Profit engineering is all about managing risk both on the upside and the downside and discovering your target profit goals via cost volume profit analysis.
Although a manufacturing company will face welcome challenges when its sales volume increases significantly, it is usually more difficult to survive periods where major volume losses occur. Both challenges will eventually happen if a business has been operating for several years.
During the good times, owners/management in a growing manufacturing company will seize opportunities to expand a facility, upgrade or replace manufacturing equipment, or open new facilities in other regions targeting revenue growth. These changes will also increase sales volume, general & administrative expense support, and facilities to invest in this future growth. Their decisions in these good times can have a major bearing on profit planning decisions they must make during significant sales downturns or, for example, if their best-laid plans for revenue growth in a new region do not reach their full profit potential.
Making the right managerial accounting decisions during growth periods is a balancing act. Management never wants to come up short on revenue growth potential by not being aggressive enough with cost volume profit and infrastructure investment decisions. Management in financial accounting should also look at ways to go above cost volume profit and invest sensibly. In doing so, they can capitalize on revenue potential and survive inevitable times when there is a revenue shortfall from overly optimistic growth plans or severe economic downturns. The goal for a company should always be to remain above profit point during the good times and the not-so-good times.
Profit Engineering for Growth
The first step is to hold a brainstorming session with your subject matter experts around the unit variable cost and sales growth opportunities and then decide what seems to be the best opportunities for gross margin profit.
The second step is to develop lists by investment area of what would be needed to implement the plan. Develop revenue and volume by individual product sales mix over a 10-year period. Make the same for direct costs, indirect costs, SG&A, and capital investments. This plan needs to be driven down to Net Operating Profit – – both EBIT and EBITDA (Earnings Before Interest and Tax with the DA excluding Depreciation and Amortization).
Developing these figures over a 10-year period + base year will allow for NPV (Net Present Value) of EBITDA and cash flow after tax to determine if the plan supports the investment in time and money.
A discount rate (%) based on your borrowing interest rate and a reasonable expected return on investment (% adder) is needed in an NPV calculation. You can obtain the borrowing interest rate(s) from your preferred lender. Rates may vary based on the level of risk. Smaller investments compared to your current cash flow vs. more significant investments will result in different borrowing rates.
The third step is to put your cost behavior information into a financial model to determine profitability and cash flow to determine if the plans are financially viable. There are various profit equation models in Microsoft Excel available on the internet for purchase or free to assist you in creating these models. They do require someone with financial acumen and moderate spreadsheet and analysis skills.
Below you can download a basic free Capital Investment Model from the Corporate Finance Institute. https://corporatefinanceinstitute.com/resources/templates/excel-modeling/capital-investment-model-template/
A trained accountant or financial person can build more elaborate contribution margin models. The general practice recommends this method for any complex project with many variables.
NPV of Cash Flows at different possible rates (%) of return along with Internal Rate of Return (%), Payback of the investment in years, and break even on cash flow are essential to be reviewed for the final go or no-go decisions. The breakeven profit point is determined when the cumulative cash flow turns positive over time.
After building the financial model, you need to pressure test the assumptions on selling price, volumes, unit costs, and the assumed capital investment. You can determine varying sensitivities on any of these variables and sub-variables that make up these categories by holding all other variables constant and changing one variable, sub-variable high or low. Further, the company may capture results in a separate worksheet for each sensitivity scenario. Discussions should be held with your internal management accounting experts to determine the possible highs and lows that could occur with the different fixed expense variables.
It is critical to fully understand how low the lows can get for pricing, revenue, and volume as well as how high the highs can get from a pricing, income, volume, expense, and capital investment total cost. Always lean towards being slightly conservative vs. overly aggressive when making the final analysis and investment decision.
If you do have access to a trained accountant or financial professional and if they know how to do a Monte Carlo Simulation (multiple probability simulation), this will aid in quickly identifying cost behavior and understanding where the strengths and weaknesses are in your project by analyzing the contribution margin variables through computer modeling.
For those unfamiliar with this mathematical simulation, you can read about it, its use, and how it works in the following link.
In summary, it was developed by two scientists who worked on the Manhattan Project, which developed the first atomic bombs, and the simulation was named after the Monte Carlo gambling destination since, like gambling, this simulation is “used to predict the probability of a variety of outcomes when the potential for random variables is present . . . it helps to explain the impact of risk and uncertainty in prediction and forecasting models.”
https://www.investopedia.com/terms/m/montecarlosimulation.asp
Alternatives to Large Capital Investments
Some companies “bet the bank” and are very successful when their timing is right and their assumptions are rock solid. However, more often than not, the companies that are highly successful at betting the bank (or their company) are in the minority. Alternatives to high-risk / high-reward approaches are first to review your current resources and options to determine if they are being fully utilized. Then, determine how well you can leverage them to meet revenue growth. Some examples follow.
