www.craigscopy.com | Module 7. cash flow formula v1.3


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Seventh part of a 10 part series from the presenters of Finding Cash in Your Business podcast and book. Get Cash in quicker, handle it better and leverage it's power.

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www.craigscopy.com | Module 7. cash flow formula v1.3

  1. 1. Finding Cash in your BusinessWays to find cash you didn’t know you had, and attract cash you didn’t now you needed.The essential business guideModule 7 Cash Contribution by Product<br />
  2. 2. Learning objectives<br />Meaning of Contribution Margin<br />Does your company stock Chinchillas<br />Top tip<br />Case Study Example<br />Data Capture<br />Pareto principle<br />Pareto Curve<br />Lifecycle Hill<br />Total Contribution<br />Pareto curve contribution<br />The Final analysis<br />
  3. 3. Contribution Margin:is the sales price less the cost of producing the product.<br />Does your company stock Chinchillas?<br />A customer walks briskly into a pet shop in New York, gets a shop assistant’s attention and, pointing to the first cage he sees, says, ‘I want to buy that Chinchilla’. The shop assistant goes to the desk gets out a calculator and start to work out the price. After 10 minutes the shop assistant says, “Hmm that’s a rare thing, very costly and I’m not sure you can afford it.” By this time a crowd has started to build up. The customer looks around agitated and decides that it is not an expensive establishment and it’s only a Chinchilla so it can’t be that costly. The irate customer says “I’m keen to get it for my Daughter so name your price.” The shop assistant leans over the counter and apologetically says, that at cost, the best price he can offer is $5000. ‘OK’ the rich customer says, ‘I’ll buy it”. <br /> <br />The next week the customer comes back into the store to buy a second Chinchilla as the first one has died. The shop owner greets him and offers to sell him a Chinchilla for $99, but apologises that it will be another week before it arrives because they don’t stock them anymore. “$99!” exclaims the customer<br />
  4. 4. Contribution Margin:is the sales price less the cost of producing the product.<br />Does your company stock Chinchillas?<br />Before the customer can get a chance to speak the shop owner explains that he is very lucky, that he didn’t buy a chinchilla last week. It is a rare thing for an animal to stay in the shop for 15 years without being sold and last week we had a finance student helping out and he sold a chinchilla for $5000. <br />Before I left him in charge I told him to price at cost any animal that had been in the shop a long time so that we could get new animals in. When I asked him why he had charged so much he explained that it was because the Chinchilla had been in the pet shop so long. The student had factored in the initial cost of the Chinchilla plus the food consumed, the bedding, the rent and the cash invested on an opportunity basis and had come up with a best estimate of $5000.<br />Always make sure you and your employees understand what you mean by costs<br />
  5. 5. Top tip: Gear your business to customer orders rather than sales forecasts<br />Costs<br />Lets find out if your company is stocking Chinchillas. This chapter helps you assess which product provides the best financial contribution to your business. This chapter clearly defines the steps required to carry out this analysis, but I can assure you sometimes we are too close to the forest to see the trees. Before we start you need to know two key elements, the cost and revenue on a product-by-product basis. <br /> <br />This chapter provides the templates to start understanding your product or service cost base. It melds marketing with finance, prioritising product with contribution. Product contribution margin is an exciting area of investigation, done correctly it produces empirical data that will help to identify areas for cost improvement and product withdrawal. <br /> <br />I am always amazed at how little people know about their real costs. The bigger the company, the more mysterious the costs involved in building a product are. At a macro level a finance director can talk articulately about the profitability of the company’s product portfolio, but ask him about individual products and the veneer of understanding will soon peel away. Just remember if you don’t investigate your products contribution you might be stocking a Chinchilla that nobody wants at a price they can’t afford.<br /> <br />To get an idea of how product contribution is carried out I have manufactured data that is close to the real world experienced by a communications Company over a 3-month period. From this data the Product contribution is used to understand the cash flow implications of each product, and to identify which products make the largest impact on the working capital cycle.<br />
