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Volume 2012 | Issue: 2
Making Complexity Reduction Count:
How to Plan for Benefit Capture
from the Start

’
Companies are rapidly waking up to the
issues of complexity – bloated portfolios,
inflated cost structures and poor service
levels. However, many companies that launch
complexity reduction initiatives struggle
to capture the full benefits. In our work,
we’ve seen that in order to realize benefits
from complexity reduction, companies
need to consider two key inseparable
elements. Removing complexity provides
the opportunity for financial and operational
benefits. But benefit capture, as a deliberate
set of actions, needs to be considered
explicitly at the onset, otherwise the benefits
usually fail to materialize.
A primary challenge is that existing incentives
may well conflict with your complexity
reduction efforts. Absent an explicit plan, the
status quo will prevail. For example, managers
who are financially rewarded for keeping the
factory full will invariably ensure this happens,
even if it is with low margin, high complexity
products. This is why complexity reduction
requires a holistic, “joined-up” approach
where benefit capture is coupled with
complexity removal.
Before undertaking a major complexity
reduction program, it is important to have a
specific plan for converting the reduced levels
of complexity to financial benefit.
How Complexity Reduction can Translate
to Benefits
Any time a company embarks on a program
to remove portions of a product and service
portfolio, there is the opportunity to see the
following benefits:
	 Increase profits via a lower cost base
(Focus Area 1)
	 Increase profits by boosting customer
willingness to pay (Focus Area 2)
Focus Area 1: In practice, this translates
to unlocking enough spare capacity to allow
for fixed cost release. Companies may find
the consolidation of plants to be the most
dramatic way to boost their profitability. The
transformation that Cadbury UK embarked
upon in 2007 provides a prime example of
this option. At that time the company had 8
production/feedstock plants, 18 stockholding
locations, around 6,000 employees, 30
key brands, and 1,000 different SKUs.
Following a massive complexity reduction
campaign, Cadbury cut stock-keeping units
(SKUs) by 75% and reduced the number of
distribution depots from 18 to 5. The results
over a 4-year period ending in 2011 where
impressive: the company achieved a 15%
reduction in factories, a 10% increase in
margins, and revenue growth of 7% on a
2
Following a massive complexity reduction campaign, Cadbury cut
stock-keeping units (SKUs) by 75% and reduced the number of
distribution depots from 18 to 5. The results over a 4-year period
ending in 2011 where impressive: the company achieved a 15%
reduction in factories, a 10% increase in margins, and revenue
growth of 7% on a like-for-like basis.
like-for-like basis.1
This illustrates a common
phenomenon: often the biggest benefit of
variable cost reduction is the opportunity it
affords for fixed cost release.
Focus Area 2: This translates to using spare
organizational capacity to improve service
levels and offerings, resulting in improved
revenue and profit. Service levels and
offerings can be re-aligned with customer
needs around quality and delivery features
such as shorter lead time, less frequent
stock-outs, and augmented product options.
Effectively, companies increase the focus on
delivering their most attractive opportunities
flawlessly and price the offerings
commensurate with what the market is willing
to pay for “good complexity.”
As part of a turnaround in the early 2000s,
Motorola Computer Group significantly
reduced complexity by trimming 85% of
their product portfolio and deploying the
organizational capacity made available from
the SKU reduction to improve quality and
ratchet up on-time delivery from 70% to
90%. This increase in service levels resulted
in customer satisfaction leaping from 27% to
90% over a two year period.2
It also improved
the company’s cost base and helped raise
operating margins from -6% to +7%.3
Developing the Plan for Benefit Capture
In many cases, complexity reduction can lead
to benefits across both Focus Areas. Indeed,
the power of complexity reduction is that it
exposes many trade-offs to be false (e.g.,
complexity reduction can, in fact, decrease
costs and improve service levels). The key here
though is having the clarity from the outset as
to the areas of benefit that will give the business
the most lift, based on current operational
and strategic gaps. For Motorola above, the
focus was on increasing service levels and that
became the anchor motivation. As an added
benefit, they also saw their cost base decrease.
At a high-level, the identification of the plan for
benefit capture occurs through 3 key steps:
	 Take an “outside-in” view to assess the
areas of biggest opportunity
	 Identify and quantify existing
interdependencies and internal changes
for the benefits to materialize (above and
beyond the complexity reduction itself)
	 Translate the What to the How and move
to execution!
It is important to remember when following
these steps that the enemy is analysis-
paralysis and victory is achieved not when
theoretical benefits are identified, but when
1	
Stephen A. Wilson, Andrei Perumal. Waging War on Complexity Costs (New York McGraw-Hill, 2009)
2	
Michael L. George, James Works, Kimberly Watson-Hemphill. Fast Innovation (New York McGraw Hill, 2005)
3	
Even though fixed cost release and/or increasing service levels are the focal areas of this article, managers should not view these outcomes as an “all
or nothing” endeavor. Companies can continually improve margins through complexity-reducing activities like standardizing raw materials, consolidating
product designs, utilizing Lean tools to simplify value streams, cutting excess inventory, pricing enhancements, and refining the value proposition.
actual benefits land. General George S. Patton
once said, “A good plan violently executed
now is better than a perfect plan executed next
week.” In that same vein, the key to capturing
complexity-reduction benefits is to be “principally
right,” move quickly, and learn as you go.
Step 1: Take an outside-in view to assess the
areas of biggest opportunity
The core exercise here is to benchmark
your company’s performance against peer
organizations using two common metrics
within your industry: Asset Turnover and
Operating Margin. Neatly, when the two metrics
are multiplied together and compared over
time, it closely approximates changes to a
business’s Return on Invested Capital (ROIC).
