I want to share a story about two companies that I worked with, one with $2 million dollar of revenue and the other with $600 million per year. Although they were vastly different in size, they both shared the same problem. I was able to help save one, although it shrunk to almost half its size. The other one liquidated after being in business for 30 years.
Both companies had increasing sales volume over the years. So what happened? It’s all about the product mix.
Company A, the smaller one, manufactured and distributed products, selling those products at a 50% gross margin for many years. Then they began selling to big box companies, which negotiated to a 20% gross margin. But with 80% of their business still at the 50% gross margin, the company was still profitable. Life was good for many years for the owners.
The big box customers then drove the margin down further, from 20% to 12%. Again, because of the increased volume, it remained profitable because 80% of their sales were at the higher margin.
However, gradually over a three-year period, their product mix changed to 80% at the lower gross margin for the big boxes, which left just 20% at the 50% margin. Management didn’t notice the affect that this change in the product mix was having, as management tended to focus on increasing sales and became dependent on increasing bank financing. Large sales volumes frequently cover up a deeper problem.
In year three, the company had a healthy loss, ie red ink, and the banks didn’t want to lend money to this entity. I was called in and identified the mix problem. We came up with a 2-3 year turnaround plan that was reviewed with the ownership. The owners decided not to invest the money it would take to turn around the company and decided to shut the doors.
When I went to Company B, it had been borrowing more and more money from the bank, because the bankers liked the company and considered it prestigious. The bankers should have asked questions sooner but in any event, I was called in when they realized the company was in trouble.
The management first denied they had any issues with the pricing of their bill of materials, the BOM, or their product mix. They had spent millions on computer systems and software to track it and felt confident that they knew their costs. Because the company was in a low margin industry, they had realized that keeping track of the BOM was critical to making a profit and had made the investment to do so.
What I was able to determine, however, is that there had been a lot of turnover in a key position when it came to ensuring that the numbers management were receiving were accurate. The new people coming in had not been property trained, and had not been giving those fancy computers the right information for the correct cost structure. As a result, the company had been selling based on the wrong cost structure for years.
After identifying the problem, we were able to get an accurate view of the cost structure and change the product mix. Because of the severe losses it had suffered, the company shrunk from a $600 million in annual revenue to a $350 million; the owners came up with millions in new equity and the company survived.
Both companies suffered from a failure to recognize what was happening with their product mix. While management saw increasing sales, what they didn’t deal with was that profitability was going down.
Next column: What could they have done differently?
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