you will have a concrete action plan for improving your profitability. Even though this may mean difficult discussions, both internally and with your customers, the purpose of each action is fully clear, and this will give you and your organisation the confidence to carry them out, knowing that you are doing the right thing!