	 Asset Turnover effectively incorporates
elements of the company’s asset intensity
and efficiency of operating decisions to
generate revenue. Asset Turnover helps
outline whether a company is operating
at capacity and fully utilizing its plant and
equipment in its operations.
	 Operating Margin is a measurement of a
company’s operating profitability taking into
account the company’s strategy with regard
to pricing, differentiation, and utilization
of costs, including costs associated with
complexity. Operating Margin does not
account for expenses such as interest
and taxes, so it is a good measure of
the profits of a company’s underlying
operations independent of capital structure
or one-time expenses.4
After data collection, create a grid showing
where your company falls relative to your peers
on both the above metrics. The result will be an
Asset-Margin Matrix like that shown in Figure 1.
’
4	
Operating Margin and Asset Turnover tend to vary inversely. Companies with high margins tend to have low asset turns and vice versa. This is
due to low margin companies typically not adding much value to products and thus requiring high turns to generate profit (e.g., grocery stores).
However, it should be the goal of companies to achieve high levels on both metrics. Best-in-class organizations are able to do this and thus have
corresponding high returns on invested capital.
2.2 x
2.0
1.8
1.6
1.4
1.2
1.0
0.8
0.6
0.4
5	 6	 7	 8	 9	 10	11	12	13	14	 15	16	17	18%
AssetTurnover
Boost Service Levels
Reduce
Fixed
Assets
Hyperactive Winning
Under
Performing
Near
Greatness
FLO
HRL
RAH
CAG
KFT
HNZ
CPB
HSY
SJM
GIS
K
SLE
$15B
Rev.
Operating Margin (TTM)
Figure 1: Example Asset-Margin Matrix Analysis of the US CPG Food Industry*
*	Cross bars indicated relative performance via medians. Data includes trailing twelve months based on most recent SEC filing as of February 17th
,
2012 for 12 major US CPG food companies (source: company SEC filings).
4
Many investment professionals have championed
ROIC as one of the best measures of a firm’s ability
to generate superior returns. Praise for ROIC’s
virtues appears in popular pieces ranging from Joel
Greenblatt’s value investing books, to investment
white papers, to advice from renowned strategist
Michael Porter who advocates:
“ROIC is the appropriate measure of
profitability for strategy formulation, not to
mention for equity investors.” 5
While many nuances can be applied to the ROIC
equation, it is commonly calculated as:
Asset Turnover and Operating Margin are
typically calculated as:
For Asset Turnover x Operating Margin
compared over time to closely approximate
changes to ROIC over time, the following
justifications are required:
A 	(1- tax rate) expression found in the
numerator of ROIC must be accounted for
B 	Assets - Cash and Cash equivalents, the
denominator of Asset Turnover, must
approximately equal Debt + Book Value
of Equity (i.e., Invested Capital), the
denominator of ROIC
Regarding A , (1-tax rate) is relatively constant
over a short period of time. Therefore, comparing
changes to a company’s Asset Turnover
x Operating Margin over time will closely
approximate ROIC changes over time.
Regarding B , from a balance sheet perspective,
Invested Capital can be computed as follows:
So long as Current Liabilities are minimal
compared to Assets, Assets - Cash and Cash
equivalents will approximately equal Debt + Book
Value of Equity. For most companies, this is true.6
Given that Operating Margin and Asset Turnover
are the two key components of the Asset-
Margin Matrix it is logical that those companies
that are able to move to the top right –
effectively improving their ROIC – will be those
that are most successful.
Return on Invested
Capital (ROIC)
Operating Income* (1 - tax rate)
Debt + Book Value of Equity
=
Invested Capital = Fixed Assets + Current Assets –
Current Liabilities – Cash Equivalents
Asset Turnover
Revenue
Assets – Cash and Cash Equivalents
=
Operating Margin
Operating Income
Revenue
=
ROIC and the Asset Margin Matrix
5	
Porter, Michael. “The Five Competitive Forces That Shape Strategy,” Harvard Business Review, January 2008
6	
This relationship generally holds true but there are balance sheet exceptions whereby Fixed Assets + Non-Cash Working Capital do not equal
Debt + Book Value of Equity. One such example is when a company has minority holdings in other companies that are classified as assets on the
balance sheet.
Companies in each quadrant exhibit different
characteristics and will benefit from various
uses of the spare capacity created by
complexity reduction. If you look behind
the numbers, there are clear patterns in
how companies in each quadrant are using
their resources and the resulting business
challenges they face. There are four
categories, as shown in Figure 2.
Under Performing
Characterized by both lower Asset Turnover
and lower Operating Margin than competitors,
‘Under Performing’ companies also have the
greatest opportunity and urgency, for dramatic
improvements. They will need to consider a
broad range of operational and market-facing
improvements to reduce complexity and better
their competitive stance.
The focal point will be a meaningful improvement
in the business model, both in terms of service
levels/differentiated offerings and costs. The
company’s leaders must drive a return to
focusing on their customers, understanding
what drives their satisfaction, and conduct
a robust review of complexity, both good
and bad (note: customers value and are
willing to pay for “good complexity”). They
can then make better decisions about right-
sizing operations to profitably deliver the good
complexity and eliminating bad complexity.
Hyperactive
Characterized by high Asset Turnover but low
on Operating Margins, these companies are
either working too hard for their results or, as is
less often the case, they are concentrating on
relatively high revenue but low margin products.
