The primary reason for establishing standard costs is to provide management with a handle on how the business is going from day to day without making it wait for delayed accounting reports. Of course, a company must establish product and overhead costs to determine pricing and ensure profitability. However, they must also recognize that the basis on which the pricing is established changes over time. Rate reevaluation rarely keeps pace with these changes; more often management is forced to rely on instinct and judgment.

    In a volatile product environment, someone who has an overall feel for the products and the impact of changes in the product mix must be on the lookout for fluctuations. I even remember one process engineer in a company that manufactured printed circuit boards who could walk by the copper tanks and spot a problem by the different shades of blue in the bath. This kind of specific expertise develops more readily in a single-product environment. While operating a job shop, I tracked the added value realized from shipments (billings) on a daily basis. (I defined Added Value as Total Sales - Material Costs.) I had a good handle on the direct costs of each product, and I knew the margin required to break even and to turn a profit. Finally, I kept my eye on the new orders to ensure that the pricing covered, and would continue to cover, the added value and profit.

    I’ve seen many companies whose management was not sensitive to the impact of product mix on the bottom line. Managers often brag about the high gross margin percentage they are receiving for their products. However, gross margin must cover all the supporting costs currently in place before anyone realizes a profit. A plan to cover $1.6 million in supporting costs from a 40% gross margin assumes a minimum (or break-even level) of $4 million in sales. Six months into the year, the GM is proud because he’s now getting a gross margin of 48%. Unfortunately sales are running at a projected annual rate of $3 million. Unless the support structure is changed to reduce costs, the gross margin of $1,440,000 will not cover the supporting costs and the company will lose $160,000.

    It might be reasonable to expect that average product costs would go down as a company adds products because indirect costs are spread over more products, but this isn’t the case. Unfortunately, efficiency and yield tend to decrease as new items go into production.

    Component manufacturing provides a good example. With only one product, the process can be optimized, and any deviation from the norm quickly recognized and corrected. In another company I worked in, I was responsible for the manufacture of memory components. When we were a one-product shop, we were able to improve efficiencies and attain an average cost of $2 per thousand. When we added a second component with only slight specification differences, the overall average cost rose to $2.20 per thousand. A third similar component drove the cost to $2.50 per thousand. It was not that the added components were more difficult to manufacture; in fact, the yield from component three was better than that for component one. The problem was that with each added component, efficiency decreased and scheduling requirements kept us from staying with each product long enough to maximize the yields. In addition, the support staff’s attention was spread over the three components, so they couldn’t give each one the same focused attention they had before.

    The impact on efficiency that adding products to the mix has is easy to demonstrate. I’ve often felt that someone who took the time could probably develop a formula that could predict this effect with reasonable accuracy. However, absent such a brain, keeping an eagle eye open to the changes in the wind is the best solution.

    Since different products have different yields and efficiencies, the most important step is to make sure that prices get adjusted as each product is added. It is difficult to allocate the indirect costs with precision, so a good gut feel or instinctive understanding of the situation is required to set prices appropriately.

    When I worked in a systems manufacturing environment it was possible to achieve 100% yield by repairing the systems that aren’t functioning, but here again, specialization becomes important. With only one product, everyone knew the product well enough that there were no drawings or written specifications. None were needed. Assemblers could often detect and repair defects with minimal impact on time and schedules. However, as more systems were added, rejected systems had to be set aside to be repaired later on by more skilled personnel. This always added a cost to the system and increased the indirect product cost.

    In that environment it was even more difficult to meet the testing schedules, and often any problem system was merely set aside. This cherry picking only delayed the inevitable. Often the picked-over systems were very difficult to fix, and the cost for repairs was far above that allocated in the estimate. In fact, the real product costs weren’t known until it came time to close out a work order.

    Some companies mask problems by not closing out work orders in a timely fashion, letting that inventory build up instead, and then when this inventory is written off, it is generally as a lump sum that still isn’t recognized as a cost of the product line that caused the leftovers. This approach gives false data about product cost and margins.

    Here is the problem for High Growth companies: As new products water-down company specialization, average costs will go up. Further, the redundancy of having specialists working on various products isn’t cost effective and is particularly expensive with a continually changing product mix.

