Harvesting the Extra Profits Hiding in Your Product Mix

Harvesting the Extra Profits Hiding in Your Product Mix How product mix improvement programs can increase asset-intensive manufacturers cash contribution by 3+% of revenues Michael Rothschild, CEO March 1, 2013

Introduction It s no secret that four key factors: price, cost, volume, and productivity largely determine the cash flow, profit, and return on assets of any manufacturer. However, across a broad swath of manufacturing, a fifth factor product mix has an enormous impact on financial results, an impact that few manufacturers know how to fully exploit. From the cutting-edge world of semiconductors, electronic components, and printed circuit boards to long-established industrial sectors like steel, aluminum, paper, auto parts, chemicals, plastics, textiles, rubber, and glass experienced manufacturing executives know that small shifts in product mix can dramatically alter quarterly results, even when prices, costs, volume, and productivity remain virtually unchanged. Some companies have even been known to blame ugly quarters on the mix monster an unexpected shift in the product mix that ate up planned profits. Manufacturers who produce electronic components and industrial parts which are then assembled by their customers into final goods often produce well over 1000 distinct product varieties. In these Ultra High Product Variety companies, where the complexity and financial impact of product mix is greatest, it is shocking but true that virtually no company can precisely measure and control the profit swings caused by mix shifts. Why? Because traditional measurement methods, arising from conventional cost accounting systems, are not capable of rigorously isolating and quantifying the cash and profit impact of mix changes. Consequently, very few companies have a disciplined method for proactively managing their product portfolios to maximize cash, profit, and return on assets. Management teams shocked by a surprise attack of the mix monster shouldn t be. After all, as the old business adage goes, You can t manage what you don t measure. Frustrated by their lack of control over quarterly results, several leading global manufacturers have implemented innovative solutions that allow them to precisely measure and control product mix profitability. The financial benefits of these efforts vary by company and industry, but documented results show that a remarkable $50+ million in profit gain is achievable for every $1 billion in revenue (5 points, or better, of revenue). Contrary to the common belief of managers and executives, increasing cash flow and profit by proactively managing product mix is not a matter of selling more of the higher margin per unit products. Instead, it starts with gaining visibility into what truly drives profitability for the business, profit per time also known as Profit Velocity. Though used virtually everywhere to guide decision-making, the traditional metric of profit per unit (ton, gallon, piece, wafer, etc.) sends misleading signals to a company s sales, marketing and operations personnel. Time-based profit metrics, however, incorporate the realities of production into product profitability measures. Armed with Profit Velocity metrics, a manufacturer can pursue mix changes that typically increase operating income by 5+ points of top line revenue. Our strategy is to shift our product mix towards products with a higher profit per minute, so we can make significant improvements in cash flow and overall profitability. Jim Kutka, Vice President Commercial, U.S. Steel Corporation To improve mix, a management team must not only be able to define, isolate and measure the amount of cash and profit generated as a result of a specific mix shift, but management must also employ a system and process for continuously improving mix by focusing the entire organization on the products that generate the highest return for shareholders based on Profit Velocity metrics and not rely solely on margin per unit metrics. This whitepaper provides a foundation for understanding mix management and details key elements required to measure, control and maximize product mix profitability. Page 2 of 13

Defining Mix Gain Product mix is often loosely defined as the relative amount of each product sold in relation to the overall product portfolio. Mix is often reported as a percentage share of total unit volume or revenue. When comparing performance across two time periods at the product level, an increase in total cash can arise from only two potential sources: 1) an increase in unit volume, or 2) an increase in cash per unit (net price minus cost). If cost is held constant, then total Cash Gain can be driven only by an increase in price, Price Gain, or an increase in volume, Volume Gain. Given the massive amount of data thrown off by the thousands of product items in the product portfolio of an Ultra High Product Variety manufacturer, management tracks price changes by monitoring the average price for a group of similar products in a product family, rather than by attempting to understand price fluctuations for each individual product item. Using an average price consolidates the details into an understandable summary for management, but it hides relative volume changes among products within a product group and makes gains and losses caused by product mix shifts to be invisible in management reports. In short, by failing to break out the Mix Gain buried inside an average Price Gain, conventional cost accounting reports do not provide management with an accurate picture of what is actually driving change in cash and profit. FIGURE 1. Page 3 of 13

Analysis A few simple examples using single and multi-product companies will show how the problem of isolating mix gain can be solved. One-Product Company For a company with a single product, there is no opportunity to generate more cash from one time period to the next through product mix changes. The only way a single product company can change total cash contribution is by changing price and/or changing volume. Assuming the Material Cost of the product does not change, then: Price Change x Volume Change = Cash Change FIGURE 2. In this example, an incremental $25 in price is multiplied by the volume sold in the current period to arrive at $27,500 in cash gain due to price. Similarly, the incremental volume of 100 units is multiplied by the cash contribution per unit during the baseline period (price minus cost equals $200 per unit) to yield $20,000 in cash gain from incremental volume. The $200 cash contribution per unit figure in the baseline period is used, since the increase in cash per unit for the extra volume was already accounted for in the cash gain attributed to price. FIGURE 3. Page 4 of 13