  6. 6. Example<br /> So lets get on with the example. Within a communications company there is a large number of products and within that there is a large variety of bespoke solutions based loosely around the product descriptions. <br />Stop there! Factor product complexity! It is impossible for me to get the costs! You are not alone in your products complexity. Much of your cost analysis will be based on best estimates provided by the experts who put the products and solutions together. So no excuses go talk to the experts and get their best estimates.<br />
  7. 7. Data Capture<br /> <br />You need to build up a table and capture the revenues and costs on a product-by-product basis. Here one I cooked up earlier. There are 21 product descriptions included in the data.<br />Once you have the revenue and cost data the gross margin drops out. <br />
  8. 8. Example cont.<br /> The next step is to rank the data in terms of highest overall income as shown in Table below <br />
  9. 9. Pareto principal:also known as the 80-20 rule, named after Vilfredo Pareto who observed that 80% of income in Italy went to 20% of the population.<br />The Pareto curve<br />The Pareto curve graphically shows that the Pareto principle can be applied to products e.g. 80% of the sales revenue comes from 20% of the product portfolio.<br /> <br />
  10. 10. The Pareto curve cont.<br />The Pareto curve by income displays the relative importance of each of the products against total revenue generated. The Pareto curve helps to distinguish products between the vital few and the trivial many in terms of income. On that basis the set consisting of these ‘trivial’ products could include the last 20% of income; products 9, 18, 19, 5, through to 13.<br />From the Pareto curve it is clear that 9 products generate 80% of the total income.<br />
  11. 11. Lifecycle Hill<br />To understand which products can be discontinued, consideration needs to be given to where that product is on lifecycle hill.<br />The figure above graphically shows the product life cycle for Internet access. The graph has two lines - one to shows profit, and the other sales revenues. The Blue ball represents Internet Access (code 17) and the key objective is to get the product to the point where profit is maximised and then keep the ball there for as long as possible. <br />
  12. 12. Lifecycle Hill cont.<br />At first view Internet Access would appear to be trivial as it is ranked as 17th by revenue. However, much effort has been exerted in pushing the product up lifecycle hill and it would be a ludicrous to discontinue the product just before it achieves maximum profit. <br />So it is vital to understand where the product is on lifecycle hill and consider the expected future contribution to conclude whether a product is trivial or of strategic importance. <br />It is expected that traditional voice and data revenues will migrate to being transmitted over the Internet.  So far from being trivial Internet Access is strategically important to the future revenues of the business.<br />
  13. 13. Total Contribution<br />The Table below ranks the products by contribution margin.<br />
  14. 14. Pareto Curve Contribution<br />The Pareto curve is plotted opposite. The Pareto curve enables you to distinguish between the vital few and the trivial many in terms of contribution. On this basis the ‘trivial products’ might include 14, 16, through to 21.<br />The Pareto curve for contribution shows that 80% of contribution is generated by 38% of the total product range. Many of the products show little effect on the contribution chart even although in themselves they are high margin products.<br />Ultimately, the optimum product range is determined by the company’s long-term strategic goals.<br />Equipment installations (Code 20 and 21) show a negative amount of contribution and are ranked as 20 and 21 respectively. However, the Equipment installations products are vitally important as they are only sold with the high margin Equipment maintenance products (Code 1 and 2).<br />
  15. 15. The Final Analysis<br />Generally products will be closely match their revenue and contribution rank, and those that do not merit investigation.<br />The Table below is used to compare the income and contribution rank of each product. <br /> <br />Mobile (Code 18) is showing a higher rank in revenue than contribution. This can be explained as Mobile is sold under a reseller agreement with high revenues and low margin. <br />
