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LTT Business Bulletin - October 2014

 

Ed Kreamer, Chair of LTT1, and former CEO of KraMar Pet Supplies

explains why sometimes you just need to “Shoot The Dogs”.

 

I was appointed CEO of our small family business back in 1990. The business manufactured and imported pet accessories (collars, brushes, toys, shampoos etc). It was a well run business, operating in a growing market segment. However, despite a steadily growing sales line the business did not make money.

Well we just needed to grow a little bit faster and we would then start making money…..so I thought !!

Well at the end of my first year as CEO the business looked something like this:

Sales                           $4.4m
EBIT                            $51k
Debt                            $800k
Gross Margin            28.5%
No. of Customers     700
No. of SKUs               5,500+

So with interest rates at an all time high (circa 18%) we had big problems, not to mention a very uncomfortable banker.

Now Einstein famously once said, ‘madness is doing the same thing over and over again and expecting different results’. It was clear for reasons I will explain later that we were never going to grow our way out of this and that a different approach was needed.

We knew that of the 5,500 products we sold some provided very high margins, some very low margins and some in between. There would be no prizes for guessing which ones we sold the most. We decided that if we stopped selling the low margin products and reduced our operating expenses in line with the resulting lower revenue, not only would we start making a profit, we would also free up cash to pay down debt, as lower sales would mean reduction in stock and debtors.

Now we knew we could not change overnight. It would need to be a rigorous process consistently applied over time. So we commenced executing our plan, slowly deleting the low margin products. As we did so we started to focus on the better margin products (of necessity more than anything else). To our surprise not only did we start making profits and reducing debt, our revenue line didn’t decline.

So here is where we ended up in 2005 when we sold the business:

…………………………. 1990          2005           CHANGE
Sales                       $4.4m      $23.1m          +425%   (12% Compound)
EBIT                        $51k         $2,800k         +5,390% (31% Compound)
Debt                        $800k         NIL              -100%
Gross Margin         28.5%        55.7%          +95.4% (27.2 points)
No. Customers       700             700                 Nil
No. SKUs                5,500         2,500              -54.5%

There are only four ways to improve the profit of a business. Put simply they are to sell more, charge more, reduce costs (cogs and operating) or increase margin (by changing the product and/or customer mix). Here is what we found about each of these drivers.

Sell More

As we discovered early on, selling more when the margin mix is wrong increases working capital and operating costs in an unsustainable way. It is imperative in any business and particularly those whose working capital to sales ratio is high, that profits and profit growth exceeds the growth in working capital requirement.

Equally as sales grow, so do costs. Variable costs by definition typically increase in line with sales. Fixed costs on the other hand tend to increase in ‘steps’. For example at one stage we reached a point where our warehouse was running at or near capacity.

This gave a great recovery rate for a period and this fell straight to the bottom line. That disappeared (and more) when we had to move into a larger facility where we were operating well under capacity.

Charge More

In our earlier days there was little difference between the products we sold and those of our competitors. Often it was the same product coming out of the same factories in Taiwan or China. To charge more you need to differentiate your product or service. Being first to market is also a great way to push price.

When you have been in an industry for a long time you can sometimes become your own worst enemy when it comes to setting prices. We become conditioned by what prices use to be, as opposed to what the current consumer would be prepared to pay. Your sales team can often be a road block when it comes to pushing prices.

Again this is particularly true if they have been in the business for a long time. I am sure at some point you have had one of your sales people say, “my customers won’t pay that”. Know the margin/price you need to achieve from each product/customer to reach your profit target and have the courage to ask and hold your price.

Reduce Costs

Most SMEs run lean so reducing operating costs is often hard to do. Whilst it is imperative to diligently control costs, remember that ‘you can’t cost cut your way to prosperity’.

In regards to the cost of goods and services you buy, if you are dealing with good suppliers then like you they are no doubt constantly reviewing the profitability of their products and customers. Whilst it is important to maintain ‘competitive tension’ they, like you, need to make a profit.

Change the Mix

This is where it all started to happen for us. Shooting the ‘dogs’ (products and customers) and replacing them with ‘rising stars’. Just like spring time in the garden, as we pruned back the unwanted ‘vegetation’, good things started to grow.

I gave up trying to teach my sales people about margin and just focused them on selling. We took control of what they sold and at what price. Yes, they were given tools with which they could negotiate but these were known, controlled and measured.

Most importantly we controlled the mix. If a product or customer did not meet the margin hurdle, it did not remain as part of the offering. By omission we were able to focus the sales team on what we wanted them to sell. It became the mantra of the business that ‘our success would be determined more by what we said No to than what we said Yes to’.

It was however imperative that we applied detailed, fact based decision making to the process. Decisions has to be made on data not emotion. We knew in detail the cost of doing business with each customer and the margin contribution of each product.

Dealing with retailers there was an abundance of below the line costs. By way of example the cost of doing business with a specific retail account would look something like this:

General Overheads                  20.5%
Selling Expense                           3.6%
Merchandising                             2.6%
Co-op Advertising                       2.5%
Over & Above Advertising         1.2%
Mark Downs Support                0.6%
Rebates                                         6.9%
Settlement Discount                  5.0%
Ullage                                           0.3%
Freight                                          3.1%
EBIT                                            10.0%

Margin Required                    56.3%

From this analysis we knew that if we wanted to achieve an EBIT return of 10% from this account we needed to achieve a starting GP of 56.3%.

Lastly, and most importantly this became an ongoing process not a one-off event. It required constant review of the costs of doing business with each customer or customer type and regular review of the product range.

To execute effectively it requires discipline, courage and belief in the process by everyone in the organisation. It is easy to act when the product or customer has withered and died. It takes courage to act early, in order to focus on and create new opportunities.

Ed Kreamer is the Chair of LTT1 in Sydney. You can read more about his background on his profile.

To contact Ed Kreamer:
Phone: 0408 868 380
Email: ed.kreamer@leadershipthinktank.com.au