Two-Product Company Expanding the analysis to two products, this company has the opportunity to generate more cash from one period to the next through a third option: a shift in product mix. In fact, when a mix change occurs it can increase total cash contribution without raising any individual product prices or increasing total volume. In certain cases, individual prices and unit volume could actually decline, if an offsetting mix gain generates enough extra cash to cause an increase in total cash contribution. In the following example, the prices for Products A and B were not changed from the Baseline Period to the Current Period. Therefore, it would be misleading to attribute any incremental cash gain to Price Gain. Similarly, since the total volume of the two products did not increase, cash gain should not be attributed to a Volume Gain. Logic allows only one conclusion. The only possible source of the $20,000 in extra cash is a shift in product mix, or Mix Gain. FIGURE 4. In this example, the weighted average price of the products sold increased from $540 to $560 even though the actual product prices of both products remained unchanged. The traditional cost accounting approach has been to label such a Mix Gain as if it were a Price Gain. By relying on the change in average prices from one period to the next rather than doing the calculations to analyze the far more detailed shifts in the mix and actual product prices, traditional cost accounting methods of variance analysis fail to reveal the profit generating power of product mix management. Page 5 of 13

A final example expands the analysis of the two product company with incremental changes to both product prices and total unit volume. Using traditional variance analysis methods, the total increase in cash is split between an average price increase for the two products, and a total volume increase. A complete examination of price, however, reveals that a shift in product mix yields the most significant contribution to the total cash gain. FIGURE 5. By isolating actual price changes at the individual product level, the traditional metric of Price Gain can be broken down into cash gain from individual product price changes versus cash gain from a shift in mix. Since price gain is based on changes in specific product prices, $20 per unit for both products, $22,000 of gain can be attributed to price ($20 x 1100 units = $22,000). Incremental cash from volume is calculated by multiplying the cash contribution per unit during the Baseline Period by the number of incremental units in the Current Period ($240/unit x 100 units). Page 6 of 13

FIGURE 6. The $26,000 in Mix Gain arises from two sources. First, there was a shift in 200 units of the original volume from Product A to Product B, providing a net increase in cash of $20,000 (200 units x $100/unit). The second piece of Mix Gain comes from Product B as its cash per unit value of $300 exceeds the average cash per unit by $60, generating $6,000 more in Mix Gain ($300 - $240 = $60 x 100 = $6,000). If the incremental volume had been proportionately split between the two products, preserving the average unit cash value, then the cash from the new units would have been caused purely by Volume Gain. Multiple-Product Company: The Real World In the simple world of a two-product company, management s inability to isolate, quantify, and manage Mix Gain is not threatening. As product prices and volumes change, the back of an envelope offers more than enough space to do the math, quantify the value of Mix Gain, and take appropriate action. But for Ultra High Product Variety companies, the challenge of controlling Mix Gain is huge but so is the profit upside. Without sophisticated information tools, even with today s computing power, the data management and computational challenge of mastering Mix Gain is overwhelming. For this reason, most business analysts working inside manufacturing firms have continued to rely upon the traditional cost accounting approach of aggregating products into product groups, and reporting the impact of a mix change on average prices for each product group as if it were a Price Gain. Even if companies can accurately quantify the impact of a product mix shift, that is not enough to ensure profit improvement. Traditional product profitability measures must also be updated frequently to enable management to proactively drive mix changes to drive up total profit even when many product prices are falling. This is where Profit Velocity comes into play. To understand how to achieve a more profitable mix, an Ultra High Product Variety manufacturer needs to know precisely which products, customers, and markets have the greatest impact on profits. Traditional margin per unit analysis cannot provide the information needed to answer these questions and will, in fact, frustrate profit improvement efforts by producing misleading reports. Page 7 of 13

