1. Actionable Analytics must start with measuring the
right data points
Despite much time and money invested in collecting data, processing it, drawing conclusions, setting new courses of action, there can still
be blind spots that hide significant risks. What if a business strategy designed to build rapid market share with excellent customer service
levels achieves those objectives but brings the business to its knees? But worse still, what if all the outward signs of success, such as
physically growing bigger, and traditional measures, such as gross margin, said ‘growth policy is on track’, but hidden from view the
seeds of disaster had germinated. In this case study Brian Plowman(1)
outlines a real business situation with a salutary lesson. Lots of
measurement and analysis can still mask the true picture if the right data points are not being gathered.
A wholesale mobile phones business had done well in its early
days of high demand, growing both its customer base (retail
outlets) and levels of service to become a large and impressive
business. To visit and step inside the company was to feel success
oozing from every pore. Bonuses, based on gross margin, were
putting smiles on people’s faces as every sale had a positive gross
margin.
But as sales volumes
increased so profitability
plummeted. On a
turnover of £250m, it
began to make losses of
£1.5m per month.
Its share price followed,
tumbling to 3% of its
highest level and causing
consternation among
shareholders.
What was a mystery was that its strategy had been fulfilled. It did
have 90% market share of all the small independent phone retail
outlets; it did manage 99.5% next day deliveries; it had moved
into new office premises together with its own high bay
warehouse.
The CEO had no idea what had caused the problems -he was in
despair. A walk round the business soon suggested that looking at
things from a new perspective might point to where the problems,
and the solutions, might lay. It wasn’t a long walk as the key
processes were about as simple a business model as you can get.
Products were replenished direct from the manufacturers and held
in a large warehouse. Orders from customers were credit checked,
passed to the warehouse, picked, packed and dispatched to UK
and Export customers who were then invoiced and the cash
collected.
Stock
The walk started in the warehouse. With the growth in business
volumes the company had acquired large warehousing facilities
fuelled by a desire to improve service levels and an eye on
opportunistic discount deals on large quantities of products from
the manufacturers. But having lots of stock masked a number of
underlying problems.
It turned out that a quick analysis of stock levels in relation to
demand revealed that highly popular new models were often out
of stock. These lines accounted for the 0.5% of late deliveries but
they were also the lines that consumers were hammering on the
doors of retailers to get hold of. The company’s retail customers
were complaining as the ‘early adopters’ weren’t loyal – they
simply wanted to get their hands on the latest models so went
anywhere to get them.
The analysis also showed that half the products had stable
predictable demand but also had unnecessarily high stock cover.
Normally such demand characteristics provide opportunities to use
forecasting and so get just-in-time deliveries from the
manufacturers. But there was worse news to come.
The warehouse manager showed the CEO the pallets of stock with
a thick layer of dust on them. In fact there were mountains of stock
of these unpopular lines that turned over less than six times per
year. When these products’ prices were scrutinised it transpired
that the ability of this stock to retain a positive gross margin fell
away rapidly after two months. Customers didn’t want old models.
So the 40% of stock in this category had changed from an asset to
a liability, and a major source of value erosion.
A history of making large volume purchases fuelled by ‘special
discounts’ from the phone manufacturers were the root cause of
many serious negative product net margins. Interestingly the
purchasing director’s bonus was linked to the amount of discount
he ‘negotiated’. Was it possible that manufacturers were giving
big discounts on bulk purchases of what were soon to be
superseded models? The CEO made himself a note to check this
out.
Years

2. Throughput
The walk through the warehouse, followed by a walk along the
stages of order processing, revealed an insight that hadn’t really
been noticed before. It became clear that the overriding cost
driver was the number of orders. Almost irrespective of the size of
the order, ranging from a whole pallet down to a single phone,
each order drove much the same set of activities such as ‘order
entry’, then ‘credit check’, then ‘pick and pack’, then ‘despatch’,
then ‘invoicing’, then ‘chasing payment’.
In other words each order created much the same activity cost in
the business and people costs were a big percentage of the total.
Suddenly the key issue dawned on the CEO. For any orders where
the gross margin was less than the costs of processing the order
through the business, a loss was made. Far from believing that a
positive gross margin was always good because it was making a
contribution to overheads, if the real net profit was negative then
more volume meant ever-increasing losses!
The CEO asked the Finance Director and the Sales Director to join
him in his office where he outlined what he had found during his
walk. He asked them to set their minds on resolving two
questions.
1. Were there particular customers who were placing orders
which just lost the business money every time?
2. Why, when volumes were increasing, did growth seem to lead
to declining overall profitability?
The analysis of the figures now turned to looking at the
characteristics of various customer segments.
Using the insight about cost drivers the CEO had already done a
rough calculation and found that for the company as a whole the
average cost to process an order was around £50. One particular
segment, small high street retailers, mostly ordered small
quantities of phones with an average order gross margin of only
£15 which meant that on average each order lost the company
£35. This segment placed 87% of the orders accounting for over
50% of sales value! This answered both questions. Taken
together with other analyses, these customers were the source of
the falling profitability of the business as overall volumes and
number of customers increased.
The CEO’s blood ran cold when he realised that the ‘next day’
delivery promise had allowed these retailers to de-stock. A
handful of sales to consumers could be quickly replenished by the
wholesaler. The strategy had led to an inexorable growth in total
numbers of small quantity orders which made for a lot of activity
throughout the company needing more and more people in ever
larger premises. The company’s apparent successful growth had
really been in increasingly unprofitable business. The Sales
Director looked at the Finance Director then they both looked at
the CEO, who was not pleased.
The solution
Setting the minimum order value such that the gross margin
was always greater than £50 ensured no further unprofitable
orders were taken. Most customers complied with the new
minimum order values. Those that threatened to take their
business to competitors were encouraged to do so. The
competitors would welcome the business. They, like many
companies, would add the new business volumes to total
sales and feel comfortable that gross margins were positive.
But unwittingly they would be taking on a significant loss.
It was now very apparent that the policy of paying the sales
force a bonus based on gross margin had also led to the sales
force unwittingly driving the business into the ground. Sales
people didn’t realise that the processing costs of high volumes
of low value orders were crippling the business. If the net
profit was negative but the gross margin positive, they and
the sales director still got their bonuses. The CEO, however,
took the view that the Sales Director and the Finance Director
should have seen the root causes of the loss of profitability.
Lesson learnt
The key lesson for this company was the ease with which an
apparent excellent growth strategy had led them to become
blinded by its apparent success. The founder and MD of the
business realised that growing the physical size of the
company had taken a terrible toll. Initially the City had
measured success in sales volume terms. Also share prices in
the sector had rocketed for everyone so a true measure of
performance was obscured for a considerable time.
Members of the salesforce were generating positive gross
margins and collecting bonuses, so they weren’t complaining.
No signals came from the sales director of the impending
problems as he didn’t have the true knowledge from the right
information about what was happening. No signals came
from the finance director of the impending problems.
Tracking the changes to net
profit is not ordinarily shown
in the management reports.
But time and effort should be
devoted to uncovering the
real relationships between
costs and the drivers of costs,
and to understand how the
relationships to certain
customer segments can sow
the seeds of disaster as
volumes increase
(1)
Brian Plowman is Managing
Director of CostPerform Ltd the
UKI marketing, sales and
implementation support channel
for the Activity Based Costing,
Analysis and Modelling software
tool CostPerform.
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