’
Figure 2: Interpretation of Matrix Locations
HIGH
Hyperactive
Typically rush to fill spare
capacity, overly manage
inventory, and erode
profitability in the process
Winning
Have the balanced
formula of right-sized
operations (both
capacity and complexity)
and high margins
Under Performing
Have excess capacity
and are not financially
efficient with the capacity
being utilized
Near Greatness
Close to winning with high
margin product mix, but
currently suffer from
underutilized or potentially
overly complex operations
LOW
Operating Margin
LOW
AssetTurnover
HIGH
6
Companies that are ‘Hyperactive’ often
focus on operational metrics without
fully understanding the implications for
customers and profitability. For example, in
an effort to keep inventory costs low, these
companies might frequently stock out of
items that customers demand. Alternatively,
a company might focus on high machine
utilization and fill spare capacity with low
margin products and/or entice customers
to buy additional volume at a discount. This
increases revenue to cover fixed costs, often
an incentive, but destroys profit and long-
term competitiveness.
‘Hyperactive’ companies should aim to
utilize complexity reduction and spare
capacity to improve service levels/
differentiate offerings to their customers.
For example, by using freed up capacity
to have more changeovers in a production
environment, companies are able to keep
work-in-process (WIP) and inventory costs
low but increase service levels via shorter
lead times.
Near Greatness
Characterized by high Operating Margins
but low Asset Turnover, companies in
this category have the right focus on their
customers and product offerings. But
compared to the competition, they require
more assets to produce each dollar of
revenue. ‘Near Greatness’ companies would
benefit by reviewing their asset portfolio and
potentially achieving fixed cost release.
Often, profitable companies are reluctant
to take cost cutting measures that remove
options. Examples include divestiture of
infrequently used equipment or consolidation
of under-utilized assets. Though this is
understandable due to a general desire
for operational flexibility, ‘Near Greatness’
companies often like to keep options open
and desire more flexibility than is required
based on forecasted demand. Maintaining
lean operating discipline will benefit these
companies, as complexity will have fewer
places to hide and the costs associated with
complexity will thus be kept at bay.
Winning
Characterized by a Strong Capability in
Optimizing Complexity, companies in this
category will still benefit from performing
ongoing reviews of their product portfolio,
proactively preventing complexity from
creeping back into their business, and
utilizing tools to drive profitable growth. Be
wary of a focus on a singular metric as they
typically give only a partial answer. Complexity
creeps in over time, so even the best run
organizations need to guard against gradual
product proliferation, erosion of service
levels and inflation of costs. A key leading
question for ‘Winning’ companies may be:
is the complexity of your portfolio growing
faster than your revenues over time? If so,
take action promptly to preserve the good
fundamentals of your business.
Step 2: Identify and quantify existing
interdependencies and internal changes for
the benefits to materialize
Once you’ve established an outside-in view,
the management team will have a strong
sense for what needs to be the “anchor”
goal for driving benefit: fixed cost release,
or focus on service levels, or potentially
both. Step 2 clarifies the end state through
analysis, accounting for interdependencies
and changes required for benefit capture.
Embarking on Step 2 is where many
management teams stumble as uncertainty
takes hold and teams find themselves in a
state of analysis paralysis.
The reason paralysis sets in is that identifying
and accounting for interdependencies can
be dizzying! Take, for example, a recent
manufacturing company client in the ‘Near
Greatness’ quadrant aiming to improve service
levels and, correspondingly, revenues. To
do so, a determination was required as to
how increased service levels would equate
to increased customer willingness to pay.
Operationally, increasing service levels required
smaller batch sizes and freed up capacity to
allow for more product line changeovers. More
changeovers resulted in higher scrap costs,
but reduced WIP and associated working
capital. From a commercial perspective,
training was required to augment sales force
skills. Customer call centers required refined
service-oriented processes. And so on…
It is important to consider interdependencies
such as those mentioned above in advance.
For Focus Areas 1 and 2, you will need to
consider areas such as:
	 Product profitability after correcting for
complexity costs. This is a critical facet for
identifying the optimal portfolio. The key
is to make the link between products and
their fully-loaded profitability, taking into
account both the fixed and variable costs
required. From our experience, low-volume
products as well as those with high variation
in demand are almost always under-costed
using traditional costing techniques.
Conversely, high-volume products and
those with low variation in demand are over-
costed. It is crucial to correct for imprecise
cost allocation techniques.
	 Cost and Service Breakpoints. This will
tell you how much capacity is required
to achieve Focus Areas 1 and/or 2. With
respect to fixed cost release, you need to
explicitly define the cost-level breakpoints
at which assets can be released by either
cutting products or moving their production
to alternate facilities. Regarding service
level increases, you need to conduct
customer research and competitor
analysis or leverage current management
understanding to ascertain customer
willingness to pay corresponding to
augmented service levels.
	 Migration paths and one-time costs.
This will detail the costs associated
with transitioning the business to the
desired future state, which may include
costs associated with closing facilities,
discontinuing or moving production.
Moreover, this will highlight the
“choreography” required to execute on the
SKU reduction plan and adjacent initiatives.
To make complexity reduction count,
there are nearly always a set of “before”
processes and “after” processes, which
need to be planned and executed.
Step 3: Translate the What to the How and
Move to Execution!
Step 3 is robust project planning, translating
what in Step 2 to how by layeringin
deliverables, activities, timing and
responsibilities. While volumes have been
written on the topic, a few complexity
reduction best practices will greatly increase
your odds of capturing full benefits:
	 Invest sufficient time educating the team on
how complexity reduction will benefit the
business. Any time you change peoples’
’
8
jobs, you’ll encounter resistance. Also
it’s not uncommon for the internal team
to become attached to the idea that a
particular asset or product category is
critical, and should not be touched, no
matter what the data says. It’s essential to
keep reinforcing the messages around the
business case.
	 Sustain project momentum through the
right cadence and right team structure.