What is your current capacity utilization?
- How many shifts do you run at your plant? If you only run one shift a day, five days a week with some limited overtime, then you are using your facility at around 30% of its potential, which is known as capacity utilization. You have capital invested in the facility, and 30% utilization gives you a poor rate of return on the investment. Your operating income is not optimal. Think of it this way; you could have a facility 1/3 the size at much less investment cost to manufacture and sell the same amount of products. Although this scenario does not give you room to grow, you would increase profitability by leveraging your manufacturing and SG&A fixed costs.
- Alternatively, staffing up and running up to 24 hours / 7 days per week can add about 70% more in manufactured products which equals higher sales dollars. If you have viable growth plans, you can use overtime to meet interim sales demand and then add shifts one at a time when you see that this new demand is permanent.
- Later in the process, add overhead as needed to support the growth. Leveraging overhead increase profitability to the bottom line. Overhead Absorption is one calculation to keep overhead in balance (overhead costs divided by the cost of goods sold). Try to keep this % from growing too much over time. It is actually best for profitability to drive the percentage down.
Upgrade Existing Facilities and Equipment
- If you are behind the times with manufacturing technology used in your industry, a good alternative to a facility’s expansion is investing in new technology that will allow you to manufacture more with less. Updating technology is also beneficial for employees since it will enable them to upgrade their skills. If all goes well, you can bring new employees into your workforce.
- Measure the reasonable potential output, investment, and training cost with a similar investment in a facility expansion or a greenfield plant. As your sales volume grows, these investments can be planned and made over time, so you have money coming in sooner rather than later with the alternative investments.
Consider Outsourcing Non-Essential Functions
- Historically, many businesses have started up and viewed all aspects of their manufacturing process as proprietary. This concept also prevented other companies from gaining knowledge about the company’s processes and inviting competition. However, there are always less value-added processes in a manufacturing company that can be outsourced without the risk of inviting new competition.
- If a manufacturing company’s products require accessory equipment used in conjunction with their product, and if the company can easily acquire these accessories in the marketplace, why detract from your core business by manufacturing them? This extra production is a variable cost you should consider cutting. If a company believes it needs control of these accessories, it can manufacture them as a private label by a competent third party. Another approach would be to act as a distributor for these accessories for a trusted supplier. These situations allow control of core technology so as not to invite competitors into your space.
- Companies can push other non-critical and preliminary manufacturing steps back to suppliers of raw materials needed in your downstream production. This strategy could eliminate equipment and allow labor to be used in other locations in the plant. Always be sure that more than one supplier can easily perform these steps so you are not giving away too much of your core competencies.
- If you are in equipment manufacturing, you can also outsource some minor non-essential parts manufacturing.
- CAUTION: as with any outsourcing, good QC and inspection practices are critical to your product’s quality. If the volume is significant enough, then outsource with more than one supplier in case a supplier has delivery issues.
Lease Space Instead of Acquiring Buildings at Other Locations
- Leasing space for expansion in light manufacturing can be an attractive alternative to a greenfield investment or expansion. If you experience a downturn and have favorable lease terms, you may shut down or mothball the leased facility to reduce your fixed cost expenses more easily than an outright owned facility.
- The same would be true for warehouse space that houses excess but sellable inventory.
- Look at better ways to manage your production scheduling to avoid these inventory builds. If the inventory build is not part of a seasonal sales revenue drive, consider the unit cost minus the warehousing and see if it is as profitable as you once thought.
Alternatives to Building a New Facility to Service Expansion into Other Regions
- If you can get more production out of your existing facility using the methods described above, you can take a long-term approach to expand into new regions. Leasing warehousing in a low-cost and safe area in the new region will dramatically reduce total fixed cost investment. The warehouse can also house new sales and tech service staff hired or transferred to develop the market in that target region.
- Businesses can develop a low-cost margin investment plan over time to allow for incoming cash flow early in the project, establish a good market presence, build sales revenue and then make a timely decision to expand into that region with manufacturing capabilities. The latter can be planned over time and extended if you utilize a leased facility with options to expand the manufacturing footprint.
Examples of where you may need to invest in greenfield manufacturing even if you have excess capacity at another location:
- Your customer requires production to be in a certain geographic region where they manufacture or sell to keep costs down. Examples are selling to big box retailers like Lowes or Home Depot.
- Another example would be selling road marking materials (paint) to states where they demand that the material is manufactured in their state to employ the local population. Some businesses like mining have to locate their operations and processing facilities in the location where they mine the raw materials. Not seizing opportunities to build a greenfield facility may open the door to doing the same, and they may grow faster than you.
Profit Engineering During a Revenue Downturn
First, don’t panic! Remember, just like when you planned for growth and new investment, you need to do the same when a revenue downturn occurs. However, you need to develop a well-grounded profit equation sooner rather than later. Do a complete CVP analysis and a cost behavior analysis to discover where you can make changes.
