They messed up and left... Part III

A fanciful story inspired by events observed in different companies in the contract manufacturing market and could happen again in the future in other companies in the same industry.

Connection to Parts 1 & 2

The family owned CDMO became PE owned. A 5-year BP is ready indicating quadrupled EBITDA at the end of the 5th year. As “the company does not have a production cost issue”, profitability improvement is expected to come exclusively from discontinuing “unprofitable business” and from Price increases and Recharges. Any new RFQ should be reviewed in terms of EBITDA. But how the targeted company’s EBITDA is translated into RFQ EBITDA? Opinions vary.

Chapter 5: The army of people increasing the overheads

The cost structure of this CDMO was not that different from the majority of companies with manufacturing operations in this world. There were direct costs, the costs that were related directly to the production of a product, the fixed (or indirect costs) that were specific to a manufacturing site and general overheads that were costs related to the corporate functions not linked to any product or any manufacturing site but were needed to support the manufacturing operations.

Direct costs mainly included cost of raw and packaging materials and labour costs of people in the production area. Normally these costs get higher the bigger the production gets, they were something like variable costs.

Fixed costs mainly included costs that the manufacturing sites would require in order to operate, regardless the number of products in the site. For example the head of the site and the rent for the site were included in those costs. If they were high or low compared to the market standards it’s another story. In any case this CDMO did not have a cost issue, its problem was the pricing policy.

General overheads included for example the cost of business development department, the cost of corporate finance, procurement, global quality and so on and so forth. These costs were then allocated to manufacturing sites according to their revenue, production volume etc… Therefore, a manufacturing site with low revenue or volume would absorb a lower part of general overheads compared to a higher revenue site. No matter how exactly they were allocated, all general overheads should at the end of the day be financed by the overall production of the CDMO. So total revenue coming from manufacturing activities, should be enough to cover apart from direct and fixed costs of the sites, also the overheads in order for the company to have a positive EBITDA. And this is how companies usually operate.

In order to prepare a company for sale in few years, you need to add some more glamour to it. You need to hire some consultants to make the business plan for you, you need to hire some well paid professionals in every corporate function that know the business, you need to have a very nice and big stand in exhibitions in order to impress the audience, you probably need to participate in more and more fairs and exhibitions and of course you need to increase the manpower of several departments such as business development and finance. And of course in order to meet more customers you need to travel more. Anyway, the business plan was clear to this. Part of the growth should come from expanding in new geographies so more people would be required to make this expansion happen.

And why not increasing your overheads a bit more by acquiring a contract manager, a communication expert, a sales operations department, a financial business partner for every corporate function and adding to these some more consultants on the way to make sure you did not forget something?

All these additional overheads would make the company better, it would make it work more professionally, they would help to get the most out of it and most importantly they would increase its value when the time was right to be sold. It’s different to try to sell a company with several financial business partners for every corporate function and different to try to sell the company without them.?Who would buy it without them?

But maybe it was forgotten that if you don’t increase your sales, your current production should be enough to cover apart from the existing overheads, all these new ones. And probably it was also forgotten that in order to bring new business in a CDMO you need more than one and a half years. But wait a minute; did anyone remember that this company was a CDMO?

Maybe not. Because if someone remembered that this company was a CDMO, it should be clear that if you increase your overheads in year one so much, you cannot expect to have a better EBITDA immediately, through new business. Because it takes time for the new business to enter the sites. And if you don’t want to decrease your direct and fixed costs, if you don’t want to improve the efficiency of your sites, if you don’t want to invest in some new equipment, the only way to increase your EBITDA is to increase your prices. And to remove of course the low profitability products. With one more detail. No matter how low the profitability of some products is, if you remove them from your portfolio, all remaining products should be able to cover all the costs that stay there.

So when some people in the middle management looking at the figures, were arguing that the profitability improvement initiative is offset by the negative impact of discontinuations in the long run, they were told politely to stop making these comments. They did not help anyone. The results of those actions (especially the discontinuation of products) would not be immediately visible in the actual figures of the sites. And this is because it takes time to discontinue a product in the CDMO world. Maybe years. And so, nobody from the top management was ready to listen to these details that would ruin their day and would not be visible in the short term. What it mattered was to convince the members of the board that we follow the Business Plan. So we continue the effort of increasing prices, we continue discontinuing low profitability products and we keep up the effort of bringing in new business. For the moment, “who will do what by when” to meet the Business Plan was enough to reassure the company that we are in a good track. And by the way, we also made the company more professional as the Business Plan was suggesting by increasing the overheads.

So an army of corporate people joined the company and they were ready to support the company to grow. The army was ready to support the manufacturing sites by giving reporting guidelines, by bringing in new business, by advising what should be included in the budget of the sites and by setting up new processes and harmonization practices.