Ensure the team includes “doers” (analysts/
line management) and “thinkers” (senior
people that can make decisions), and
includes key representatives from major
functions involved. Appoint a senior project
sponsor to quickly remove roadblocks and
make final decisions. This person should
be capable of holding the line, the point
of elevation for dealing with the (almost
inevitable) set of issues that crop up. Use
weekly Steering Group meetings to keep
urgency high, elevate issues and ensure
tight deadlines.
	 Actively manage customers’ expectations
and commercial risk. One common barrier
to complexity reduction is the perceived
fear of losing a customer with a portfolio
change. However, this is often overstated,
particularly if communication with
customers is handled well. Bring out the
positive messages. Promote the benefits
of complexity reduction (e.g., improved
response time, sales force focus, etc.) and
if necessary, offer meaningful assistance
transitioning customers from one product to
another, such as a promotional price break.
The 5% profit uplift
Many executives know that their business
is too complex and want to affect change
to make their business simpler to operate
and more profitable. From our experience,
their instincts and judgment are right: many
companies achieve a bottom-line boost of 5%
or higher by attacking complexity.7
Complexity
reduction is not easy; it often requires
companies and people to work differently,
and may require a direct engagement with
customers. Given the arduous nature of the
task, companies need to be confident of
realizing the benefits at the end of the day.
With the approaches and mindsets described
in this article, companies can more confidently
attain the rewards from their complexity
reduction initiatives.
7	
Wilson Perumal & Company project experience
From our experience,
low-volume products as well
as those with high variation
in demand are almost always
under-costed using traditional
costing techniques.
Since the start of their turnaround in
January 2008, Starbuck’s share price has
more than doubled, outperforming an index
of its peers by 50%.To achieve this relative
outperformance, Starbucks launched an
aggressive, effective, and well chronicled
turnaround that serves as a model for
companies moving from the ‘Under
Performing’ to the ‘Winning’ quadrant.
Starbucks’ stock price declined more
than 40% in 2007 with dire prospects
as the recession took hold. Operating
Margins were in freefall and the company
seemed burdened by overexpansion, rising
competition in the premium coffee market,
and an increasing “commoditization” of
the brand. It was not merely an issue of
cyclical forces at play because many of
Starbucks’ competitors were profiting,
as shown by the modest gain in the
Dow Jones Restaurant and Bar index or
McDonalds’ near 40% gain in 2007.
Starbucks recognized the need to take on
both fixed costs and boost service levels.
During the turnaround the company closed
more than 900 stores, reined in expansion
and associated capital expenditures, and
eliminated more than 1700 non-store
support and management positions and
6000 associate jobs. On the service
Starbucks TurnaroundKey Takeaways
	 Complexity removal provides
the opportunity for financial and
operational benefits. But benefit
capture, as a deliberate set of
actions, needs to be considered
explicitly at the outset; otherwise the
benefits usually fail to materialize.
	 Complexity reduction can expose
perceived trade-offs – the notion
that you can have either cost
improvement or service-level
improvements. Complexity reduction
often yields both.
	 Complexity reduction efforts that
fail to identify where the benefits will
come from tend to falter in the face
of concerns about the impact of
revenue loss. Conversely, complexity
reduction is most likely to succeed
when it is simply an enabler to
reaching a significant and meaningful
benefit (such as fixed cost release).
	 Identifying and executing the best
option requires the following 3 steps:
•	 Take an “outside-in” view, utilizing
the Asset-Margin Matrix to assess
the areas of biggest opportunity.
•	 Identify and quantify existing
interdependencies and internal
changes for the benefits to
materialize (above and beyond the
complexity reduction itself).
•	 Translate the What to the How
and move to execution!
’
10
$35
30
25
20
15
10
5
0
25%
20%
15%
10%
5%
0%
1/1/08 7/1/08 1/1/09 7/1/09 1/1/10 12/31/107/1/10
SBUX share price ROIC
Figure 3: Bold changes made by Starbucks from 2008-2010 and the correlation between ROIC improvement and stock price
side, Starbucks invested in new technologies,
training, and processes to improve the customer
experience. Some of the renewed quality
practices moved the store-front operations away
from previous efficiency-oriented practices. For
example, the baristas “returned to the practice
of grinding whole beans” and brewed “smaller
batches with a hold time of no more than 30
minutes.” These changes paid off as indicated in
the 2009 improvement in YOY same-store sales,
growing cash balance, elevated 2010 forecast 8
,
and significantly increased ROIC.
8
Starbucks annual reports, 10-K and 10-Q filings, Investor Conference Call Transcripts 2007-2010
Jan 2008: Announce return
of Schultz as CEO with plan to:
a improve customer experience,
b slow store openings and
close under-performing stores,
 realign organization and
management, and  accelerate
growth abroad
Mar 2010: Gains continue
with cash surplus enabling
first cash dividend and
authorization for additional
share buyback
July 2008: Announce closing
of 600 stores and reduction of
1000 non-store positions at a
cost of ~$340M
Sept 2009: Reduced store
openings cut Capex by 50%
from $985M in 2008 to
$450M in 2009.
H2 2009: Cost reduction
targets ahead of forecast; EPS
improves 50% yr-over-yr and
operating. margin moves from
(0.8%) to 8.5%. Growing cash
balance enables payoff of all
short-term debt.
May 2008: Investments in
tools and training to boost
quality and consistency of
in-store experience including
changes to brewing methods
and introduction of newly
acquired brewing tech
Jan 2009: Announce closing
of 300 additional stores and
6000 associated positions
plus the elimination of 700
non-store positions
General
Fixed Assets Focus
Service Focus
Wilson Perumal & Company, Inc.
Two Galleria Tower
13455 Noel Road, Suite 1000
Dallas, TX 75240
contact@wilsonperumal.com
www.wilsonperumal.com
Wilson Perumal & Company, Ltd.
