Managing Profitability in Uncertain Times

Written June 30, 2020

Categories: Journal Articles

During this period of volatility, it is critical that owners know the profit-making elements of their business. While this might sound simple, it is often much more complex than it sounds. As volumes of work fluctuate, maintaining profit margins can be difficult due to the mix and type of work being performed. Assessing customer contribution provides important information and is an essential decision-making tool in normal times and even more so now.


Uncertain Markets

With the news from the Federal Reserve stating that first quarter gross domestic product (GDP) decreased over 4% (as of May 1), everyone is wondering what the second quarter will bring since the full force of COVID-19 did not affect the economy until mid-March. Most retail/consumer businesses (and schools) did not fully shut down until the last week of March via government order. The impact to the second quarter is likely to be more significant due to the delay in the economic effect, with inventory drawdowns, order lead times, and production/supply chain timing. And, the longer the shutdowns drag on, the greater the lasting impact to the economy. Figure 1 shows that, as the effects of COVID-19 and the related shutdowns persist, the likelihood of a quick recovery are waning. Most major banks do not see U.S. GDP returning to 2019 levels for the next two years.

A more discrete analysis of markets shows that there is high variability in expected economic decline. A study by LionTree1, shown in Figure 2, paints a similar but more dynamic picture. Nearly all technology, media, and telecom economic sectors are experiencing significant declines, with consumer facing and ad-based sectors being the hardest hit.

By way of comparison, ECI has recently released an advertising forecast for the entirety of 2020 suggesting that some ad channel pricing (newspapers and magazines) will decline over 20% for the full year.2 Other ad verticals suggest a decline in the 5% to 15% range. Similarly, the retail environment is also very mixed. Non-discretionary retail (consumer staples) companies are only expected to be down 1% to 2% in 2020 from a market perspective while discretionary retail is forecasted to drop more than 34%.3 A graphic published by McKinsey4 shows that most consumers throughout the world expect their incomes, and thus discretionary dollars, to decrease in 2020.

Customer Risk

Understanding customers is critical to businesses’ maintaining successful outcomes through this period. As business leaders navigate this journey, they should be aware of not only the financial health of customers, but also the market risks they face. In general, the closer the business or a customer’s business is to the physical consumer, the greater the impact to the enterprise during the COVID-19 period. The market verticals a firm sells into will drive decision-making over the next few months to a year. Figure 4, from the International Labor Organization5, shows the risk (via color — red indicates the highest risk; blue, the lowest) to economic output of the workforce in various industries. Nearly 50% of the workforce is at high risk of delayed output, separation, or other negative economic impact.

Understanding customers is both a quantitative and qualitative exercise. From a qualitative perspective, business owners should get to know their customers’ markets as they can vary significantly:
• Who do they sell to?
• Are their industries in distress?
• Are customers’ businesses reliant on the physical presence of consumers or labor conditions that make social distancing difficult?
• Can customers easily pivot to e-commerce or digital solutions?
• What is their current labor situation; are they enacting furloughs, implementing meaningful cost cuts?
• Has their credit rating changed recently; do they hold meaningful levels of debt?

This can be accomplished via discussion with customers and doing background research. This will enhance decision making and inform the treatment of each customer and customer segment moving forward.

Controlling That Which Can Be Controlled

Unfortunately, there are many uncontrollable forces affecting the economy, businesses, and consumers alike. Now more than ever, it is incumbent upon business owners to closely manage the elements of their business they do have control over. Applying a sound methodology, such as customer contribution analysis, enables making quick and consistent decisions. Contribution analysis is an effective way to intelligently address and improve controllable revenue (i.e., customers) and manage controllable costs.

Contribution Analysis

In this environment, it is critical businesses serve those customers who respect and rely on their products and services and are willing to pay a profit-making price. In recent years, with favorable economic conditions, pricing has become a challenge in various print markets due to overcapacity and waning demand, especially for legacy goods and services. Multiple firms are fighting for the same dollars. Pricing products at thin margins over the course of a year or multi-year period can result in revenue leakage and lost profit, especially when customers pull-back volumes and/or cancel orders. The reason for this being that prices tend to be locked-in, or at least constrained, while cost constantly creeps higher. And, as volume declines, fixed costs represent an ever-increasing percentage of the cost structure. Ultimately, more contribution per unit is required to cover fixed costs to attain positive earnings before interest, taxes, depreciation, and amortization. This is achieved one of four ways:
• Reduce semi-variable cost structures — improve productivity, reduce material spend
• Change the mix of high/low profit volume
• Increase prices on the same volume of products and services — a price increase falls directly to the bottom line
• Reduce fixed cost structures — overhead, and selling, general, and administrative
expenses

Performing the Analysis

The first step in assessing customer contribution is to understand the full suite of products and services the firm offers to each customer. When undertaking this type of analysis, use the 80/20 rule or pick the top 25 and bottom 25 customers and start there. Also, when evaluating a customer, look at the parent organization to best assess the revenue that an organization contributes. This includes all “add-on” services (creative, agency, tracking, etc.), all fringe benefits, all fulfillment concessions, and any associated
discounts and rebates. The result will give a true picture of customer revenue.

Secondly, and more complex, is calculating the costs associated with each customer. Owners need to be honest in asking whether:
• They have a good perspective on the fixed and variable costs within the business. There tends to be more complexity in the nature of fixed and variable costs than expected. Figure 5 shows common ranges of variable cost among profit and loss cost categories.
• This is driven by vendor contracts, customer agreements, labor schedules, PT/FT labor mix, and internal accounting procedures, to name a few.
• Job costing systems are up-to-date with the latest wage inflation changes, impacts of productivity improvements or losses, changes in material pricing, etc.