    In my experience a changing product mix in the computer/electronics industry is a way of life. I used to wonder how American manufacturing managers would fare with a manufacturing schedule that was firm and consistent. I got at least part of an answer shortly after a company I was working for merged with a large Japanese computer company.

    We were accustomed to weekly, even daily meetings to redo the manufacturing schedule, and it was a constant struggle to get salespeople to at least stick to the schedule for the month. After the merger, new manufacturing rules forced us to commit to and to purchase to a schedule that was absolutely fixed for at least six months out. After that, we were only allowed a minimal flexibility of a 5% change for months seven through nine. It didn’t matter, even as partners, that we couldn’t sustain the sales rate. Every Friday, those systems landed on the dock like clockwork, and most of them just went into our warehouse.

    I’ve never had the luxury of giving this kind of commitment to manufacturing managers working for me in other companies. If I had, they would have thought they’d died and gone to heaven. However, in the normal world product mix should, to some extent, be sensitive to what the company can sell.

    If a company is experiencing any kind of growth, the product mix is changing, so it becomes vital that a manager be able to gauge the costs and resources needed for a given mix. One company I worked with was very aggressive in the electronic components and systems markets. After several acquisitions went sour, we began to look for what those failures had in common.

    What we had done was give the previous owner several million dollars and then move him aside. Then we put in one of our rising management stars with our big-company management style. Not only did we end up losing the previous owner’s drive and enthusiasm, we also ended up losing his know-how and experience with that particular mix and set of resources.

    One such gentleman in particular really understood that to win the war you must sometimes give up a battle or two, and he had a real knack for knowing when to stop chasing an opportunity and walk away. He knew what products were best to take. In a way no accounting system could duplicate, he knew when to compromise the margins, and most importantly, when not to compromise the margins. If his instinct told him it wouldn’t be the best thing for the company, he was also quite capable of saying “no” to an aggressive sales staff, even on those rare occasions when they actually made some sense. In contrast, our accounting system was not particularly sensitive to changes in product mix.

    Companies that don’t understand product mix sometimes take jobs with lower margins, believing that existing customers (the backlog) already cover fixed costs. They reason that the incremental costs of the added business will be comfortably covered by the lower margin with room to spare for profit. However, this does not plan for the possibility that the existing customers, with their higher margins, may not be customers forever. In this case, the added work, even with its higher revenue, often can’t cover all the costs in place. Management may have considered this a calculated risk but many times they forget that the good times end, leaving potential disaster in its wake.

    A similar situation arises when one customer provides a significant percentage of the business, and the company doesn’t plan for the possibility that it might lose that business. Limiting customers to 25% of the business is not the answer. Some companies using this rule try to reduce the amount of business they get from that customer, rather than increasing business from other customers. It makes more sense to treat the situation like a honeymoon-enjoy it while you can, and plan ahead for the days after it ends.

    One $3-to-$5 million OEM manufacturer with great technical expertise wanted to do end-user sales in the worst way. Because of its impressive technical expertise, it was able to convince one giant company to place substantial orders for three new products. Instantly, the manufacturer was looking at more than $20 million a year in OEM sales.

    Needless-to-say, the manufacturer jumped at this once-in-a-lifetime opportunity, and with great cooperation between the two companies, the manufacturer geared up very rapidly to meet the new demand. All this required heavy involvement from the manufacturer’s president, but otherwise added little to support costs. The pricing was fair, and the margins were better than from any other order. The terms were so good that the order absorbed a lot of overhead and made the manufacturer more competitive with its other products as well. Unfortunately, the owner chose to spend all these newfound resources developing an end-user side to the business. With a new $500,000 advertising budget, several new vice presidents, and all kinds of additional costs in place, disaster struck-all large company orders were canceled.

    Even with reasonable termination costs, the company’s resources were soon depleted trying to sustain the end-user business. To make matters worse, that side of the business never really did take off, and supporting costs were much higher than on the OEM side (See Table 3). Too late, the owner tried to restructure back into a $3 million OEM business, but he couldn’t pull it off and went into bankruptcy. If you are not careful with your increased expenditures, if (or when) the project ends, the Supporting Costs put in place in the flush years will run your company dry.

Table 3: The Impact of Losing a Large Customer
  

    In another case, a printed circuit board manufacturer got one-third of its business from a single customer. This customer was able to manufacture the same product, but used the company to cover peak needs by purchasing only the inner layers of a multi-layer board from them. Sales to the customer had been stable over a couple of years and were covered by a well-defined contract that provided for better margins than the base business.