100 Pall Mall
London SW1Y 5NQ
United Kingdom
This article was authored by:
Stephen Wilson, Managing Partner with
Wilson Perumal & Company, Inc. Contact
Stephen at swilson@wilsonperumal.com.
Craig Foos, Manager with Wilson
Perumal & Company, Inc. Contact
Craig at cfoos@wilsonperumal.com.
Gabriel Wilmoth, Consultant with Wilson
Perumal & Company, Inc. Contact Gabriel
at gwilmoth@wilsonperumal.com.
About Wilson Perumal & Company:
Wilson Perumal & Company is a premier
management consulting firm and the leading
advisor on how to manage and capitalize upon the
complexity of today’s world. To learn more, visit
www.wilsonperumal.com.

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Vantage point 2012_issue2

  • 1. ’ Volume 2012 | Issue: 2 Making Complexity Reduction Count: How to Plan for Benefit Capture from the Start 
  • 2. ’ Companies are rapidly waking up to the issues of complexity – bloated portfolios, inflated cost structures and poor service levels. However, many companies that launch complexity reduction initiatives struggle to capture the full benefits. In our work, we’ve seen that in order to realize benefits from complexity reduction, companies need to consider two key inseparable elements. Removing complexity provides the opportunity for financial and operational benefits. But benefit capture, as a deliberate set of actions, needs to be considered explicitly at the onset, otherwise the benefits usually fail to materialize. A primary challenge is that existing incentives may well conflict with your complexity reduction efforts. Absent an explicit plan, the status quo will prevail. For example, managers who are financially rewarded for keeping the factory full will invariably ensure this happens, even if it is with low margin, high complexity products. This is why complexity reduction requires a holistic, “joined-up” approach where benefit capture is coupled with complexity removal. Before undertaking a major complexity reduction program, it is important to have a specific plan for converting the reduced levels of complexity to financial benefit. How Complexity Reduction can Translate to Benefits Any time a company embarks on a program to remove portions of a product and service portfolio, there is the opportunity to see the following benefits:  Increase profits via a lower cost base (Focus Area 1)  Increase profits by boosting customer willingness to pay (Focus Area 2) Focus Area 1: In practice, this translates to unlocking enough spare capacity to allow for fixed cost release. Companies may find the consolidation of plants to be the most dramatic way to boost their profitability. The transformation that Cadbury UK embarked upon in 2007 provides a prime example of this option. At that time the company had 8 production/feedstock plants, 18 stockholding locations, around 6,000 employees, 30 key brands, and 1,000 different SKUs. Following a massive complexity reduction campaign, Cadbury cut stock-keeping units (SKUs) by 75% and reduced the number of distribution depots from 18 to 5. The results over a 4-year period ending in 2011 where impressive: the company achieved a 15% reduction in factories, a 10% increase in margins, and revenue growth of 7% on a
  • 3. 2 Following a massive complexity reduction campaign, Cadbury cut stock-keeping units (SKUs) by 75% and reduced the number of distribution depots from 18 to 5. The results over a 4-year period ending in 2011 where impressive: the company achieved a 15% reduction in factories, a 10% increase in margins, and revenue growth of 7% on a like-for-like basis. like-for-like basis.1 This illustrates a common phenomenon: often the biggest benefit of variable cost reduction is the opportunity it affords for fixed cost release. Focus Area 2: This translates to using spare organizational capacity to improve service levels and offerings, resulting in improved revenue and profit. Service levels and offerings can be re-aligned with customer needs around quality and delivery features such as shorter lead time, less frequent stock-outs, and augmented product options. Effectively, companies increase the focus on delivering their most attractive opportunities flawlessly and price the offerings commensurate with what the market is willing to pay for “good complexity.” As part of a turnaround in the early 2000s, Motorola Computer Group significantly reduced complexity by trimming 85% of their product portfolio and deploying the organizational capacity made available from the SKU reduction to improve quality and ratchet up on-time delivery from 70% to 90%. This increase in service levels resulted in customer satisfaction leaping from 27% to 90% over a two year period.2 It also improved the company’s cost base and helped raise operating margins from -6% to +7%.3 Developing the Plan for Benefit Capture In many cases, complexity reduction can lead to benefits across both Focus Areas. Indeed, the power of complexity reduction is that it exposes many trade-offs to be false (e.g., complexity reduction can, in fact, decrease costs and improve service levels). The key here though is having the clarity from the outset as to the areas of benefit that will give the business the most lift, based on current operational and strategic gaps. For Motorola above, the focus was on increasing service levels and that became the anchor motivation. As an added benefit, they also saw their cost base decrease. At a high-level, the identification of the plan for benefit capture occurs through 3 key steps:  Take an “outside-in” view to assess the areas of biggest opportunity  Identify and quantify existing interdependencies and internal changes for the benefits to materialize (above and beyond the complexity reduction itself)  Translate the What to the How and move to execution! It is important to remember when following these steps that the enemy is analysis- paralysis and victory is achieved not when theoretical benefits are identified, but when 1 Stephen A. Wilson, Andrei Perumal. Waging War on Complexity Costs (New York McGraw-Hill, 2009) 2 Michael L. George, James Works, Kimberly Watson-Hemphill. Fast Innovation (New York McGraw Hill, 2005) 3 Even though fixed cost release and/or increasing service levels are the focal areas of this article, managers should not view these outcomes as an “all or nothing” endeavor. Companies can continually improve margins through complexity-reducing activities like standardizing raw materials, consolidating product designs, utilizing Lean tools to simplify value streams, cutting excess inventory, pricing enhancements, and refining the value proposition.
