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Taking Costs Out Of A Business Without Sabotaging It


The CEO and Board rely on the CFO’s advice and guidance, but this could lead to trouble unless the CFO has proactively reviewed the business processes to ensure the systems they rely on are sound.

This two-part blog outlines one method of looking under the covers for opportunities to improve margins and cash flow, using a real-life case study. This is based on how an automotive accessories company with cash flow problems achieved a $3.5 million improvement in the first year.

Background

Many CFOs may be engaged to help a company to improve financially or operationally, but where do you start?  The following outlines a real case study from turnaround experts Vantage Performance, and the discoveries highlighted issues which are common in many businesses, in varying degrees.

A rational and methodical approach to conducting a review can help turn chaos into order. This blog will highlight the issues we discovered during our review. My next post will clarify the priority actions we implemented to turn things around, given the issues discovered.

Our case study business specialises in automotive accessories and the company had transitioned from supplying the after market (low volume high margins) to the OEM market (high volume low margins) and had $50 million in annual sales.  The business did not properly complete the transition and was still trying to service both markets, satisfying neither effectively. Vantage’s objective was to take costs out of the business and to improve margins – however the initial and obvious problem was a severe cash flow crisis.

What Vantage Performance did

The first phase was to collect high level summary information of the key details (such as items sold, customer listings, supplier listings) and sort them into dollars, quantity and category of product (made, sold or purchased) and transaction frequency.  The method was to sort and prioritise the details using the Pareto principle (the 80/20 rule).

Once inventory items were determined and sorted, a second phase included acquiring or validating the product costs and margins.  The discoveries that came out of this investigation set the pathway for corrective action, including improving systematic business control and monitoring processes which had failed.

Issues Discovered

Products:

  • 897 types of products were manufactured – the top 20 items (2.2% of range) contributed to 75% of revenue (very skewed under the Pareto rule which typifies 20% of the items contributing to 80% of revenue)
  • 2 of the top 20 items had very low gross margins
  • 5% of the revenue was from 751 items
  • 495 items were despatched 10 or fewer times per year
  • The low-value low-volume products were interrupting the flow of the main products and consumed disproportionate resources and a major area of customer complaints
  • Many products did not have price increases for 2-4 years, as management were concerned about losing volume.  The key stakeholder had the view that increased volumes would increase net profitability, despite two of the high volume products having low margins, and the business needed $1 million sales per week to break even.

Customers:

  • 203 customers, with the top 18 customers representing 91% of the revenue
  • 167 customers contributed to 4.3% of the revenue
  • The two low margin products were with one customer, who represented 53% of the revenue
  • The average delivery on time to customers was 50% to 65%.

Suppliers:

  • 466 active suppliers/creditors
  • The top seven suppliers accounted for 50% of the spend and the top 31 accounted for 80%.

Costing System:

  • The product estimating process was found to be using incorrect manufacturing overhead rates, thus understating the correct labour costs and full cost of manufacture
  • A cost plus price structure (a mark-up method of product pricing) was being used instead of margin % pricing. The mark-up method did not cover sufficient overheads or provision for profits.
  • There was confusion about what the hourly rate and mark-up represented, and the difference between mark-up and product margins
  • The 2 key business units were using different costing processes with different cost inputs, despite manufacturing being similar
  • The estimates had not been signed off nor adequately reviewed by management.
  • The P&L did not capture the incidental and high R&D costs which were incorrectly classified and capitalised on the balance sheet (i.e. did not comply with accounting standards). This had the effect of under-stating the loss and not being considered in the overhead calculations, and over-stating the tangible value in the balance sheet.

Inventory:

  • Accurate inventory records were not being maintained, resulting in unnecessary purchases as the inventory was on site, but too difficult to find
  • No expediting of purchase orders resulted in frequent stock-outs.

As you can see, there were a number of good reasons why this client was having cash flow and profit issues. Look forward to sharing our solutions with you soon!

Keith Bailey was a former client director at Vantage Performance, specialising in assisting under-performing businesses and providing support and resources for recovery, rapid growth or challenging situations. Vantage Performance is a member of the Turnaround Management Association Australia and was awarded the 2008 and 2009 “Turnaround of the Year” awards.

 

 

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