Suppose you did take the conservative approach during revenue increases by increasing capacity utilization with existing facilities and resources. In that case, it is much more cost-effective to reduce costs by rolling back the direct labor shift additions you made to increase manufacturing capacity. The same would be true for the additions to overhead. Compare the cost of these actions to having a 100% owned facility and idling the related equipment.
What is Driving the Downturn & Estimate How Long will it Last & Potential Actions?
Economic Recession or Depression / up to 2 years +
- Reduce your fixed cost structure in the plant and office to weather the storm. Use it as an opportunity to move or let go of underperforming employees. You need all your people to perform at a high level during these times. These actions will also give them a sense of urgency, just like you will.
- You can also consider reducing work hours across the board if you are concerned about laying off people who may not be available for hire once times are better. In most cases, people can file for unemployment for the days they do not come to work.
- As mentioned earlier, outsourcing more aspects of the business. Keep manufacturing your core competency production in-house.
- If you have flexible manufacturing and marketing, you may be able to produce a wider range of products for sale and move into other markets with stronger demand.
- Mothball lower-performing facilities and consolidate production into fewer locations.
- Use this slow period to plan for the future when the market will rebound. Keep your people busy doing value-added work that they always seem to need more time to get done during busy periods. Be prudent in managing costs on these projects as well.
Severe Supply Disruptions / Temporary
- Look for alternative sources or substitutions that will still allow you to manufacture quality products at a lower profit point.
- As mentioned above, reduce your costs both in manufacturing and the office.
- Ride it out. Other competitors are likely facing the same challenges.
- If you have the cash, buy a competitor. The sales price could be attractive.
- Buy a supplier to control the supply side of a critical/limited resource.
- As mentioned above, have your people work on projects that do not require a lot of cash but are activities they never seem to have time to do during busier times.
Act of God Disaster (e.g., fire or earthquake) / Should be Temporary
- Look into private label manufacturing arrangements with other suppliers, DO NOT LET YOUR COMPETITORS gain access or knowledge about your customers!
- Although it will increase shipping costs, have the private label products shipped to an offsite warehouse and then sent from there to your customers.
- Include the Force Majeure clause in your contracts and ration your remaining supply to your customers.
- Note: There are strict legal guidelines governing this process.
- Get the plant back up and running, even if it is in stages.
- Follow through with very good communications to the industry publications and your customers. Communication will demonstrate that the situation is temporary and that you are doing everything possible to minimize disruptions during this limited time.
New or Existing Competitors Entering Your Region
& Competitor Aggressively Taking Market Share / Temporary or Permanent
- Take innovative sales & marketing actions to prevent sales loss
- Try to leverage your current customer relationships and offer innovative deals to entice them to stay with you.
- If a competitor takes key customers away based on selling price, use the same tactic to go after some of their key customers. Quick action like this sends the competitor a strong message that their actions are not tolerated and may avoid an all-out price war.
- If the competitor is based outside of the US and has no US production, consider an Anti-Dumping case with USDOC and International Trade Administration.
- Note: this can be very effective in leveling the playing field on price, but it is an expensive + 1-year process.
- Introduce new products to compete head-on or beat the competitor’s performance.
- Buy a competitor to gain and leverage a superior supply chain, manufacturing, R&D, or pricing position.
- Invest in your operations to significantly reduce the cost to become competitive on price.
New Government Regulations / Could be Permanent or Temporary
- Depending upon the situation, find alternative markets for your manufacturing capabilities or downsize and weather the storm.
Substitution in the Marketplace or Product Obsolescence / Permanent
- Find alternative markets for your manufacturing capabilities or sell the business as soon as possible. Without a successful plan implementation, the businesses’ value will only decline.
Reasons Why the Original Investment Decisions Can Impact Profit Engineering when Experiencing a Loss of Revenue
By now, you may understand the negative outcome of not finding ways to economically leverage your current assets and resources when you need to expand manufacturing to meet growing sales demand. Developing a longer-term plan with triggers that meet key milestones can reduce the risk of going all-in with a bold bet on the company move. However, when you reach trigger points, review and adjust the plan if assumptions need updating for changing market and cost conditions. It allows you to spread the capital expenditures out over multiple years while still generating an increase in sales over the same period of time. However, when the company truly taps out on leveraging existing resources, an “all-in” approach may still be necessary, and you will need to invest in greenfield manufacturing to maintain a leadership position in your industry.
The key to lowering long-term risk is finding innovative ways to leverage current resources or assets as customer needs allow before investing in a greenfield expansion. Having to downsize and reduce costs during a sales downturn is more expensive when dealing with a relatively new greenfield expansion unless you decide to shut down the old facilities and operate your most advanced locations.