  • 4. actual benefits land. General George S. Patton once said, “A good plan violently executed now is better than a perfect plan executed next week.” In that same vein, the key to capturing complexity-reduction benefits is to be “principally right,” move quickly, and learn as you go. Step 1: Take an outside-in view to assess the areas of biggest opportunity The core exercise here is to benchmark your company’s performance against peer organizations using two common metrics within your industry: Asset Turnover and Operating Margin. Neatly, when the two metrics are multiplied together and compared over time, it closely approximates changes to a business’s Return on Invested Capital (ROIC).  Asset Turnover effectively incorporates elements of the company’s asset intensity and efficiency of operating decisions to generate revenue. Asset Turnover helps outline whether a company is operating at capacity and fully utilizing its plant and equipment in its operations.  Operating Margin is a measurement of a company’s operating profitability taking into account the company’s strategy with regard to pricing, differentiation, and utilization of costs, including costs associated with complexity. Operating Margin does not account for expenses such as interest and taxes, so it is a good measure of the profits of a company’s underlying operations independent of capital structure or one-time expenses.4 After data collection, create a grid showing where your company falls relative to your peers on both the above metrics. The result will be an Asset-Margin Matrix like that shown in Figure 1. ’ 4 Operating Margin and Asset Turnover tend to vary inversely. Companies with high margins tend to have low asset turns and vice versa. This is due to low margin companies typically not adding much value to products and thus requiring high turns to generate profit (e.g., grocery stores). However, it should be the goal of companies to achieve high levels on both metrics. Best-in-class organizations are able to do this and thus have corresponding high returns on invested capital. 2.2 x 2.0 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 5 6 7 8 9 10 11 12 13 14 15 16 17 18% AssetTurnover Boost Service Levels Reduce Fixed Assets Hyperactive Winning Under Performing Near Greatness FLO HRL RAH CAG KFT HNZ CPB HSY SJM GIS K SLE $15B Rev. Operating Margin (TTM) Figure 1: Example Asset-Margin Matrix Analysis of the US CPG Food Industry* * Cross bars indicated relative performance via medians. Data includes trailing twelve months based on most recent SEC filing as of February 17th , 2012 for 12 major US CPG food companies (source: company SEC filings).
  • 5. 4 Many investment professionals have championed ROIC as one of the best measures of a firm’s ability to generate superior returns. Praise for ROIC’s virtues appears in popular pieces ranging from Joel Greenblatt’s value investing books, to investment white papers, to advice from renowned strategist Michael Porter who advocates: “ROIC is the appropriate measure of profitability for strategy formulation, not to mention for equity investors.” 5 While many nuances can be applied to the ROIC equation, it is commonly calculated as: Asset Turnover and Operating Margin are typically calculated as: For Asset Turnover x Operating Margin compared over time to closely approximate changes to ROIC over time, the following justifications are required: A (1- tax rate) expression found in the numerator of ROIC must be accounted for B Assets - Cash and Cash equivalents, the denominator of Asset Turnover, must approximately equal Debt + Book Value of Equity (i.e., Invested Capital), the denominator of ROIC Regarding A , (1-tax rate) is relatively constant over a short period of time. Therefore, comparing changes to a company’s Asset Turnover x Operating Margin over time will closely approximate ROIC changes over time. Regarding B , from a balance sheet perspective, Invested Capital can be computed as follows: So long as Current Liabilities are minimal compared to Assets, Assets - Cash and Cash equivalents will approximately equal Debt + Book Value of Equity. For most companies, this is true.6 Given that Operating Margin and Asset Turnover are the two key components of the Asset- Margin Matrix it is logical that those companies that are able to move to the top right – effectively improving their ROIC – will be those that are most successful. Return on Invested Capital (ROIC) Operating Income* (1 - tax rate) Debt + Book Value of Equity = Invested Capital = Fixed Assets + Current Assets – Current Liabilities – Cash Equivalents Asset Turnover Revenue Assets – Cash and Cash Equivalents = Operating Margin Operating Income Revenue = ROIC and the Asset Margin Matrix 5 Porter, Michael. “The Five Competitive Forces That Shape Strategy,” Harvard Business Review, January 2008 6 This relationship generally holds true but there are balance sheet exceptions whereby Fixed Assets + Non-Cash Working Capital do not equal Debt + Book Value of Equity. One such example is when a company has minority holdings in other companies that are classified as assets on the balance sheet.