With one detail… the sites should become independent and P&L responsible…

Chapter?6: Sites are P&L responsible

“Nothing is happening in the headquarters, the heart of our business is within the manufacturing sites and all other corporate departments are just support functions”. These were the words of the new CEO when he joined the company. And from a first glance he was right. If it wasn’t for the manufacturing sites, there would not be any business for the CDMO. And the manufacturing sites, should be responsible for their actions. So, the message of the CEO was right. But behind these words, laid an implication, which was new to the company. If the sites are the heart of the business and all other corporate departments are support functions, this should make the sites responsible for their fate. The message of the CEO gave to the sites the power to be responsible and accountable for their actions and their decisions. “The sites should become P&L responsible”, the CEO continued.

Even though from a first glance this message should not be something that would change a lot in the company, as a matter of fact it did. And it mainly, did because of the strict timelines that the CEO was given from the board. Everything should be done fast, in order to meet the business plan’s timelines. So, an initiative like this that should take several months to be implemented, now it had to be finalized in much shorter time.

Therefore from one day to another, the sites were responsible for their budget for example. If they did not achieve their targets, they should take whatever actions they considered appropriate in order to meet them. And nobody could force them to take specific actions as long as the budget figures made sense. So when a site had to increase its EBITDA, there were two ways to do it. Either to increase its revenue or to decrease its costs. And guess what all the sites chose. But of course the first solution which is the easy one. They argued during the budget process for 2019 that Business Development should increase prices not related to cost increases but to profitability increases. There were also sites that assumed that some of the offers made to customers pending approval, they would be awarded within the next months to the site and this would help them meeting their targets.

So what if Business Development who was responsible for the negotiation with the customer for new business, argued that it would not be prudent to include this new business in your budget because it is not certain that it will come. It did not matter. The sites could assume that both prices increases and new business introduction would take place. And then if this did not materialize, Business Development should be held responsible because it could not support the sites enough as it should do.

And the CFO was asking for people between sites and Business Development to align on what should be included in the budget. This was impossible because of different agendas. The sites were desperate to increase their budget figures while BD’s guidelines were to report new business only when there was an official customer approval.

Even the Head of Operations was not able to force the sites on what to include in their budget. There were only suggestions. “I suggest that you should do something to improve your efficiency. Maybe you should also consider decreasing your costs”. But nobody told to the sites “cut your costs and don’t include to the budget figures unrealistic assumptions”. But don’t forget that the business plan that was created by the non-industry expert consultants, was very aggressive and each year the EBIDTA of each manufacturing site should increase. So, the manufacturing sites, that were under pressure to meet the increased targets of profitability, did not have much of a choice but to say that we will meet them. And what would happen after one year, it was too far away to worry about.

Another area where this new approach had an effect was in the quotations. The sites could refuse to quote for a specific product either because it did not fit to their strategy or because it was difficult to produce. So business development department turned down customers’ requests for new business because one site in Germany did not want to produce bulk only products or another site in Belgium did not want to produce small volume products. “I can speak to them but I cannot guarantee that I can change their mind” the Head of Operations mentioned.

There were also cases where the sites should decide if they are able to produce specific products included in RFQs. For instance, if there was a quotation for a product with high toxicity levels it was debatable if this would be allowed to be produced in the site. Even though the sites did not have the expertise to decide, they did so according to their opinion. Global quality department could have a say on the matter but at the end of the day it was up to the sites to decide if they can produce it. Let alone the fact that global quality was not capable to decide on such a matter within few days. And because the quotation process had strict deadlines for people who had to evaluate the project, sites had to decide if they can or cannot do it within some days. And of course it would be their fault if they argued that they can do it but at the end of the day it appeared that they couldn’t.

So the sites took the power and everyone else around them should be there just to support them. Business Development should not challenge the costs or the investments asked by the sites for a specific new quotation and all figures provided should be taken as granted. And if the figures were wrong, this was a problem of the manufacturing site that provided them. If the investments related to a new RFQ were sky high, Business Development that should negotiate with the customer could not challenge them, they should just communicate them. And on the contrary, if the figures were unrealistically low, Business Development should not challenge them. They should just communicate the quotation to the customer and if at the end it proved that the figures were wrong it was the site, which should be held responsible. Of course if this happened and profitability was not at the expected levels, BD should ask the customer for price increases to restore profitability but this was another story. And this CDMO never covered all the distance of the journey to see if what it had been quoted was in fact right at the time of production. Because the time needed from the moment you quote until the moment you produce is quite long and it would become clear very soon that the CDMO would not have that much time left…

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Disclaimer: This is a fanciful story inspired by events observed in different companies in the contract manufacturing market and could happen again in the future in other companies in the same industry