    There were a number of distinct advantages to building this product. Manufacturing and quality control had fewer problems because the yields were so high.The firm schedule allowed Manufacturing to optimize the yield and reduce scrap. There were no depreciation expenses because the customer provided and installed state-of-the-art equipment in the company’s shop and related expenses were included in the contract rate. Support costs, especially indirect labor, were virtually non-existent. Manufacturing’s material and production controls didn’t vary from week to week, so one clerk could manage them. Sales needed very little customer contact. Engineering’s major tasks ended with the initial release to manufacturing. Finance needed to produce one invoice per week to bill one third of the revenue.

    The party ended when someone else bought the manufacturer. One zealous purchasing agent saw a chance for glory when he noticed that the contract could be canceled if the supplier changed owners. After reassessing the situation, the customer decided it could save money by bringing the job back in-house. While disappointed, the new management was enthusiastic and believed the market was strong enough to pick up the lost business in a relatively short period of time.

    The company did well in finding and filling in the lost business, but the real problem was that its entire cost structure had been disrupted. The special product had cost very little in overhead and G&A, but in the pricing formula the product still carried one third of the company’s costs in these areas. Now, with one third fewer sales, the remaining sales had to carry nearly 150% of its former overhead and G&A burden. Rather than reducing costs, management attempted to increase sales quickly, but profit and cash continued to decline.

    Why?

    Sales and Accounting both needed additional staff to boost sales and to keep the billings timely. Also the less efficient products had higher direct labor costs. Engineering ended up paying heavy overtime to get several new products on line in a hurry. Scrap levels increased, and more quality control people were needed. Finally, the company had to add capital equipment because the additional production used more of the mainstream process equipment. Finally, the new rate structure killed the competitive pricing in a situation where the pricing had been under pressure all along. Ultimately, mounting losses and negative cash flow forced the new owners to virtually give the company away to get out from under the debt obligation.

    Better due diligence might have revealed that the company could lose the contract, but often due diligence doesn’t deal with the subtleties of product mix. Perhaps because management didn’t totally understand the phenomenon to begin with.

    It is essential that a company isolate the requirements and rewards of a major company program, not only to prepare for the time when the program will end but also to avoid contaminating the base product line. Normally such a product should be physically separate from other products. Keep all direct costs and resource requirements flexible and avoid committing to fixed costs, such as a long-range building lease, in support of the product. These actions will help minimize the impact of losing such a customer and avoid masking the true cost of the company’s other products. Management must also use the rewards that customer generates carefully and not fund other programs sloppily or on a whim. (See Table 4.)

Table 4: Matching Cost Structure to Product Mix
  

    Many companies get in trouble by making only short-term plans and assuming that market conditions won’t change over the long-term. Product lines run out of gas and companies that don’t plan ahead will eventually get stuck. Even when the problem is obvious, sometimes management just doesn’t want to face it.

    However, a management sensitive and mature enough to look ahead will often have the time to take the actions and make the adjustments necessary to continue with a different product line. It’s difficult to look for catastrophe in the midst of success, but all good things are finite, and a company must plan for that contingency or face the consequences.

    One company was able to command a 65% margin and built sales to $10 million over several years. When the market for its product started shrinking, it recognized the problem early on, and began to lower margins to continue growing. It introduced new products at a rate designed to maintain the sales level. Unfortunately, its new products had trouble commanding a 40% margin, much less a 65% margin.

    In response the company began to do some sound long-range planning. It developed proforma financial forecasts, and although the arithmetic was hard to swallow, the conclusions were very clear. Over the short term, $10 million in sales with a 65% margin provided $6.5 million to cover overhead, G&A and a before-tax profit of $1 million. Over the long term, however, the profile was very different. $10 million in sales at a projected 40% margin only left $4.0 million to cover support costs and profit. Even giving up the profit, no change in the cost base would still leave it with losses of $1.5 million if no action were taken.

    To put this in perspective, total payroll, including fringes, was about $3 million, and since payroll is generally the most significant expense, most of the $1.5 million reduction (the minimum required just to break-even) had to come in staffing cuts. Overall, to provide $1 million in profit, would require reducing support costs by $2.5 million out of the $5.5 million they originally had to work with.

