Company Turnaround: when there is no margin

Sam could only say: "This is ridiculous".

Five seconds past and nobody in the call said nothing.

Just a shy cough from Emma, the controller, broke the uncomfortable silence.

"Well, at least we know".

The ask was to remake the numbers on their product costing.

But not to repeat them to check for any mistakes.

Remake them in a way, that we could really understand what was going on.

That is, for each product sold, separate in:

• Sales price (revenue).
• Variable costs without labour in it.

And then we asked to collect all operating expenses, including all the direct labour payroll.

Once done we played unit economics...

Sam was surprised because, the numbers were painting a different situation of what they've been following.

They were growing 25% from the previous year, yet, they needed still another 15% more sales to fill the gap on operating expenses.

We'll use that case to guide this edition.

Let's go!

HOW DO WE MAKE MONEY?

It is quite fundamental, but we need to understand how a company makes money.

And every-time I bring this up, I get weird looks.

But do the trial, ask in your company a random colleague and ask: "how is this company making money?".

You will be surprised on how complex answers, or plain wrong answers you will get.

Now, it is not a problem of those who you ask, is that we tend to overcomplicate this.

Plus one thing is know how and then be able to articulate the numbers behind.

But in essence:

We sell a product or a service, in exchange for money, assuming we will make a profit in return.

And here is when we like to make things complicated.

Because we start with direct and indirect labour, with cost classification, amortizations, etc....

Let's make it easier:

Profit = Revenue - Costs. (hey, remember to pay your taxes).

There is just one problem with that. "Cost" is one of those words that mean multiple things, and this causes all kind of problems.

For the sake of this article, and following the problem diagram of the first edition, we will ignore the cash flow topic in here.

Let's make it a little bit more specific:

Profit = Revenue - Variable Costs - Operating Expenses.

With some definitions:

• Profit: how much we are left for the business. Hopefully more than 0.
• Revenue: for how much we sell each one of our units.
• Variable Costs: all of those costs directly related with the production and sale of one of your units. Do not include labour here. We explained why in this article.

Here both revenue and Variable costs are a multiplier for each one of your units.

• Operating Expenses: all the other costs to run your business. Utilities, rent, salaries, etc... In general we can find them as "fixed" but is a term, that also leads to confusion.

As an example. We sell leather wallets.

Sales Price = $200.

Variable Costs = $100. We include here: material, transports, etc...

Operating Expenses = $20,000/month.

Now we can play unit economics.

We'll use words first.

"For each wallet we sell, we make $100". That is still not profit. That is Contribution Margin.

"That means that to cover our Operating Expenses we need to sell 200 wallets a month".

Simple, right?

Well, the thing is, we tend to overcomplicate that calculation.

And we do it maybe for good reasons, but we end up in a bunch of numbers that nobody understands.

We average things, we mix things, we try to be super detailed on the costs and classify them in multiple ways.

We want to sound smart maybe?

The end result is that the truth is hidden under those numbers.

In Sam's business that was the main problem.

When we went through the numbers in that way, we discovered that:

• Some products had less margin than expected.
• The units needed to cover expenses were higher than they expected.

But how this can happen?

Let's see.

NO CONTRIBUTION MARGIN

How this can even happen?

I mean, who would sell a product without making a profit?

Well, it does happen.

And in some places it even happens on purpose, as a way to attract customers, setting on their minds "this is a place where everything is the cheapest", and make a profit in other products.

Common in big consumer retailers. But they know what they are doing...

But it does happens for multiple reasons, without even realizing it.

In case of Sam's business, some of the products were not reviewed for months.

And as material prices changed significantly, products that a few months back were the cash-cows, they were now a black hole.

Also they had a system to quote the products (semi customised) and get the sale, but not a review process to understand if they were hitting their targets.

In other words: they said:

"We will sell for $1,000 , will cost us $800, so $200 to the pocket"

The reality was.

"We are selling for $975, is costing us $830, so $145 to the pocket"

That is a deviation of 2750 basis points from the original target.

Not a problem if you forecast that, but a problem if you were crunching numbers with the not updated figure...

In our experience, those are the main drivers of this problem:

• Not reviewing the targets: do we have the same variable costs as we quoted?
• Not updating costs: do we still buy for the same price we quoted? If costs are higher, either you need to make efficiencies or you need to raise your prices.
• Sales incentives: do we sell for what we need? You will be surprised in how many companies, the sales people do not really know the contribution margins and how much they can play with them. It also happens that purchasing does not communicate a pricing problem to sales. It does happen.
• Product changes: customized products face this all the time. What was sold and what is being delivered is not the same. More features, changes in materials or dimensions... All of that ends up eating your margins if not done properly.
• Missing costs: things like transports or ad spends, are in some cases, hidden in a myriad of numbers. Make the calculations as you operate. If for each unit to be sold, you need to spend $32, count on it. Putting it somewhere will not make life better, but much worse...

Another example of missing costs. Sometimes a strategy to sell more, is to sell more units, at discounted price.

It is all good, but the needs to manage a significant more volume, at times means increased Operating Expenses.

Managing 50% more orders, is not a problem only on production capacity, but also you need to handle the logistics, the claims, the quality controls, etc...

OPERATING EXPENSES TOO HIGH

Growing companies face this quite frequently.

They start spending like there is no tomorrow, for the sake of "growth", but in an uncontrolled way.

The end result is operating expenses that can't be sustained.

How do we know they are "too high"?. When our unit economics tell us that we are not selling enough to cover them. That simple.

If we had to sell 200 wallets and our data tells us we are hitting 150 a month, we are in trouble. Either we sell more or we need to start looking into cost cutting. Not nice, not fun but...what are the options?

Sam's business experienced a healthy growth, but they took some decisions that lead to excessive Operating Expenses.

A new office space they could not afford on the long run, IT equipment not used...

Yes, the growth was good, but not enough to pay for all of that.

The main calculation to do is:

How much of X, Y, Z we need to sell, to pay for all of our operating expenses.

From there two approaches, that they work in tandem:

1. What can we do to make sure we hit those numbers. This could be selling more units, selling for more price or both.
2. What can we do improve our operating expenses. Synergies, negotiating prices, long term agreements, eliminating things...

But whatever you do: make sure you run your numbers to understand those unit economics.

Now, some of you might say. Well, my business is more complicated than that.

I have multiple products, a product mix, etc...

And you are right.

But you need to run those numbers and see how it looks like.

How those product mix affect your overall margin and answer that question:

What is the minimum we need to do, to pay for our Operating Expenses.

That's it.

One remark on the Operating Expenses: they behave a little bit like that cabinet that you have somewhere full of things you do not even recall.

They pile up, specially in the modern world where everything is sold "as a service" and as "subscription".

Businesses evolve, and when you do evolve some of the things you were doing no longer apply. The same for expenses. Question and review them, you will find gold...

FINAL NOTES

If you made it all the way to the end, thanks for that.

You would also realise that I emphasised twice that you move your direct labour to Operating Expenses, and I linked a previous article.

There is a simple reason for that. Do you fire people every time you stop production or make a change over? Hopefully not, and hopefully you pay them.

Do you fire people every time you have less production than another day? Hopefully not.

So the reality is that those are Operating Expenses and not variable costs.

Think about them as Operating Expenses and you will not be surprised...

I do hope also that the article helps you unlock some of the hidden problems your company might go through, so you can fix them.

Still confused?

Still in pain and need some help?

Ping me, I am available for you.

Thanks for reading me!