Margin Myths and the Missing Link: Profit Velocity Ultra High Product Variety companies with broad product lines have historically generated far less cash than they are capable of producing. The inability of large companies with very broad product lines to correctly track and control Mix Gain as an explicit, measured Key Performance Indicator (KPI) plays a significant role in this problem of inadequate returns on shareholder capital. An ongoing effort to generate more cash by optimizing the product mix cannot be pursued without crystal clear metrics that accurately reflect profitability and rigorously quantify Mix Gain. Until recently, however, the information tools required to measure and control Mix Gain have not been available. The primary obstacle preventing Ultra High Product Variety manufacturers from harvesting far more of their true profit potential is the widely held belief that product unit margins accurately reflect the relative profitability of the various products in a product portfolio. The common strategy throughout manufacturing businesses worldwide is to use margin per unit data to guide product portfolio decisionmaking at all levels of the organization. Underlying this approach is the assumption that ranking products by margin per unit will ultimately translate into more overall profit. This is a myth an incredibly costly myth. Unit margin in excess of variable cost, contributes the dollars to the pool of funds that drives the numerator in return on assets (ROA). As we saw earlier, each unit of Product B, whose margin was higher than that of Product A, contributed more dollars to the profit pool. But does this mean that Product B also generates a higher ROA than Product A? Not necessarily. What if Product A is produced twice as fast as Product B on the same production line? Judging products based on margin per unit data alone assumes that units of each product are equivalent (a ton is a ton) and the primary difference is their relative margin dollars. In fact, margin per unit ignores a fundamental product attribute that significantly impacts that product s dollar value...its production velocity. This product attribute is the speed at which the product is produced, its unit velocity or flow rate. In the steel industry, for example, it takes more time on the mill to roll thin gauge steel sheet than thick gauge sheet. When the mill s capacity is taken as a whole, the variation in flow rates amongst the various thicknesses will ultimately determine how much steel and how much cash the mill produces in a given period of time. The mill itself does not care what gauge it is running at any particular time; it is capable of producing a wide range of gauges. For this reason, the cost of the mill s capacity is the same regardless of what product is being run. The profit difference of the products, from the perspective of the assets, is the result of both cash per unit and the unit flow rate. Together, these determine the Profit Velocity of each product, its true dollar value. Unless both margin and velocity are taken together, the profit analysis will be misleading. This is the core weakness of traditional cost accounting. FIGURE 7. Returning to an earlier example, Product A has a margin of $200 per unit versus Product B s $300 per unit. Product A s production velocity flow rate, however, is twice that of Product B. As a result, Product Page 8 of 13

A generates cash 33% faster than Product B. For the same amount of capacity, say 100 minutes, the machinery will create $160,000 of cash running Product A, while creating just $120,000 running Product B. Despite Product B s higher margin per unit, it is less profitable when the capabilities of the manufacturing assets are included in the valuation. FIGURE 8. The economic implications of different production speeds is enormous. With respect to Return on Assets, the higher Profit Velocity products generate more dollars for a given amount of production capacity and yield a higher ROA. In short, it is the combination of unit margin and unit velocity that generates the financial results that shareholders demand: Profit Velocity, earnings, and ultimately ROA. In order to create revenue and profit, manufacturers transform raw materials by use of their fixed assets into saleable products. It is the economic efficiency of that transformation which determines the company s long-term success. The companies that sell and market the products that generate the highest cash and profit per asset hour will generate the highest earnings, ROA, and ultimately the highest return for shareholders. To generate higher cash and profit per hour from the product mix, then, companies must know precisely how to shift their mix toward higher Profit Velocity products. Using Profit Velocity to Guide a Shift in Product Mix In the conceptual examples shown earlier, the one and two product companies have few options when trying to maximize return on assets. But Ultra High Product Variety manufacturers have lots of options if they know how to make the most of them. While the potential value of each minute of capacity on a given production line is the same, its actual value depends on the Profit Velocity of the product being run. Therefore, the total value of the capacity used depends on the blend of products run and the associated mix of product Profit Velocities. Maximizing the return on assets comes down to maximizing the combination of capacity utilization and the overall rate of Profit Velocity. Customers, prices, and volumes will always be the prime drivers in determining the value of the total mix. But consistently positive changes in the mix will only come about if marketing and sales is able to rely on a more revealing metric to rank the most to least profitable choices. Instead of relying solely on margin per unit (dollars per ton, dollars per wafer, etc.) to guide decisions, dollars per minute of production time at a critical process step becomes the key metric in understanding how to boost total profits. Implementing a Profit Velocity approach to setting sales priorities reveals previously hidden opportunities. Hard data from Ultra High Product Variety manufacturers, shows that products reported Page 9 of 13