    That level of changes obviously required thorough restructuring, and the company’s management rose to the situation by moving more into distribution rather than basic manufacturing. By holding on to some of the high-margin product, it was able to keep margins above the 40% rate for a while, which bought time to make the necessary changes. It was only because the company’s good leaders were alert to the situation that they were able to make the transition in time. (See Table 5.)

Table 5: Business Direction Change
  

    Resources spent on unrelated activities are wasted, even if those activities are profitable. One group leader in a large company had a very small but profitable division (approximately 2% of his business) with a product line completely foreign to his main group products. I tried to explain to him that any energy spent on marketing and managing that division would be better spent on the main product lines, which were under heavy competitive pressure. He rationalized that so long as the division produced profit, he should leave it alone.

    In fact it was diluting his resources. Selling the division at a fair price would have produced eight to 10 years’ worth of instant profit, which could then have been used to help the main product lines. However, that didn’t matter to this group leader, because he was unwilling to give up his conversation piece.

    While it’s important for the champions in a company to make new things happen, too many champions can take needed focus off the real moneymakers. Sometimes in their excitement the champions forget where they’re getting the cash to support their new projects. If management makes the new things too high a priority, everyone will turn their backs on the golden goose, which then dies from neglect.

    The big companies’ ability to tolerate losing product lines has always been disconcerting to me. Even when the product was losing money, politics could still prevented a change. For example, one company I was in tolerated a foreign operation with mounting losses for far too long because at a recent shareholders’ meeting the corporate office had bragged about our entry into the foreign electronics market. In another company, upper management refused to discontinue a large division with constant losses because the loss in corporate fees would have required them to downsize at the group headquarters.

    Profit and Loss (P&L) reports for individual product lines are a must. Without them management can make bad decisions and miss good opportunities. The product line P&L attempts to define the net contribution of a product line by comparing the direct and support costs to the sales dollars. A product may have a very high gross margin, but by the time all the other costs are added in, it may not yield as much profit as other products.

    A company with $5 million in annual sales established a policy that all new products had to have a gross margin of 50%. The mainstream product was operating at a gross margin of 52%, which met the requirement and justified its existence. This major development product was budgeted to cost $500,000 for the year, with an additional $150,000 set aside to promote potential new products. From a product line P&L perspective, any new product would lose $650,000 that year, but the company did not break down the numbers in any other way. The rest of the engineering budget for the year totaled $350,000, or 7% of sales.

    A unique opportunity arose to introduce a new product in a short time, with very little engineering support. Since the product was to be purchased from another company, margins would be tight, and start at 45% tops. The product planning committee rejected the deal on the first pass, but the controller forced a product line analysis that clearly indicated the new product would yield a higher profit contribution than the mainstream product. Because it was a completed design, it would not require engineering support in addition to that needed to sustain the existing product line.

    Simply subtracting the 7% of the engineering budget spent on the mainstream product from their 52% margin, the contribution from the mainstream looked very similar to that from the new product. From then on, the other costs of manufacturing, administration, etc., were higher on a proportional basis for the existing product than for the new product. The net result was that the new product would produce a higher percentage profit at the bottom line than the existing products, even though the existing products seemed to have a higher gross margin. (See Table 6.)

Table 6: Product Line Profit and Loss (P&L)
  

    In operating a job shop or a professional service company, it’s important to think of the backlog of orders as filling up existing buckets or needs. Essentially, you are selling hours, and since there are so many hours already in place, you must cover them as soon as you can. First concentrate on filling up this month’s bucket then put effort on covering the next month’s buckets one by one. The trick is to get the buckets filled as far out as possible.

    Once the hours in place are covered, and assuming they are sold at a price sufficient to cover the fixed costs and provide profit, then as a manager your next task is to get more effective hours in your buckets to take full advantage of the margin contribution. In a job shop, once the fixed costs for the period have been covered, working people overtime, even at additional cost, is a small price to pay for the significant extra output and the incremental margin added with no penalty.

    Even for a professional service, mix is important. It is not enough to sell the equivalent in total hours. If, for example, more hours of junior personnel (as opposed to senior personnel) are sold than before, the support costs in place may not be covered by the lower-priced hours. (See Table 7.)

