Roger's equipment manufacturing for the building industry was growing, buy why were the profits squeezed?
Roger was a manufacturer of equipment for the building industry. His company’s line ranged from simple machines for low volume producers to complex, automated machines for high volume producers. The company was well established with national distribution and a great reputation for value.
As the business grew, profits were squeezed. Research and development on the more complex machines were costly; their manufacture required longer lead times and more parts. And because the larger machines commanded higher prices, the selling cycle was longer, further delaying recovery. Finally, Roger was faced with building more machine shops to manufacture the various parts.
I suggested that we do a “product profitability analysis” – one of the techniques in The Profit Process. Since the machine shop was the bottleneck, the question became “What does each hour in the machine shop contribute to the profitability of each product?” The answer was enlightening – an hour in the machine shop on the complex machines contributed $50 per hour to profit, while an hour spent on the simpler, low volume machines contributed $175 per hour! Roger and colleagues were focused on dollar volume instead of profit volume, a common mistake in business.
Predictably, the company’s sales and marketing efforts had been focused on the higher priced, complex machines, since each sale yielded four or five times the revenue from smaller machine sales. But the product profitability analysis prompted Roger to change the sales focus to selling lower priced machines. We also decided to limit production of the complex machines and raise their prices significantly. The switch freed up machine shop time to produce the equipment that contributed far more profit per sale.
Profits jumped substantially the next year. With the focus shift, the idea of expanding the machine shop was swept into the dustbin. All it took was refocusing on what produced profit, rather than sales. Further analysis prompted us to reduce the number of parts in all machines through redesign. Fewer parts meant fewer set-ups, resulting in a more efficient machine shop.
As a business grows, it is easy to get caught up in the competitive race to make the most sophisticated product and be the biggest. But the race can distract you from profitability. All businesses should periodically perform a “profitability analysis” – both on its products and on its customers. Over time the most profitable products and customers frequently end up subsidizing the unprofitable products and customers. Of course, the goal is to have all products and customers contribute to profitability.
Reprinted from the Sacramento Business Journal, March 22, 2002