A provider of highly engineered metal solutions operated a profitable business for over 20 years and wanted to take the company to the next level.
Annual revenue was over $10 million. Yet the gross margins had consistently decreased over the course of a few months, dropping from 38% to 31%.
A physical inventory was performed each month. The company was not only ISO certified, but had excellent processes in place and a proven team with an average tenure of over 12 years. The selling, general and administrative expenses were consistent throughout this period. The product mix sold also remained relatively steady.
The company had invested in major equipment in the past six months intending to optimize material, labor and efficiencies. Even with the training time and inefficiencies associated with the new equipment, the drain on the gross profit margin (GPM) eluded the client. Expectations were that the GPM should improve, not deteriorate.
This falling GPM was becoming a concern. The company believed the decrease was due to anomalies, such as inventory counts, the new equipment, valuation of the inventory, standard cost systems and a complex product mix. GPM loss was projected to be approximately $700,000, year over year. This alone generated an extrapolated loss of $700,000.
As a result, Lakelet Advisory Group (“LAG”) was engaged to:
- Identify the root cause(s);
- Correct the situation(s);
- Establish formal processes to prevent the situation from reoccurring in the future; and
- Develop benchmarks to optimize future opportunities.
The initial phase involved LAG benchmarking the company against itself. The detailed accounts and activities were compared to the past three years of activity to note discrepancies.
The next phase involved comparing the company to 23 other companies in the same industry and of the same size to determine the “average.” Although the industry average GPM was 34%, the client’s processes and equipment should have allowed them to generate 38% GPM or better.
This raised a question – why was the client’s GPM so much higher than their competitors in the first place?
The answer to this question was to come from the client’s customers. Under the disguise of a CI (Continuous Improvement) survey, LAG personally contacted the top 12 customers, as well as many others via an online survey tool. LAG found the following as to why our client generated a higher GPM:
- History – The average Customer was with the Company more than 10 years.
- Technology – The Company was not only replicating high-end engineering requirements, but also truly adding value via options for materials and design. With an average of 10+ years together, they knew their customers’ businesses.
- Delivery – The Company delivered on time – ALWAYS. To achieve this, they were willing to have excess inventory on hand and work the necessary hours to complete each order without a last second “fire drill.”
- Quality – This was a function of longevity within the organization, longevity with the customers and the technology utilized.
Commitment from Senior Leaders. Customers were regularly visited by a senior executive from the Company. They executives didn't deliver a “sales pitch,” but were there first-hand to see the customer’s challenges on the floor and listen to the customer and their employees.
Clearly, the client was doing a good job servicing their customers. So where was the problem? Sometimes the answer to the most intricate problem is simple. That was certainly true in this case. During LAG’s engagement, one glaring fact was noted: prices had not changed in 18 months, despite the unparalleled fluctuation of the costs of materials during this period.
Tentative reluctance existed in attempting to increase the prices back to the 38% levels. This was due to contractual relationships and a fear of jeopardizing the customer relationship with this relatively elastic set of products. However, it was decided that with the outstanding reviews from the client, aggressive adjustments were warranted. LAG’s approach included:
- Confirming what the competition was charging for similar products. The Company was on average 3% lower in price than the competition. (Note: In many cases, the accounting costs are not the same as the true economic costs.) By performing a true economic costing model, the customers were able to verify that they indeed were underpaying for the products and ancillary services.
- Assessing the pricing difference for new and existing customers. In two years, the Company lost no clients. However, the bid work for new business had a less than 10% hit rate. The pricing for new clients was being used to compensate for underpricing present customers. And yet, new customers were not able to quantify the intangible values cited above and added by the client.
- Obtaining industry costs for all the raw materials over the past three years and statically correlating the change in these costs to an internally developed price model. From this detailed data, LAG prepared a presentation for each customer illustrating the ramifications of the failure to adjust pricing on a formal basis.
- Visiting 100% of the revenue base with a customized presentation reflecting the sales activity of that customer for the past three years.
The client committed to live with the pricing model LAG developed. It was truly a “double edged sword.” It was inevitable that the outrageous costs of oil, steel and other key materials would decrease, requiring the client to decrease the price proportionally.
LAG developed a user-friendly process to keep the client’s customers informed each quarter about the costs of materials and the ramifications on the correlating prices. The result? The client returned to its 38% GPM within 60 days. Another key benefit of the process was a 7% increase in the quantity of products shipped.
A major surprise associated with this endeavor was that the client’s sales grew 7%, year over year. There was not only an improvement in the GPM, but also an increase in the gross volume.
The reason behind the increase was that with the automated online pricing model tool LAG designed for each customer, they could more accurately forecast their material requirements by reviewing year-to-year numbers for the past three years. The online tool even drilled down to the specific SKUs. This “soft sale” process was supposed to remind the customers to order in advance, which it clearly did.
Another benefit related to the online tool was the virtual elimination of “firefighting” due to reduced last minute orders. With this forecast and the development of a formal communication process, the client was able to proactively plan their quantity for the next quarter.
Client relationship building is a time consuming exercise. For this client, the CEO oversees and actively participates in core relationships. This open communication between the CEO, sales force team and customer is a win-win scenario, which will serve the Company well for many years to come.
*Note: In many cases, the accounting costs are not the same as the true economic costs.