Table 7: Product Mix -- Consulting, Inc.
   

  
  
My bottom-line?

    Profit does not come from paper and pencil exercises but is very dependent on the mix and timing of all the products sold. The subtle concept of product mix and its effects on your business can make or break YOUR bottom line!

FORECASTING OR DREAMING

    Fred Founder had never seen a sales forecast before Mary Marketing came on the scene. His forecasting was done in his head and included only his probability of getting a reorder from his present customer base and what he had to do to get it. Fred had a very conservative and successful approach to risks. He would not order material until he had a firm, documented commitment from a customer. He had found this to be important when he had gotten his first loan from a bank. Since he had a relatively new company and little track record, the banks were cautious about lending him money.

    One of the important issues related to the loan was the amount of backlog. What was his backlog of orders that had to be filled? Since he was a 100 percent owner and had no outside investors or debtors, he let the accounting be loose at times. He knew he could always catch up and straighten things out at year-end when he gave all the records to his accounting firm.

    He had to clean up his act for the bank because they wanted accurate records to base the loan on. This included his balance sheet and P & L statement, monthly reports on accounts receivable (A/R) and accounts payable (A/P). The bank wanted to see how much money he owed to vendors (A/P) and how much he might collect from customers (A/R).

    In other words, was he debt worthy?

    It wasn’t enough just to provide total dollars; the aging became important. When were the collections and payments due? The bank put the final touches on the task by asking for a cash flow projection. Fred had not done anything like this before. His cash management strategy was collecting more than he had to pay out.

    Fred learned that the banks were not about to lend him money unless he could prove to them that he could pay it back. And, most banks want more than one source of revenue from which to pay it back. That is why, even with a great positive cash flow projection, they also wanted Fred’s personal guarantee, pledging his home and first-born child.

    Coupled with all the financial records, including cash flow, Fred still had to convince the bank the risk was low. This is why he had to provide revenue and new order forecasts, supported by the backlog and other sales and marketing rhetoric. Verbal commitments were out. The backlog had to be for firm commitments. To be entered into the backlog a sales order required a customer purchase order number and a delivery schedule. Firm orders now eliminated letters of intent where the customer had made an agreement to purchase product over time. Even orders with a bonafide purchase order number but with no scheduled dates were passé.

    Mary got the forecasting started by forecasting new orders by month, by units, by customer and by dollars. It soon became apparent that for planning the business, shipping dates were far more important than the dates that orders were received. The backlog delivery dates were very important. They were over-layered to give Manufacturing, Accounting, Sales and Marketing the revenue forecasts they needed.

    For a period, there were credibility problems stemming from the fact that everyone who provided input to the forecast had a different feeling and definition of probability. For instance:

    One sales person giving a 70% probability meant a 70% chance to get it all.

    Another sales person with a 70% probability meant a 100% chance to get 70% of the business from the customer.

    There were also the dreamers predicting 100% probability because of their gut feel.

    100% isn’t possible until the order is booked and has a P.O. number and schedule. Eventually, Fred and Mary agreed to a consistent measure for probability that ran from 10% for suspects (someone who might have an interest) to 90%, based on having some of the following:

    Fred and Mary assigned probability numbers to each level. Even as it worked its way up the ladder, Fred learned and Mary conceded, “The longer something takes to happen, the less chance it has of happening.”

    Because of this, Mary initiated a Report of Outstanding Proposals. It listed all proposals in the works, and included pertinent information such as customer products and dollars. Most importantly, however, it had a column for the latest probability and the number of weeks since the proposal had been submitted. This report gave Fred very good view of what was going on and, after he determined some calibration based on the customers and aging, it became even more useful.

    Fred learned quickly that with the lending institutions, it isn’t likely you will get what you hear. For instance, in searching for the loan, everyone started with “you can borrow 80% of your accounts receivable.” For a small growing company it is great to have 80% of the cash available the day you invoice the customer.

    Unfortunately, in the early days, Fred had a European distributor, sold to NASA, and had two large customers who dominated his customer profile. The banks voided foreign sales and sales to the government, and limited what he could borrow against customers beyond 25% of his accounts receivable. The bank also made any receivable over 90 days ineligible for the borrowing back. At best he was able to borrow 60% of all the receivables.