  16. 16. The Final Analysis cont.<br />From the previous table it is possible to create the scatter diagram of below. The scatter diagram is a snapshot clearly showing which are the most important products to the company at a specific point in time.<br />Generally as a quick ‘rule of thumb’ the further away you get from where the x and y axes meet the less important the products are to your business.<br />Premium Rate numbers services (PRS) (Code 8) are showing a higher rank in revenue than contribution. Premium rate number services such as a TV voting lines can generate huge turnover with wafer thin margins. <br />Following a strategic review using Pareto analysis remedial action on poor performers can be instigated to increase margins and sales. Value Analysis can be used at this stage in the process to reduce inventory, and material/labour costs.<br />
  17. 17. Conclusion<br />In 1990 I was in Ho Chi Minh City, Vietnam. At every hotel I ate they served food and drink using the same beautifully decorated China. This started me thinking, was this a local produce? Whoever had won the supply contract must have been very fortunate. I asked the waiter if he knew who the supplier was. The waiter smiled and said, "American standard issue”. His reply still amazes me. So let’s get this straight the American Army transports very fragile China from America to Vietnam to support the war effort. This may be a controversial thought but I do not believe that this well travelled China gave the Americans Army any competitive advantage.<br />This chapter has been about understanding your product range and hopefully has helped you to reduce of the unnecessary and get a tighter control of the necessary product range.My experience is that companies love to produce products and have a hard time discontinuing them. <br />The greatest impact on WCC will be achieved by concentrating on the products that have the highest financial contribution to the business as a whole. Focus on the highest contributors and revamp your product range using value analysis. Value analysis consists of simplification, standardisation and specialisation and is the topic for another discussion.<br />For the record can I point out that I have nothing against Chinchillas. They are small cuddly creature that people get attached to but beware they are made up of lots of fluff with very little substance. <br />Within your company there may be a need to stock a full range of products that includes some chinchillas the next module will look at ways to reduce there overall cash call burden on your business. <br />
  18. 18. Quiz 1 of 2<br />What is a Contribution Margin?<br />Is the difference between revenue and variable cost.<br />Is the sales price less the cost of producing the product<br />Is the marginal profit per unit sale.<br />All of the above<br />Why should you gear your business to customer orders rather than sales forecasts? <br />This will stop you stocking products nobody wants.<br />Reduce the amount of cash tied up in stock.<br />Creates potential to reduce warehousing.<br />All of the above<br />Why is it important to understand costs?<br />If you don’t know the cost you can’t work out the margin.<br />Knowingcost helps prioritise cost improvements.<br />Knowing costs helps in working out if the optimum product or service volumes.<br />All of the above<br />
  19. 19. Quiz 2 of 2<br />What does product contribution help you achieve? <br />Empirical data that helps in prioritising areas for cost improvement.<br />Empirical data that helps to identify areas for product withdrawal.<br />An optimised product/ service offering.<br />Highlights cash generative products or services<br />All of the above<br />Which of the following unit values are different from the Quarterly Revenue Cost and Margin Data?<br />Revenue Internet Access is 668<br />Cost Internet Access is 278<br />Gross Margin Internet Access 390<br />Revenue for Equipment Installations – data 473<br />Gross Margin for Equipment installations – data negative 101<br />All of the above.<br />What is the Pareto Principle?<br />The 80-20 rule<br />An observation which describes the income of Italians <br />A statistical technique used in decision making.<br />All of the above.<br />
  20. 20. To contact the author: craig@craigscopy.com<br />Finding Cash in your BusinessWays to find cash you didn’t know you had, and attract cash you didn’t now you needed.<br />Here’s some other free resources you’ll enjoy.<br />Podcast: http://itunes.apple.com/us/podcast/finding-cash-in-your-business/id347814983<br />Blog: http://craigscopy.blogspot.com/<br />Tweets: http://twitter.com/craigscopy<br />Here’s the answers to the questions:<br />2. 4. 4. 5. 4. 5.<br />
  21. 21. What next<br />The next Module we will investigate the sixth segment of the Cash Flow Formula. Here we are looking to understanding which product makes the best use of the WCC. <br />