  • 6. Companies in each quadrant exhibit different characteristics and will benefit from various uses of the spare capacity created by complexity reduction. If you look behind the numbers, there are clear patterns in how companies in each quadrant are using their resources and the resulting business challenges they face. There are four categories, as shown in Figure 2. Under Performing Characterized by both lower Asset Turnover and lower Operating Margin than competitors, ‘Under Performing’ companies also have the greatest opportunity and urgency, for dramatic improvements. They will need to consider a broad range of operational and market-facing improvements to reduce complexity and better their competitive stance. The focal point will be a meaningful improvement in the business model, both in terms of service levels/differentiated offerings and costs. The company’s leaders must drive a return to focusing on their customers, understanding what drives their satisfaction, and conduct a robust review of complexity, both good and bad (note: customers value and are willing to pay for “good complexity”). They can then make better decisions about right- sizing operations to profitably deliver the good complexity and eliminating bad complexity. Hyperactive Characterized by high Asset Turnover but low on Operating Margins, these companies are either working too hard for their results or, as is less often the case, they are concentrating on relatively high revenue but low margin products. ’ Figure 2: Interpretation of Matrix Locations HIGH Hyperactive Typically rush to fill spare capacity, overly manage inventory, and erode profitability in the process Winning Have the balanced formula of right-sized operations (both capacity and complexity) and high margins Under Performing Have excess capacity and are not financially efficient with the capacity being utilized Near Greatness Close to winning with high margin product mix, but currently suffer from underutilized or potentially overly complex operations LOW Operating Margin LOW AssetTurnover HIGH
  • 7. 6 Companies that are ‘Hyperactive’ often focus on operational metrics without fully understanding the implications for customers and profitability. For example, in an effort to keep inventory costs low, these companies might frequently stock out of items that customers demand. Alternatively, a company might focus on high machine utilization and fill spare capacity with low margin products and/or entice customers to buy additional volume at a discount. This increases revenue to cover fixed costs, often an incentive, but destroys profit and long- term competitiveness. ‘Hyperactive’ companies should aim to utilize complexity reduction and spare capacity to improve service levels/ differentiate offerings to their customers. For example, by using freed up capacity to have more changeovers in a production environment, companies are able to keep work-in-process (WIP) and inventory costs low but increase service levels via shorter lead times. Near Greatness Characterized by high Operating Margins but low Asset Turnover, companies in this category have the right focus on their customers and product offerings. But compared to the competition, they require more assets to produce each dollar of revenue. ‘Near Greatness’ companies would benefit by reviewing their asset portfolio and potentially achieving fixed cost release. Often, profitable companies are reluctant to take cost cutting measures that remove options. Examples include divestiture of infrequently used equipment or consolidation of under-utilized assets. Though this is understandable due to a general desire for operational flexibility, ‘Near Greatness’ companies often like to keep options open and desire more flexibility than is required based on forecasted demand. Maintaining lean operating discipline will benefit these companies, as complexity will have fewer places to hide and the costs associated with complexity will thus be kept at bay. Winning Characterized by a Strong Capability in Optimizing Complexity, companies in this category will still benefit from performing ongoing reviews of their product portfolio, proactively preventing complexity from creeping back into their business, and utilizing tools to drive profitable growth. Be wary of a focus on a singular metric as they typically give only a partial answer. Complexity creeps in over time, so even the best run organizations need to guard against gradual product proliferation, erosion of service levels and inflation of costs. A key leading question for ‘Winning’ companies may be: is the complexity of your portfolio growing faster than your revenues over time? If so, take action promptly to preserve the good fundamentals of your business. Step 2: Identify and quantify existing interdependencies and internal changes for the benefits to materialize Once you’ve established an outside-in view, the management team will have a strong sense for what needs to be the “anchor” goal for driving benefit: fixed cost release, or focus on service levels, or potentially both. Step 2 clarifies the end state through analysis, accounting for interdependencies and changes required for benefit capture.
  • 8. Embarking on Step 2 is where many management teams stumble as uncertainty takes hold and teams find themselves in a state of analysis paralysis. The reason paralysis sets in is that identifying and accounting for interdependencies can be dizzying! Take, for example, a recent manufacturing company client in the ‘Near Greatness’ quadrant aiming to improve service levels and, correspondingly, revenues. To do so, a determination was required as to how increased service levels would equate to increased customer willingness to pay. Operationally, increasing service levels required smaller batch sizes and freed up capacity to allow for more product line changeovers. More changeovers resulted in higher scrap costs, but reduced WIP and associated working capital. From a commercial perspective, training was required to augment sales force skills. Customer call centers required refined service-oriented processes. And so on… It is important to consider interdependencies such as those mentioned above in advance. For Focus Areas 1 and 2, you will need to consider areas such as:  Product profitability after correcting for complexity costs. This is a critical facet for identifying the optimal portfolio. The key is to make the link between products and their fully-loaded profitability, taking into account both the fixed and variable costs required. From our experience, low-volume products as well as those with high variation in demand are almost always under-costed using traditional costing techniques. Conversely, high-volume products and those with low variation in demand are over- costed. It is crucial to correct for imprecise cost allocation techniques.  Cost and Service Breakpoints. This will tell you how much capacity is required to achieve Focus Areas 1 and/or 2. With respect to fixed cost release, you need to explicitly define the cost-level breakpoints at which assets can be released by either cutting products or moving their production to alternate facilities. Regarding service level increases, you need to conduct customer research and competitor analysis or leverage current management understanding to ascertain customer willingness to pay corresponding to augmented service levels.  Migration paths and one-time costs. This will detail the costs associated with transitioning the business to the desired future state, which may include costs associated with closing facilities, discontinuing or moving production. Moreover, this will highlight the “choreography” required to execute on the SKU reduction plan and adjacent initiatives. To make complexity reduction count, there are nearly always a set of “before” processes and “after” processes, which need to be planned and executed. Step 3: Translate the What to the How and Move to Execution! Step 3 is robust project planning, translating what in Step 2 to how by layeringin deliverables, activities, timing and responsibilities. While volumes have been written on the topic, a few complexity reduction best practices will greatly increase your odds of capturing full benefits:  Invest sufficient time educating the team on how complexity reduction will benefit the business. Any time you change peoples’ ’
  • 9. 8 jobs, you’ll encounter resistance. Also it’s not uncommon for the internal team to become attached to the idea that a particular asset or product category is critical, and should not be touched, no matter what the data says. It’s essential to keep reinforcing the messages around the business case.  Sustain project momentum through the right cadence and right team structure. Ensure the team includes “doers” (analysts/ line management) and “thinkers” (senior people that can make decisions), and includes key representatives from major functions involved. Appoint a senior project sponsor to quickly remove roadblocks and make final decisions. This person should be capable of holding the line, the point of elevation for dealing with the (almost inevitable) set of issues that crop up. Use weekly Steering Group meetings to keep urgency high, elevate issues and ensure tight deadlines.  Actively manage customers’ expectations and commercial risk. One common barrier to complexity reduction is the perceived fear of losing a customer with a portfolio change. However, this is often overstated, particularly if communication with customers is handled well. Bring out the positive messages. Promote the benefits of complexity reduction (e.g., improved response time, sales force focus, etc.) and if necessary, offer meaningful assistance transitioning customers from one product to another, such as a promotional price break. The 5% profit uplift Many executives know that their business is too complex and want to affect change to make their business simpler to operate and more profitable. From our experience, their instincts and judgment are right: many companies achieve a bottom-line boost of 5% or higher by attacking complexity.7 Complexity reduction is not easy; it often requires companies and people to work differently, and may require a direct engagement with customers. Given the arduous nature of the task, companies need to be confident of realizing the benefits at the end of the day. With the approaches and mindsets described in this article, companies can more confidently attain the rewards from their complexity reduction initiatives. 7 Wilson Perumal & Company project experience From our experience, low-volume products as well as those with high variation in demand are almost always under-costed using traditional costing techniques.