    Based on his experience with the bank, Fred realized he had to take risks on sale’s forecasts to attain the growth he wanted. To be competitive with delivery times, Fred was forced to buy inventory on the come, before the purchase order was received. If a purchase order says six weeks, but the material delivery takes 10, he had a problem. The company also needed to change the mix of customers and to be more careful to qualify them in terms of credit. From an accounting viewpoint they had to enforce the payment terms and conditions.

    Thanks to Mary Marketing and Al Accounting, Fred was able to grow by using good sales forecasts and good cash management. Most importantly, the forecasting gave him a degree of comfort in living with the personal guarantee and having his house and family at risk on a daily basis. One thing is for sure, with all that is at stake, be it pressure from internal planning, your bank or shareholders, once the forecast has been made it is necessary to perform to it.

MARKETING REPORTS

    There are several reports and forecasts (metrics) that a marketing department can turn out that will benefit the company in terms of visibility, assessing check points and influencing or initiating an action. Of course any report must be responsive to the type of business and information needed by management. The following wish list can be tailored to fit your business profile:

    The planning force that drives the company starts with the report on the Bookings (new orders) in dollars. Once the bookings have been established, management can evolve planning for product, inventory, operations expenses, manpower, resources, profit and cash flow.

    Since the Bookings forecast only describes the potential revenue, it is important to know how it will be spread out in time and turned into shipment dates. This is where the Revenue Forecast comes in.

    Product mix can be very significant in structuring the overall costs. Dollars alone won’t give the necessary detail. In a product company it is necessary to forecast units, and in a service company, hours.

    It’s only natural to follow the forecast with reports on the actual performance as compared to the forecasts. This measure of performance is needed to determine whether to go forward with the plan or to make adjustments. Graphs are quite useful- actual and forecast results can be shown on the same graphs.

    This is even a more impressive graphical measure of performance of a company’s visibility. A graph of the ratio of bookings, divided by revenue on a monthly basis, will indicate if the company is growing (when greater than one) or going down (when less than one).

    Industries such as the semiconductor industry do this on a per market basis. It even helps economists in the prediction of the national economic health.

    This is a measure of a company’s health. It is a record of orders on hand that have yet to be delivered. Of course, a big backlog gives management comfort. However, once again timing (the backlog aging) is important. Large backlogs with deliveries way out in the future are not as comforting as smaller backlogs with near-term delivery requirements.

    Because an order put into backlog can be distorted by including promises to buy or even written Letters of Intent, it is important to define what qualifies as an order. An agreement to buy a quantity of units or number of hours over a period of time can vanish long before the period is over. Certainly verbal orders should never be considered backlog. An order should be defined as an order from a customer with a bonafide purchase order number and a scheduled delivery date.

    While new activities help keep the perpetual business machine busy in-house, it helps even more to know how long a proposal has been outstanding (submitted to management or a client) and how much credibility to give it. Confucius says, “The longer something takes to happen, the less chance of it happening.” This report should include proposed sales dollars, a measurement of the degree of probability, as well as aging-time to product completion and revenue.

    Reports related to customers and performance can be generated by the finance department. These include:

    And, of course, there are reports beneficial to marketing:

    This can be a measure of the investment in the promotion of a program. It will compare the number of leads related to the dollars involved in advertising, trade shows, direct mail or whatever promotion vehicle is being used.

    Individual performance measures are needed, including:

    This comparison of the actual sales and visits to the customer allows management to see how well the sales staff is performing and helps to eliminate unproductive or bogus customer visits.

    Of course these checks and progress reports can drive Sales/Marketing management crazy. Whenever sales personnel resent providing reports, they say, “Do you want reports or sales dollars?”

    The answer is easy, “Both!”

    Keep in mind marketing drives the company and the more feedback and information available the less risk involved in going ahead with the plan.

WHAT THEN IS MARKETING ALL ABOUT?

    When a dynamic company president wants to step on the throttle and accelerate growth or bring about change, the major hindrance is often the gap between him and the staff. The biggest obstacle to overcome is inertia. A president who is keyed up to change direction leads the charge with his very personal call for self-improvement. Getting the staff to grasp the new vision is difficult, but getting them to change the way they do things for the new culture is even more difficult. In response to your plea for ideas, you may get nothing more than exasperating blanks stares, puzzled looks or furrowed brows that indicate they believ