If not, the process becomes more time consuming but still achievable using activity-based costing (ABC). The more directly costs can be associated to a customer, the more accurate the analysis. ABC is a ground-up build of all costs and cost variations within the business. It involves segmenting processes, equipment, labor, and materials into discrete groupings that can be applied to each customer. This includes all material variations, time and labor costs to create, prepare, produce, finish, package, and ship each type of product or job. The greater the level of segmentation detail, the more accurate the result. For example, some companies may have the ability to apply actual wage rates and production setup, runtime, and changeover time to a specific
job or equipment type. This provides the best view of direct cost. Others may not have access to that level of detail, which then requires the use of wage and staffing ratio
averages. This approach is workable, but it tends to normalize or spread costs across all customers as fragments of time are shared as opposed to being directly linked to a finished product. Once direct costs have been calculated for the segments of the enterprise, contribution is simply the difference between revenue and cost. The analysis can be viewed several ways:
• By individual customer
• By customer segment or industry vertical
• By equipment type
• By product or format
• By plant, location, or shift

This will provide much better insight into the customers, processes, locations, and equipment that contribute the greatest level of benefit to the business, and those that do not. Figure 6 shows the various areas of the business where contribution analysis can make a meaningful impact, both tactically and strategically.

Leveraging Strengths — Go-to-Market Strategy

Customer contribution analysis quickly identifies one’s competitive advantage uncovering where the company is the best (most efficient and proficient) at what it does. These are the customers that give the highest pricing leverage or are the customers whose products can be produced at the lowest price, or both. In this environment, knowing this is critical. Print shops that are feeling the pain of this drastic economic downturn will need to shrink to their base for a period to weather the storm. This will result in more reliance on competitive advantage which, in turn, represents the most resource efficient dollars the company can earn. Competitive advantage and profitable customers are nearly synonymous. It is important to continue to foster and support these customer relationships as they are key to maintaining profit. Straying from competitive advantage will likely result in higher cash burn (incremental investment in resources, inefficiency, waste) and may permanently damage the balance sheet.

Selling the Core

Selling during this period can be difficult and can expend resources for very little return. The advantage of customer contribution analysis is that it identifies the best market verticals and naturally identifies a business’s ability to profit from the prices that the market will bear. The industry segments with the highest contribution create a natural sales roadmap. These are the customers and customer types that contribute the most to the business and likely similar customers purchasing similar products will do the same. Further, salespeople are likely connected and proficient at selling in these verticals, which will give the company the ability to acquire revenue at the lowest cost. Contribution analysis also enables implementation of an intelligent growth and pricing strategy, leveraging secondary and adjacent markets — those that are similar in scale, type, and characteristics to the business’s core. Those where the company has some market share but not currently a meaningful amount. If the opportunity is available, this is a good place to “reach.”


Optimizing Cost Structure

Contribution analysis provides insight into high cost (low contribution) processes, environments, and equipment. Operations can be segmented into low and high margin segments. Acting on the low margin segments mitigates revenue risk by choosing to cut those costs most directly associated with the least profitable customers. In many cases, this requires small changes that can be shared between the business and its customer — moving to a new material type, converting to a different piece of equipment, modifying a schedule. More often than not, customers will be willing to work with businesses, whether it’s temporary or permanent, and especially if the business shares a little bit of the savings with them!

This analysis can also identify what equipment and processes provide the highest benefit to the enterprise. As a result, this not only informs investment and capital expense schedules, it can save money on repairs, preventative maintenance (delayed or reduced services) and purchasing (supplies, equipment, materials, inks, and other substrates).

Take Action

Once businesses have undertaken this analysis, they can approach low or unprofitable customers armed with evidence to support their argument. The benefit of addressing low or unprofitable customers can be significant. For those customers that are contribution
margin negative, simply losing that customer will improve contribution margin. But, the range of actions or responses is wide and will depend on the market and the relationship status of customers. The simplest response to an unprofitable customer is to raise price, but without a strategy, that can lead to acrimony and customer churn. Taking the time to explain the situation and working with customers can lead to any number of positive
outcomes for both parties. This could result in switching to a different, less customized product, choosing a different production process, or a combination where price is increased moderately and components are adjusted. But it is impossible to have this conversation without the appropriate information. Having a keen knowledge of the company’s cost structure can ensure a positive outcome for the business.

Contribution analysis provides a clear view of the profit-making and profit-losing customers and elements of a business, and can be a valuable tool in times of volatility and uncertainty. 

References:
1LionTree Perspectives: Market & Sector Update. April 1, 2020.
2 mediapost.com/publications/article/350847/report-delineates-adprice-deflation-for-2020us.html
3 JP Morgan [Median % of analysts reporting revisions from 2/19/20 to 4/20/20]
4 mckinsey.com/business-functions/marketing-and-sales/our-insights/aglobal-view-of-how-consumer-behavior-is-changing-amid-covid-19. April 2020.
5 ILO Monitor: COVID-19 and the World of Work, Second Edition. April 7, 2020

Tim ThompsonTimothy Thompson is a managing director in the Publishing + Digital Media practice of FTI Consulting. Thompson has more than 15 years of consulting, project management, and mergers and acquisition advisory experience focusing on post-merger integration and change management in a variety of industries, including publishing, manufacturing, logistics and distribution, engineering and construction services, and telecommunications. 
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