by traditional cost accounting systems to have nearly identical unit margins often yield widely different Profit Velocities and therefore widely divergent rates of return on assets. How could this be? Because margin per unit actually measures return on material cost, while profit per time, or Profit Velocity, measures return on assets. In short, the standard practice of management teams of relying on margin per unit to set priorities, when their shareholders want a higher return on assets, amounts to a fundamental disconnect between daily operational practice and strategic financial goals. In the following example, a product portfolio of a major chemicals producer illustrates how margin data can mislead management by obscuring the actual profitability of an entire product line. Standard margin is plotted on the vertical axis. Each product s Profit Velocity is used to calculate ROA, which is plotted on the horizontal axis. Each bubble represents an individual product and is scaled in size to represent the total amount of cash generated by an individual product during the period covered. The results shown here are typical for Ultra High Product Variety manufacturers: Along the vertical axis, products are narrowly clustered around a particular margin level. This results from a unit-cost-plus-target margin pricing model where management s primary focus is on controlling margin. In this case, a 10% margin was the company s floor pricing for selling into the automotive segment. Along the horizontal axis, product profitability is spread across a broad range of ROA values. Like virtually all Ultra High Product Variety manufacturers, this manufacturer had no ability to integrate margin and production speed data to monitor and control the ROA of the product mix. If the manufacturer attempts to raise overall profitability by emphasizing the sales of its higher margin products far and away the most common approach to boosting profitability the narrow range of margins across the product line, not to mention competition, provides few opportunities for significant gain. Even worse, by following that policy, the manufacturer would typically neglect products with low margin that also have very high ROAs. FIGURE 9. Page 10 of 13

Harvesting the Profit Following the conventional cost accounting driven approach of trying to raise overall margins by shifting the mix toward higher margin products often exaggerates conflicts between the sales and production teams. The highest margin products are often the slowest and most difficult to make. At the same time, there may be some low margin, high Profit Velocity products that actually generate high ROA that are neglected. Instead of running into these same unresolvable debates again and again, management teams should enhance their profit measurement systems to be able to monitor and control the Profit Velocity generated by each product, each customer, and each machine, to equip the managers with information to understand how local decisions in each part of the organization impact the overall production rate of profit per minute, and implement programs that increase earnings and ROA by shifting the product mix toward a higher overall average Profit Velocity (and higher ROA). Ultra High Product Variety manufacturers in a variety of industries around the world have found new ways harvest the benefits of mix gain by proactively managing Profit Velocity: Aggressively grow volume and market share in products that generate a high Profit Velocity, even if they generate below average margin per unit (the Hidden Winner strategy) Equip the marketing organization with the ability to measure and adjust the customer order mix in ways that raise dollars per minute for fixed total volume orders. Manage production line loading to help raise the average Profit Velocity. Substitute or eliminate low Profit Velocity products that chew up production capacity but offer limited market opportunity. Use Mix Gain as a hard metric to quantify the success of product mix improvement initiatives. Significant profit improvement awaits companies that learn to use Profit Velocity to manage their product mix. Ultra High Product Variety manufacturers who have implemented such solutions have documented profit gain of $50+ million per $1 billion in revenue. Page 11 of 13

The chart below illustrates the cumulative cash gain for a manufacturer that implemented a Profit Velocity system to help drive their product mix strategy. The chart highlights the value of isolating, controlling, and improving product mix by increasing overall Profit Velocity. In this case, more than $75 million of additional cash was generated over the first 12 month period (approximately 4% of revenue). FIGURE 10. Executives responsible for profitability at manufacturers with broad product lines, who are truly committed to gaining tight control over their bottom line results, should explore the implementation of tools and methods that will allow their organizations to intelligently manage the product mix and tame the mix monster. Any company with more than a thousand products has plenty of opportunities to alter its product mix in ways that would significantly raise profits without disrupting the customer base. Identifying such opportunities and measuring the cash value of those actions is the challenge. Manufacturers, who have attempted to manage their mix with spreadsheets, or by simply promoting higher margin products, commonly fail. Simply put, traditional methods do not have what it takes to properly manage the data and calculations required to manage mix, nor do they provide easy-to-use information tools needed by the various departments to turn mix management into specific, profit-enhancing action steps. Page 12 of 13

Contact: Based in San Francisco, with offices in key manufacturing centers worldwide, Profit Velocity Solutions offers PV Accelerator, a breakthrough in the power and sophistication of business analysis and planning tools for manufacturers. Available only through its global network of consulting firm alliance partners, PV Accelerator reveals new profit improvement insights to drive continuous profit improvement. By supplementing traditional profit-perproduct-unit margin analysis with the previously unavailable missing metric of profit-per-machine-hour, high-productvariety manufacturers can tap previously hidden opportunities to accelerate cash flow and achieve major gains in annual profit and ROA. San Francisco New York One Market Street 245 Park Avenue 36 th Floor 24 th Floor San Francisco, CA 94105 New York, NY 10167 Tel: 1.415.456.1000 Info@profitvelocitysolutions.com Chicago Singapore One South Dearborn Street One Raffles Place Suite 2100 Level 24 Chicago, IL 60603 Singapore 048616 Shanghai Taiwan 9/F Eco City Shin Kong Manhattan Bldg 1788 Nanjing West Rd 14F, Section 5, No. 8 Jing an District Xin Yi Road Shanghai 200040, China 110 Taipei, Taiwan For more information, contact us at http://www.profitvelocitysolutions.com. Page 13 of 13