  • 10. Since the start of their turnaround in January 2008, Starbuck’s share price has more than doubled, outperforming an index of its peers by 50%.To achieve this relative outperformance, Starbucks launched an aggressive, effective, and well chronicled turnaround that serves as a model for companies moving from the ‘Under Performing’ to the ‘Winning’ quadrant. Starbucks’ stock price declined more than 40% in 2007 with dire prospects as the recession took hold. Operating Margins were in freefall and the company seemed burdened by overexpansion, rising competition in the premium coffee market, and an increasing “commoditization” of the brand. It was not merely an issue of cyclical forces at play because many of Starbucks’ competitors were profiting, as shown by the modest gain in the Dow Jones Restaurant and Bar index or McDonalds’ near 40% gain in 2007. Starbucks recognized the need to take on both fixed costs and boost service levels. During the turnaround the company closed more than 900 stores, reined in expansion and associated capital expenditures, and eliminated more than 1700 non-store support and management positions and 6000 associate jobs. On the service Starbucks TurnaroundKey Takeaways  Complexity removal provides the opportunity for financial and operational benefits. But benefit capture, as a deliberate set of actions, needs to be considered explicitly at the outset; otherwise the benefits usually fail to materialize.  Complexity reduction can expose perceived trade-offs – the notion that you can have either cost improvement or service-level improvements. Complexity reduction often yields both.  Complexity reduction efforts that fail to identify where the benefits will come from tend to falter in the face of concerns about the impact of revenue loss. Conversely, complexity reduction is most likely to succeed when it is simply an enabler to reaching a significant and meaningful benefit (such as fixed cost release).  Identifying and executing the best option requires the following 3 steps: • Take an “outside-in” view, utilizing the Asset-Margin Matrix to assess the areas of biggest opportunity. • Identify and quantify existing interdependencies and internal changes for the benefits to materialize (above and beyond the complexity reduction itself). • Translate the What to the How and move to execution! ’
  • 11. 10 $35 30 25 20 15 10 5 0 25% 20% 15% 10% 5% 0% 1/1/08 7/1/08 1/1/09 7/1/09 1/1/10 12/31/107/1/10 SBUX share price ROIC Figure 3: Bold changes made by Starbucks from 2008-2010 and the correlation between ROIC improvement and stock price side, Starbucks invested in new technologies, training, and processes to improve the customer experience. Some of the renewed quality practices moved the store-front operations away from previous efficiency-oriented practices. For example, the baristas “returned to the practice of grinding whole beans” and brewed “smaller batches with a hold time of no more than 30 minutes.” These changes paid off as indicated in the 2009 improvement in YOY same-store sales, growing cash balance, elevated 2010 forecast 8 , and significantly increased ROIC. 8 Starbucks annual reports, 10-K and 10-Q filings, Investor Conference Call Transcripts 2007-2010 Jan 2008: Announce return of Schultz as CEO with plan to: a improve customer experience, b slow store openings and close under-performing stores,  realign organization and management, and  accelerate growth abroad Mar 2010: Gains continue with cash surplus enabling first cash dividend and authorization for additional share buyback July 2008: Announce closing of 600 stores and reduction of 1000 non-store positions at a cost of ~$340M Sept 2009: Reduced store openings cut Capex by 50% from $985M in 2008 to $450M in 2009. H2 2009: Cost reduction targets ahead of forecast; EPS improves 50% yr-over-yr and operating. margin moves from (0.8%) to 8.5%. Growing cash balance enables payoff of all short-term debt. May 2008: Investments in tools and training to boost quality and consistency of in-store experience including changes to brewing methods and introduction of newly acquired brewing tech Jan 2009: Announce closing of 300 additional stores and 6000 associated positions plus the elimination of 700 non-store positions General Fixed Assets Focus Service Focus
  • 12. Wilson Perumal & Company, Inc. Two Galleria Tower 13455 Noel Road, Suite 1000 Dallas, TX 75240 contact@wilsonperumal.com www.wilsonperumal.com Wilson Perumal & Company, Ltd. 100 Pall Mall London SW1Y 5NQ United Kingdom This article was authored by: Stephen Wilson, Managing Partner with Wilson Perumal & Company, Inc. Contact Stephen at swilson@wilsonperumal.com. Craig Foos, Manager with Wilson Perumal & Company, Inc. Contact Craig at cfoos@wilsonperumal.com. Gabriel Wilmoth, Consultant with Wilson Perumal & Company, Inc. Contact Gabriel at gwilmoth@wilsonperumal.com. About Wilson Perumal & Company: Wilson Perumal & Company is a premier management consulting firm and the leading advisor on how to manage and capitalize upon the complexity of today’s world. To learn more, visit www.wilsonperumal.com.